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June 21, 2005

When the Big Boys Buy
by Doug Wakefield

Imagine owning a stock that you find out Warren Buffet is about to buy or learning that the property next to your raw land had just been purchased for a billion dollar development. You'd be more than a little excited and rightly so. We know that the investment actions of large investors, who going forward, I'll call the big boys, have a major impact on our much smaller investments. In this article we will look at the ultimate big boy, who not only has the power to make huge purchase, but also can print the money needed to do so.

Let's start with the Federal Reserve Bank of New York's description of open market operations, one of the powers of the Federal Reserve. The Fed can "buy or sell U.S. Government Securities in the open, or secondary, market as one of its most flexible means of carrying out its objectives."¹

So, if we know that the Federal Reserve can buy or sell U.S. Government Securities then the most logical next question would be, how much do they trade? According to the Federal Reserve Bank of New York's, in 2003 they traded $454 billion through their 22 primary dealers.²

While it goes without saying that the Federal Reserve is a "big boy", the record regarding their sizable buys and sells of U.S. government bonds, makes it increasingly clear that the Federal Reserve is not a heady bunch of uninterested, laizzes-fair economist relegated to studying reams of economic statistics. They are also a major player who continuously exerts a substantial influence on our bond markets, and therefore our markets as a whole.

So let's look at their historical record.

Having been established in 1913, in the 1920's the Federal Reserve was spreading their newfound wings. Member bank reserves received the windfall of this newly created credit in three major surges of 1922, 1924, and 1927. The Federal Reserve took a major role in swelling the money supply through their purchase of U.S. government bonds. That is to say the Fed tripled its stock of U.S. government securities from $193 million at the end of October 1921 to $603 million by the end of May 1922. From October 1923 to June 1924 there was another buying binge that topped $339 million. In 1927 alone over $445 million in U.S. government securities were purchased.³

Before we proceed, we would do well to revisit what Fed purchases do to the amount of credit in the overall banking system.

The Federal Open Market Operations are conducted at the New York Fed and are responsible for the important function of purchasing and selling government securities in the open market. In order to increase the amount of credit in the banking system, the Federal Reserve buys government securities, and when the Fed wants to decrease the amount of credit, it sells government securities, thereby absorbing excess liquidity from the banking sector. When the Fed buys government debt it pays for these bonds by increasing the banks reserve account at the Fed. It's just an electronic transaction or a book entry, if you will. Then the banks have more excess reserves, which they can use to lend money to their customers. These loans thereby increase the money supply.⁴

The speed of the money growth then picks up pace since our banking system is based on a fractional reserve standard. That is, reserves have a multiplier effect. If the reserve requirement is 10% (technically, today it is less than 1%), then for every dollar increase in reserves, the bank can loan up to nine dollars to the public. These deposits are used for making additional loans to businesses and individuals or for investments.

The example of the 1920s coupled with the multiplier effect of fractional reserve banking may lead some to believe that we can print unlimited amounts of new money and expand the nation's debt limit indefinitely. Is this the case?

As you ponder this question, consider Fed Reserve Governor Bernanke's comments below:

In his speech given on in November 2002 entitled, "Deflation: Making Sure "It" Doesn't Happen Here", Dr. Bernanke reiterates the Feds tendency toward open market operations. "Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate and enforcing that target by buying and selling securities in open capital markets." This comment fits with everything that we have discussed so far, however the next one is somewhat alarming. "Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."⁵ (Italics mine)

Before commenting further on our current monetary policy, let's look back to the late 20's and early 30's and see what happened when the expansive monetary policies of the 1920's were coming to a close. After the Crash of '29, George Harrison, head of the Federal Reserve Bank of New York, stood ready to purchase U.S. government bonds to inflate the money supply in order to bolster the markets. "Gentlemen, I am ready to provide the reserve funds that may be needed." He certainly kept his word. In just two months the Federal Reserve increased their bond holdings by $375 million.⁶ Plainly, they intended to fight the forces of deflation. That fighting spirit continued throughout 1930 to 1933 as the amount of U.S. government securities the Fed held ballooned from $485 million to $2,432 million ($2.4 billion) - a 401% increase in 4 years.⁷

What was the effect? As you answer, consider the graph of Dow Jones Industrials in comparison with the prior noted rate of Fed securities purchases over the same time period.

Some will say, "But that was then; things are different today."

Fair enough. Let us look at a more contemporary example. The Bank of Japan has been experiencing a deflationary environment since 1989. From that peak, the value of Japanese commercial real estate is down more than 80 percent, while their stock market has lost over 70 percent.

Dr. Richard Koo spent time at the Federal Reserve in the 1970's and today is the chief economist of Nomura Securities, one of the largest brokerage firms in Japan. In his book, Balance Sheet Recession, he discusses the problems of the monetarist views espoused by Dr. Bernanke. "Many commentators who do not know how monetary policy works assume that if the Bank of Japan supplies ample liquidity (accomplished through purchasing U.S. government bonds, printing new money, and cutting interesting rates) the economy will improve because additional liquidity will make the private sector 'rich'. Nothing is further from the truth." (Parenthetical explanation mine)

Koo goes on to illustrate why an unlimited supply of money is not likely to work.

"Let us assume that the Bank of Japan one day mailed Y1 million in new bank notes to every Japanese citizen. The person who finds Y1 million in his mailbox will probably feel very happy at that moment, because he thinks he is richer by that amount. The problem is what happens next.

When the person finds out that every other Japanese person has also received Y1 million, he would turn pale. Because at that instant he would realize that what he can buy with that amount has just shrunk dramatically.

Like air, the trust people have in the Bank of Japan is so complete that no one is really conscious of it. However, if the Bank of Japan should take such a reckless action as to send everyone in the country Y1 million, the people's trust in the central bank will be lost instantly."¹⁰

Now, we both agree that Dr. Bernanke is not stating that we should send everyone a million dollars, though his reference to the printing press makes one wonder. However, the Federal Reserve's purchase of U.S. government securities of late has substantially increased the U.S. banking systems reserves, inflating the number of dollars in the system while deflating the value of those dollars. I'm forced to ask myself, is this not fundamentally the same thing?

In closing, as I consider the effects of flawed economic theory, rational thinking compels me to address a major fallacy in financial theory.

In modern finance we are told that changes in security prices are random and that these prices are rationally and efficiently determined. This line of thinking is at the core of the dangerous assumptions that go hand in hand with indexing, passive investing, and the stocks for the long run mindset. If there is anything market history continues to teach us, it is that people do not always make rational decisions and that the effect of those collective decisions is anything but random.

When the big boys act, we are affected. My concern is that Fed monetary policy will have an effect, but not the one intended. Rather than averting an economic downturn, the Fed actions may have exacerbated the problem while lulling the public to sleep. Bernanke himself states, "I should emphasize that my comments on this topic are necessarily speculative, as the modern Federal Reserve has never faced this situation nor has it pre-committed itself formally to any specific course of action should deflation arise."¹¹

Never has there been a greater need to exercise critical thinking and gain a historical perspective of the markets. Our financial futures hang in the balance.

Sources:
1. http://www.ny.frb.org/aboutthefed/fedpoint/fed32.html
2. http://www.ny.frb.org/aboutthefed/fedpoint/fed02.html
3. America's Great Depression by Dr. Murray Rothbard, pages 133,114,115
4. Dr. Mark Thornton, Sr. Faculty, Ludwig Von Mises Institute
5. http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
6. A History of Money and Banking in the United States, Dr. Murray Rothbard, pg 274-275
7. "Does a Falling Money Stock Cause an Economic Depression?" April 16, 2003, Dr. Frank Shostak, Foresight Research Solutions LLC, New York, NY
8. http://stockcharts.com/charts/historical/djia1900.html
9. http://www.mises.org/story/1211
10. A Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications by Dr. Richard Koo, pgs 13, 54-56
11. http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Doug Wakefield,
President
Best Minds Inc., A Registered Investment Advisor

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.

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