Bernanke’s ‘Tragic Flaw’ Feeds Fed-Fueled Bubble: Fed Filmmaker

February 06, 2014 at 04:23 AM

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Jim Bruce, a Hollywood assistant film editor by trade with movies like "The Incredible Hulk" and "X-Men: The Last Stand" on his resume, knew not a lick about investing when he opened an online TD Ameritrade account in 1998.

By 2005, he'd read up on market bubbles and was observing chaos in the housing market. His conclusion: a mortgage debacle was soon to come. He launched a financial newsletter to warn family and friends.

In 2007, he began shorting bank and builder stocks. With the money he made in the meltdown, and other funding, he wrote, produced and directed a documentary film: "Money for Nothing: Inside the Federal Reserve," narrated by actor Liev Schreiber.

Bruce's mission is to increase public awareness of the repercussions of the Fed's policies, especially its role in creating the global financial crisis.

The critical doc features interviews with a dozen current and former Fed officials, including new chairwoman Janet Yellen; Paul Volcker, chairman from 1979 to '87; and Alice Rivlin, vice chairwoman, 1996-1999. Also interviewed are leading economists and investors like Jeremy Grantham and Gary Shilling.

The film, which opened last September, continues to play in some theatres around the country. DVDs can be purchased through www.moneyfornothingthemovie.org

ThinkAdvisor talked with Bruce, 39, about the film in which he seeks to demystify, if not chastise, the Federal Reserve and by which to start a movement to hold it more accountable.

ThinkAdvisor: What's in your portfolio?

Jim Bruce: I'm very defensive and once again, very interested in the short side. Recently, I bought some longer-term bonds because the irony of quantitative easing is that it may prove to be deflationary — just like the housing bubble was very deflationary because it created bad debt. In the short run, interest rates could fall as the stock market comes back to earth. So I'm eyeing the short side, interested in longer-term U.S. bonds and cash, with some gold and natural resources as a hedge. I'm not interested in the financial sector at these prices.

What sort of advice do you think financial advisors should be giving to clients nowadays?

That's the fascinating part. People want to know what to do with their money. Fed policy has created a very difficult position for advisors and investors. It put a gun to people's heads: You'd better take risks or you're going to miss out. But now prices have risen to the point where you may miss out if you do take risks. So it's a great time for buy-and-hold investors to take some risk off the table and diversify.

Why now?

You definitely need to be prepared for the end of the current boom. Prices have been artificially propped up. Are you ready for a 20% or 30% decline in the stock market? On the fixed income side, there's a possibility that long-term rates haven't hit their low yet. Clients who only recently have been willing to take on more equity exposure are most vulnerable to a fall. It's a good time to be cautious. What's Ben Bernanke's legacy after being Fed chairman for eight years? In 2009, he was Time Magazine's "Person of the Year" — "the most powerful nerd on the planet."

My concern is that his legacy will follow the trajectory of Alan Greenspan's: He headed out a hero for sort of saving the day after the tech bubble and leaving the stock market higher. I'm worried that a year or two from now people will be rewriting Bernanke's legacy.

What was Bernanke's "tragic flaw" as Fed head?

He was an academic who had no background in financial markets. He didn't understand them or the people who worked in that field.

What will happen in the wake of his leaving?

We have a dysfunctional system. We aren't doing a good job of regulating, and we're not letting banks go out of business. With endless 0% interest rates and QE, we're getting closer and closer to what happened in Japan. We're following in their footsteps by doing what they did, but all the while saying we didn't want to be like them. They pumped money into a somewhat zombie system, where households aren't in a position to take on a lot more debt and banks don't really want to lend a lot.

Like Bernanke, new Fed chair Janet Yellen has an academic background. Will she tackle things differently from Bernanke?

She's the same: very smart, very well versed in all the ideas of modern economics but has no background in banking or financial markets. So she looks at things from an academic perspective. She said that she doesn't see any signs of trouble about stock valuations. I'm concerned! She's not someone who's going to be savvy and see risk in advance. Unfortunately, she will follow in that tradition of having an impeccable resume and theoretical perspective but not a thorough understanding of all the ramifications of the Fed's own policies in trying to influence markets.

How would you sum up the state of the Federal Reserve right now?

The Fed has been playing a losing hand in a poker game since the late 90s, when they decided not to resist the tech bubble. They doubled down with the housing bubble. They've put all their chips on asset prices going up — but now what do they do? If asset prices soften and begin to turn, it's going to be very hard for the Fed to live up to the promises it's made. Its policies have created artificial demand, and that's been sending a false signal to the economy. It doesn't realize how the real world is going to operate under their policies. On what do you base that statement?

The housing bubble and the moves in prices were deliberate and desirable effects of Fed policy. They knew that holding interest rates at 1% was stimulating interest-rate-sensitive sections of finance and real estate. From 2004 to 2006, they knew things had gotten a bit out of hand but thought that markets would rationally see them slowly raising interest rates and people would move away from taking risk, that the banks would manage their balance sheets and could smoothly coordinate this move away from risky behavior. But the opposite happened — everyone levered more, took on more risk and went deeper into mortgage securitization.

Do you see what's happening in today's economy and markets as a repeat of what occurred soon before the final crisis?

Yes. Once again, the Fed, through great effort on Bernanke's part, has got us back to a place where people are overpaying for risk, whether it's stocks or overpriced higher yield bonds. There's a lot of bad commercial real estate lending. In many areas, once again people are overpaying for houses. The Fed thinks of that as a good thing. But it's hurting anybody that's entering the market and keeping first-time buyers out. The Fed has brought us back to a place where it's very risky for the individual investor. I worry about falling asset prices and the transition to Janet Yellen. Markets are already losing the psychological support of QE: "The Fed's got my back."

That's lots of bad news!

Well, we're doing the same thing but expecting different results. To the extent that the Fed learned a lesson from last time, they may have to learn it again. Lower interest rates and QE have pushed stock and housing prices up, and there is a very real risk that the same thing will happen. Prices will fall back to where they would have been otherwise, which could easily be enough to put us into a deep recession. What's different now, though, is that there isn't room to respond to a crisis in the same way they did before, when the government was running just a small deficit.

What's your take on Bernanke's famed predecessor, Alan Greenspan, Fed chairman from 1987-2006?

The hubris that came with Greenspan and carried forward and expanded by Bernanke brought the idea that the Fed can game the system a little. But I worry that we'll realize, once again, that it can't. Greenspan knew someone was going to take a hit, but he didn't think it would be Citigroup; he thought it would be the people who bought Citigroup's tranches. In theory, mortgaged-backed securities would enable risk to be disbursed and sold off to investors. But banks had a hard time selling and got stuck with them. So instead of spreading risk, securitization concentrated risk. Reality was certainly different from theory!

Greenspan had assumed that the largest financial firms knew how to manage their risk, but the Fed had set off a race to the bottom. The banks were trying to make their earnings every quarter and taking tons of risk. The Fed just was not paying attention to what was happening around them.

But Greenspan said it's not possible to see a bubble in advance. Hmmm…

Back in 1996, at a Fed meeting, he said, "I understand that we have a stock market bubble problem." He spotted it so far in advance. But he also saw how hard it would be to resist it and didn't want to be the unpopular guy by raising interest rates. Three years later, when things were so much worse and more obvious, he gave a speech saying, 'We can't see bubbles in advance"; so we should just clean up afterwards.

And Bernanke took that view also?

He published a paper around that time saying that the best thing for central banks to do with bubbles is to clean up afterwards. So even though he wasn't at the Fed yet, he was a big part of the academic idea that you don't want to take the punch bowl away in the middle of a stock market bubble. Therefore, to some degree, this was an idea that Bernanke had introduced; and it became what people thought. Now they think a little differently — but not that differently. However, if you don't resist bubbles, you're courting disaster.

What was Janet Yellen's viewpoint on "cleaning up afterwards"?

From 2001-2003, she thought that it was a reasonable view. But when I interviewed her for the film, off-camera she told me that after the housing bubble collapse in 2007, it no longer seemed reasonable to anybody in central banking. Still, the problem is that Yellen doesn't think you should raise interest rates to fight a bubble. But if you use interest rates to help create one, why not use them to help diffuse one?

What does she believe should be done instead?

She thinks the Fed should use its regulatory powers. That might have done a lot to slow down the awful mortgage unwinding; but regulators have to be proactive, and history shows that the central bank is unlikely to be.

You point out in the film that Bernanke thought that putting money into the broken financial system — via QE — would trickle down into the economy. What has actually happened?

Bernanke kept saying that stimulating the stock market and housing prices would lead to economic growth. But 100% of the economic gains in the last five years have gone to the top 10%. Most of the money the Fed has poured into QE has wound up in small profits the banks make buying and selling things from the Fed. It's not really creating economic growth. Greenspan said, "There is zero probability of a U.S. default because we can always print money" to pay our debts. That apparently is the M.O.

Yes, borrowing and printing is what we have decided to rely on in order to prop up the economy. I don't think that's going to work long term. Instead of pursuing this game of the central bank's printing money, we should be rethinking our economy and trying to figure out how we can create more sustainable growth. We shouldn't be encouraging more investment in finance and real estate. We should be encouraging investments in new technology and education — things that will make people better off in the longer run. It's absolutely true: the U.S. can't default as long as it's borrowing dollars, but inflation is another way of defaulting.

It seems that, because Americans don't vote for Fed chairman, we're just victims of Fed policy.

Bernanke probably would have been voted out of office. But the Fed is not subject to political pressure, and he was protected. The Fed is protected from accountability. Congress is theoretically in charge of holding the Fed accountable; but not many members have even a basic understanding of the functions of the Fed and aren't qualified to oversee it.

Can we do anything to protect ourselves against failed Fed policy?

There is no way to buy a put against the failure of quantitative easing. And the stakes have got bigger. You could argue that the Fed isn't making objective decisions because they have a bias toward overstimulating. They have been very late to slow down a boom and very early to get one started. The Fed wants to be seen as helping the economy, not [bringing] it down. So they're very happy to lower interest rates very aggressively and very reluctant to raise them.

You say in the film that the Fed must find a way to "break the cycle of booms and bust." But don't booms and busts occur naturally?

Yes. But for the last 15 years, stocks and housing prices have been overpriced, and the Fed is stimulating them — basically creating bigger booms, which inevitably lead to bigger busts. Since the late 90s, it has put itself on a trajectory of ever-more aggressive ways of encouraging booms in asset prices. In 2012, for example, Bernanke said lower interest rates will boost stock and housing prices and that when people see their 401(k)s going up, it will encourage them to spend more. Getting back to Mr. Greenspan: Surely he knew about the subprime loans — lending money to people without jobs, income, assets. Why didn't he step in and do something?

I think it was purely a philosophical error. He didn't believe that fraud should be prosecuted or regulated; he felt the market would take care of it and that if someone is doing something fraudulent, it's a waste of time trying to prove it. He didn't think it was the Fed's role to do that in the mortgage world.

He was detached from current events.

He knew some companies would go out of business because of subprime lending, that some investors would lose a lot of money and some people would lose their homes — but he thought that was the market operating. He was right! But the market's solution to the problem was "We're going to destroy every financial company on the face of the earth!"

You view Greenspan as "a living contradiction."

He believed that if the market is going up, you shouldn't raise interest rates. But when the market went down, he cut rates left and right. As long as interest rates go up, he believes in free markets; but not so when they're going down! I don't know how he squares that in his own head. This has resulted in people's not trusting the system, a huge problem.

Citing "underlying strength in the broader economy," the Fed is continuing to cut its bond purchases. What effect will tapering have?

It's the Fed's assumption that they have an exit strategy. In 2004-2005 they thought they fixed the stock bubble and everything was great: they were going to ease out of low interest rates. Tapering is a theoretical idea. I'm concerned that reality is going to be very different.

Do you know if Mr. Bernanke has seen your film?

I know he's seen the trailer, but I don't know his reaction. We pursued interviews with him and Alan Greenspan and were turned down by both. At the time, I was disappointed. But in the end, we were able to use many comments they'd made that were [previously captured] on film. If we had interviewed them, they likely would have been guarded and careful, and everything would have been hedged.

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