David Einhorn on the Federal Reserve's Reckless Risks

I was at the Buttonwood Gathering in New York this week, a wonderful conference put on by The Economist featuring some of the greatest minds in business and finance.

Legendary investor David Einhorn sat in for a short panel, sharing his views on the Federal Reserve's quantitative-easing policies over the last four years. Below is a summary of my notes.

Einhorn disagrees with the Fed's most recent quantitative easing strategies, and isn't shy about it. He makes an analogy. One jelly doughnut is a great snack. Two is indulging. Six is an eating disorder. Twelve is a fraternity hazing. You can have far too much of a good thing; that's where we are now with monetary policy.

Einhorn said you have to consider the base assumption about a policy like QE and form your opinions from there. When everyone agrees on the same thing, they act reflexively. Most seem to assume that the economy will improve if we cut interest rates indefinitely. Usually, that is the case. If interest rates are 10% and you cut them to 6%, growth will likely increase. But we're in a far different situation today, with interest rates already at zero. Einhorn thinks we've reached a point where incremental monetary accommodation not only suffers diminishing returns, but becomes a drag on growth.

There are two big reasons for that. One, QE has pushed up commodity prices like food and oil, costing people money they otherwise could have spent on goods.

Then there's the larger issue of super-low interest rates depriving households of adequate returns on savings. One of the theories behind QE is that low interest rates will entice people to spend money instead of save it. But Einhorn says it can, in fact, do the opposite. If you earn a negligible rate of return, you have to save much more for retirement than you otherwise would if your assets earned a higher return. That's causing a hording event and driving consumption down, Einhorn says.

It's hard for economists to understand this, because their models have limited sample sets and don't look at what people are actually doing. No one is choosing not buy a home right now because interest rates are too high. No company is putting off building a new factory because borrowing costs are excessive. On the other hand, what are the risks of QE? We have created enormous tail risks, Einhorn says. That scares people and drives up risk premiums while driving down valuation multiples.

This will only get worse as time goes on. We are still in a zone where most people likely think super-low interest rates will be temporary. But if low rates continue for another three or four years, expectations will change. If savers come to believe that they will never again earn an adequate return on savings, the hoarding will grow on a multiplied basis, Einhorn says.

A questioner pointed out that there's another side to the story: Savers may not be earning a high interest rate or divided yield, but asset prices have been boosted by QE, increasing wealth. Ben Bernanke has mentioned this before. Einhorn doesn't buy it. He's not aware of any study showing that the asset inflation of QE is enough to offset the lost income from lower interest rates. He suspects that if someone studied the issue, they'd come to the opposite conclusion of Bernanke. And we've just gone through 15 years of trying to boost incomes by inflating asset bubbles -- and each has produced worse outcomes once the bubbles unwind. Einhorn asks: "Why would we want to keep doing that?


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  • Report this Comment On October 26, 2012, at 7:26 PM, Bert31 wrote:

    What do you think would happen if the Fed announced it will allow interest rates to rise? Wouldn't there be a flurry of spending to take advantage of the low interst rates that are going to rise shortly, which would in lead to economic growth?

  • Report this Comment On October 27, 2012, at 3:51 PM, Cruiser55N wrote:

    When people make choices based on misleading information like manipulated market prices (interest rates) their choices will prove unsound ultimately and painful adjustment required, much like the substance abuser who distorts, rather than manages, their mood artificially. The Feds behavior will have consequences and given the extreme nature of their actions those consequences will ultimately be extreme.

  • Report this Comment On October 28, 2012, at 5:27 PM, Darwood11 wrote:

    I agree with Einhorn. The "rising price of assets" is only a reasonable argument if one can sell those assets. Perhaps we should break off a brick or two of our homes and sell those "assets" in a few years?

    The coming "fiscal cliff" will raise dividend tax rates and will further screw investors and retirees attempting to eke out some way to supplement social security.

    Those retirees were pushed into purchasing riskier assets by deliberate policy of the Fed. The government will collect and the poor retirees will be left holding the bag of those "risky assets" with even less to show for taking these risks.

    There's nothing printable I can say about this and the politicians who caused and continue this problem.

    Except this "Bring back the guillotine."

  • Report this Comment On October 29, 2012, at 7:06 PM, KMAFool wrote:

    This is spot on and I firmly believe the policy has become a drag on growth.

    Morgan - have you heard if ALL of the Fed Governors agree with current Fed policy? I did not no if there were any strong voices against zero percent rates on the Board.

  • Report this Comment On October 30, 2012, at 11:27 AM, whereaminow wrote:

    ---> It's hard for economists to understand this, because their models have limited sample sets and don't look at what people are actually doing. <----

    That's only part of the problem. Their models are based upon the assumption that economic science consists of mathematical CONSTANTS. There are no constants in economic science such as there are in the hard sciences.

    Hence, these models are built upon sheer lunacy. It does not matter at all how much data they accumulate. They will never establish a causal relationship between monetary policy and economic growth.

    Think about that for just a moment. It means we have an entire profession of well-meaning morons playing doctor with our economy.

    On the flip side of that, the Austrian School of Economics has recognized this problem (following from a classical tradition that dates back several hundred years) and has an excellent track record of predicting and explaining the crises we face. They use a causal-realist model that stresses logical deduction from the action axiom.

    One day, I hope Motley Fool will give this school serious consideration. It has made many people, like myself, a great deal of money.

    David in Liberty

  • Report this Comment On October 30, 2012, at 4:50 PM, slpmn wrote:

    <If you earn a negligible rate of return, you have to save much more for retirement than you otherwise would if your assets earned a higher return. That's causing a hording event and driving consumption down, Einhorn says.>

    That bit above takes the concept of not earning a return to the next level. Yeah, it sucks savers don't get a return, but economists can say, "So what, that's the point. Don't save, spend!" But if their policy really just encourages people to save more, well that's entirely different because it means it's counterproductive. They (the Fed economists) need to put that in their pipes and puff on it a while.

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