The Federal Reserve: a nemesis, not a hero
John Maynard Keynes, whose wrong-headed ideas dominate economic policy making almost everywhere, did get this right: “Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency… Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose.” “Currency debauchment” is a synonym for inflation, a process with the insidious property that the more prosperous it makes people feel in the short run, the more devastating are its consequences in the long run.
Since the great financial crisis [GFC] of 2007-2008, there has been huge inflation in financial assets, but not much inflation in the prices of goods and services. The American stock markets are near their all-time highs. Interest rates are near their 5000 year lows. Unemployment is low. Global output expanded 3.7% in 2017 after years of sluggishness. What’s not to like and who should get the credit?
The narrative of the mainstream media is that America’s central bank, the Federal Reserve (the Fed), not only saved the United States and maybe the world from a deep, prolonged depression in 2008, but also it is mainly responsible for engineering the “recovery” we now observe. Most market pundits have sounded the “all clear” signal. Once, however, you see that the Fed really is engaged in a conjuring act, you may be less convinced that all is well.
The Fed, along with the European Central Bank, the People’s Bank of China, and the Bank of Japan, has performed one of the great magic acts of all time. The operative term here is “magic”. It has succeeded in creating the illusion of recovery, but only at the cost of making the eventual collision with economic reality that far worse than it has to be. What did they do? Central banks couch their pronouncements in stilted, usually vague language in order to sound authoritative and wise, but the basic mechanisms of central bank magic are simple.
Imagine you have a generous uncle who lives way, way beyond his means, and for decades has been borrowing money in ever increasing amounts. You want to help, him and happen to have a magic computer that enables you to create from nothing money other people will accept as payment for the fruits of their labor. Lenders are always happy to lend to your uncle because they know that you are always willing to buy your uncle’s debts back from them at a profit. When you buy your uncle’s IOUs with magic money, conjured from nothing, ceteribus paribus, the cost of money [the interest rate] goes down. Since the interest rate on your uncle’s debt is the benchmark for interest rates throughout the economy, all borrowers are happy.
Substitute the Fed for you and your magic computer, the US government for your uncle, and Wall Street for creditors, and you understand the basics of how monetary policy works. It all seems too good to be true, and it is. There is trouble if central banks stop creating money and trouble if they don’t.
If central banks curtail their bond buying, demand goes down relative to supply, and interest rates rise. In a highly leveraged economy, higher interest rates can lead to mass bankruptcies, financial asset losses, and rising unemployment.
Conversely, why shouldn’t central banks continue buying bonds indefinitely? The Bank of Japan, for example, already owns 43% of all Japanese government bonds, and nothing awful has happened there. Since much of the debt central banks have bought in recent years sits inert on bank balance sheets around the world, the central banks’ magic money has not spawned accelerating price inflation, so far. Since financial markets have done well since the 2007 crisis, and regular Americans are not noticeably worse off (but not better off), Fed cheerleaders in the mainstream media can argue that on balance central bank actions have been beneficial.
The mainstream narrative that the Fed can can guide the economy so that it is just right — not too hot and not too cold — is nonsense at its finest. It is clear that the Fed’s actions have been an astounding bonanza for Wall Street and C-suite executives, but have done nothing for Main Street. Moreover, the effects of stupendous central bank bond buying are far from benign, even before there is any sign that currency collapse, the usual denouement from money creation vastly in excess of actual production of goods and services, is in the offing. Here is what’s not to like about the efforts of the Federal Reserve and other central banks to substitute their ideas on what interest rates “should” be [always lower] for the the rate produced by free markets:
- Savers are are getting a negligible return on their savings. In the hunt for higher yields, they are turning to investments where the risk of loss is higher than anyone who can’t afford to lose money should have to bear.
- Investors’ awareness of risk is being dulled, so they are making too many investments they will end up regretting.
- Companies and individuals alike are incentivized to load up on debt and ignore the necessity to maintain a prudent margin of safety.
- “Zombie” companies that should be liquidated are able to stay alive. The necessary process of freeing capital from value-destroying activity is thwarted. Over time an economy stagnates if too much of its capital is tied up in losing ventures. Japan is a case study of this dynamic at work.
- Governments continue to pile up debt that can never be paid back or even meaningfully paid down absent runaway currency debasement.
- Central banks themselves are being lulled into a false sense of certainty that they understand and can control the path of their respective economies.
Let’s support these assertions with some numbers. On the one hand, during the past decade, The Fed has grown its balance sheet from $700 billion in 2000 to $4.5 trillion today. Nonetheless, as David Stockman has pointed out time and again, despite unheard-of money creation to keep interest rates low, the goods and services producing economy has performed poorly relative to past experience. In fact, it has not yet recovered to prior peaks:
- Only 2.9 million or 65% of the goods-producing jobs lost during the recession have been regained.
- Between the November 2007 peak and March 2018, the adult civilian population rose by 24 million, but the US economy generated only 9.9 million jobs, and only 5 million full-time jobs. This amounts to an annualized growth rate in jobs of 0.67% which is about half the comparable growth rate from 1990 through November 2007.
- Manufacturing output is well under its November 2007 level.
- Labor productivity, the key to growth in real [inflation-adjusted] wages, has grown around 1% annually since 11/07, versus 2.2% over nearly half a century from 1954-2000.
- Real median household income at $59,039 is very close to where it was in 1999.
- While stock prices adjusted for inflation have gained 58% since the March 2009 lows, inflation-adjusted production has grown only 2%.
- Since June 1970 nominal (non-inflation-adjusted)GDP has expanded 18X to $19.7 trillion while total public and private debt has ballooned 42X to $67 trillion.
Whatever else the Fed has accomplished, it has not helped regular Americans. What it has done is to widen the disconnect between financial markets and the real economy where most Americans live and work. In sum, central banks are engaged in magical thinking on a historically unprecedented scale. The consequence will be a self-reinforcing doom loop where increasing claims in the form of pensions, health care payments, military expenditures, “get me re-elected” expenditures, etc. will be made on progressively weaker economies. But, until this dynamic becomes too obvious to ignore, the magic act will continue to create the illusion that everything is just fine and getting better.
I would love to hear a carefully reasoned response as to why this is all wrong.