As I survey the news stories and other analysis on the Fed’s recent announcement, most fall short of describing what the Fed is really up to. Here is a hint: it’s not really about employment. It’s not really about “price stability” or really about growth either.
The Fed is engaging in QEn+1 (open ended quantitative easing) because they are trying to keep a dying system alive. The Fed will commit all of its resources and use all of its privilege in this effort because it is the only system they know. Policy makers and the institutions they represent are literally fighting not just for their jobs, but for the survival of their worldview, their lives’ work, and their raison d’être.
In this context it is not surprising that they are resorting to what Sitka colleague Mish describes as Desperation Bazooka Tactics.
Since the creation of the Fed in 1913, the U.S. has embarked on a grand experiment. The system really started to take shape in the 1930s after the Government made private ownership of gold illegal and devalued the US dollar by 40%. Following the aftermath of WWII, the U.S. gained the Exorbitant Privilege of issuing ever increasing amounts of dollar denominated debt without regard to trade and current account deficits. Following Nixon’s fatal blow to any vestige of the gold standard, in what Jim Rickards calls the Second Currency War in the early 1970s, the growth in debt reached a whole new level.
Prior to the 1970s, the Government sector was the predominant issuer of debt in the U.S. Following the move to an entirely fiat currency, consumers and businesses got in on the action. Between 1970 and 2008, Consumer debt as a percentage of GDP grew from just over 40% to just under 100%. The real action however, was in the financial sector. Financial sector debt grew from just 10% of GDP in 1970 to over 117% in 2008. This represented the tipping point in financial sector leverage which precipitated the credit crises and the great recession of 2007-2009.
Throughout the 1980s and 1990s, often referred to as “The Great Moderation,” it took ever increasing amounts of debt to fuel consumption, economic growth, and corporate profits. From 1975-1990, each $1 of GDP growth was accompanied by approximately 50 cents of debt. Throughout the 1990s and the first half of the 2000s, that relationship averaged closer to 1:1. For more on this, please see Mish’s post with data and analysis from Trim Tabs.
Any perceived or inevitable economic hiccups were met with ever increasingly accommodative monetary policy responses (Mexico 1994, Asian Currency Crises 1997, Russian default, LTCM 1998, Y2K 2000, Tech Media Telecom bubble burst 2001) as the greater systemic leverage increased the consequences of adverse market responses i.e. falling asset prices.
Central Bankers, emboldened by the perception of their success throughout the 80s and 90s, or perhaps because they have no other options, continue to double down on the policy that asset price declines are bad and should be avoided by lowering the cost of money to encourage investors and speculators to put capital to work. Commercial and investment banks have been happy to participate not only with their own capital, but by providing cheap leverage to others. In so doing, they have secured and ever growing share of GDP in both profits and compensation.
Financial Sector Profit Share of GDP
Source: http://baselinescenario.com; Bureau of Economic Analysis
The so-called ‘Greenspan Put’ has led to a mis-allocation of capital on a grand and global scale, most disastrously the housing and mortgage debt bubble from 2000-2006. In a system where the rewards for risk taking accrue to private individuals, but the risk of failure is socialized– borne by the Government at taxpayer expense– it is easy to see how poor decisions are routinely made.
Furthermore, the Great Moderation/Debt Binge required an almost unprecedented level of cooperation between Government and Corporate, predominantly Financial Corporate interests. From deregulation and/or back door anti-competitive legislation to large Government contracts, the financial industry needs the support of policy makers. Nowhere is this much needed support more obvious than in the variety of “special” or “one-time” subsidies and bail-outs we’ve seen over the last half decade where the Government remains in the red by over $175 billion. However, as I’ll discuss below, the Fed’s interest rate policy and bond buying/money printing programs are the most important, if less obvious, handouts to the banking system.
As much as the financial industry needs the Government, it seems policy makers, especially elected officials, need the financial industry. For more on Federal Reserve employees’ roles with the industry it is charged with overseeing, see this Huffington Post report. Contributions from the FIRE sector have ballooned from roughly $62 million in 1990 to over $500 million in 2008. Below is the contributions from various interests to candidates and elections in the current cycle thus far. Importantly, none of this includes the insane amounts of money spent on lobbying. For example, according to opensecrets.org and the Center for Responsive Politics, the FIRE sector has spent over $5.1 BILLION on lobbying since 1998.
Source: opensecrets.org, data from Federal Election Commission as of 08/06/2012
It should also be noted that the “Great Moderation” was not great for everybody. Income inequality has steadily grown as our economy has become more dependent on debt. It is not surprising that the increased reliance on debt has resulted in a larger share of profits to those who control the system of financial intermediation. The Fed has and will continue to play a role in keeping this system in place.
To summarize, the system, the status quo that the Fed is trying to protect is one in which assets are ever increasing in price, thereby allowing the banking system to have an ever growing capital and collateral base upon which to make ever increasing loans and extract an ever increasing share of GDP. This is the “virtuous cycle” that Fed is charged with sustaining. However, now that we’ve approached a limit to system-wide debt levels, the Fed and other Central Banks are focused on doing whatever it takes to keep the wheels on.
The End of an Era
As Hyman Minsky argued and common sense suggests, there comes a point when you can not simply throw more good money after bad and expect ever increasing amounts of debt to solve a problem (asset bubbles and subsequent crashes) caused by too much debt. We reached that point in 2008. The private market deleveraging began in earnest in 2009.
In just 3-4 years, total non-Government debt has fallen from a combined 295% of GDP to 255%. Normally, such a dramatic deleveraging would serve to lower the prices for all assets whose price is sensitive to the effects of the deleveraging. In this case, declining financial debt would have lowered prices for the assets loaned against (real estate, etc.) and held by (mortgage, corporate debt and loans, stocks, etc.) financial institutions as they sold assets to right-size their balance sheets at the same time declining consumer debt would have lowered overall demand for products often purchased on credit (pretty much everything in modern day America). These are the falling asset prices that the Fed is so desperately trying to prevent. This is the deflationary boogeyman.
In order to reflate our over-indebted economy, the Government picked up where the private sector left off. Total Government debt has increased by about 35% of GDP (a more than 50% increase in 4 years) helping to offset the decline in private sector debt of 40% of GDP. The increased borrowing really took off with the variety of fiscal “stimulus” programs introduced after 2008. Thus we have seen very little system-wide deleveraging, only a partial burden shifting, from the private, mostly financial, sector to the Government. In my opinion, it is a little to soon to conclude that America is executing a “Beautiful Deleveraging” as Ray Dalio of Bridgewater suggests. The outcome of these episodes are measured in decades, not quarters.
Total Government Debt / GDP
As the credit crises took shape in 2008 and it became clear the Government would be issuing massive amounts of debt, the Fed quickly lowered rates to near zero. This helps to keep debt service for both current and new borrowers more manageable.
Nothing Left To See Here Folks
However, it quickly became clear that traditional policies such as lowering benchmark interest rates (no matter how obscenely low) would not do the trick. With the worry (justifiable) that market participants may not want to buy ever increasing amounts of debt at every higher prices (lower yields), policy makers realized that they would have to step in where discerning, private investors may not wish to be, especially with Government deficits quickly ballooning to over $1.3 trillion dollars, approaching 10% of GDP, and no plan to reduce it in sight.
Anybody want to lend to this guy?
Since 2008, however, the reflationary model that the Fed relies upon to “save the economy” has been broken. It now takes about $2.50 of debt to drive each $1 of economic growth. For more on this, please see Mish’s post with data and analysis from Trim Tabs. Furthermore, what Zero Interest Rate Policy, Quantitative Easing, Operation Twist, and the like have proven, is that monetary policy can no longer improve general economic conditions like employment. The Fed is pushing on a string.
For evidence that the employment picture is even grimmer than the stated 8.1% rate, please consider Mish’s work in Yes Virginia, It’s a Recession that details while without the dramatic and unprecedented decline in labor force participation (mostly people who have just given up on looking for work, many of whom are now claiming disability insurance), the unemployment rate would be closer to 11%.
Lance Roberts of Street Talk Live also explains in QE3 and Bernanke’s Folly that there is “no evidence that bond buying programs have any effect on fostering employment” and the remarkable rise of the number of Americans participating in Food Assistance and/or collecting Disability leaves little doubt that the working class is not benefiting at all from QE.
Wrong Direction: # of NEW entrants into Food Assistance and Disability programs
The evidence is clear that Quantitative Easing has done little to encourage robust enough economic growth to make a meaningful impact on employment. There is also little evidence that targeted programs like purchasing MBS are materially helping the housing market broadly.
The evidence is also clear, that QE, large scale asset purchases, and artificially low interest rates, help banks tremendously. And boy do they need it.
Net Interest Margin less charge offs and delinquencies
Just as the private market deleveraging was taking hold, banks were experiencing a dramatic rise in delinquencies (green line above) and charge-offs (red line). With high financial system leverage, it doesn’t take too many losses to make many banks insolvent.
“Extend and Pretend” has become the mantra over the last few years as questionable corporate borrowers received new terms on their delinquent or maturing loans (after all, everybody knows ”a rolling loan gains no loss”). Banks didn’t want to take the losses and the Fed enabled them to avoid doing so by relieving them of troubled assets and allowing them to borrow at artificially low rates. Quantitative Easing has had the desired (if not stated) effect of improving banks’ capital position and beginning to turn a desperate situation around. Bank net interest margins after delinquencies and charge-offs (the blue line) are on the mend.
But the improved capital position of the banks has not helped the overall economy or the employment situation. Again, Lance Roberts:
The evidence is abundant that the only beneficiary of these balance sheet programs is Wall Street. As shown in the chart below the average level of excess reserves for banks was roughly $19 billion from 1984 to 2008. Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently.
With the consumer weak, unemployment high, foreclosures and delinquencies still burdensome, and businesses constrained by lack of demand – there is little desire, or need, for credit.
Artificially suppressing interest rates has additional implications beyond enabling profligate Governments and corporations to borrow more. It also represents a tax on savers, robbing them of interest income and transferring that income to debtors in the form of borrowing costs near or below the rate of inflation. My conservative estimate is that ZIRP has now robbed money market fund savers/investors alone of approximately $200 billion in lost interest income since 2008. This is the purest form of financial repression. This does not even include the lower interest income from other types of fixed income investments. Negative real interest rates have pushed savers/investors/speculators into high yield bonds allowing many low quality corporate issuers to remain in business and maintain high leverage. Surely the policy prescriptions preventing failure of businesses and slowing the process of competition and creative destruction will have a lasting impact on the robustness of our capitalist system.
In a 2002 speech, “Deflation: Making Sure “It” Doesn’t Happen Here,” now-Federal Reserve Chairman Ben Bernanke gave a hypothetical policy prescription for declining asset prices: Print money, buy securities. It was from this speech that Chairman Bernanke got his nickname ”Helicopter Ben” for proposing Milton Friedman’s idea that Government could always drop money from a helicopter to stave off deflation. Here we are, ten years later, and he is putting that theory into action.
source: Steen Jakobsen, Saxo Bank
Courtesy of the first two quantitative easing programs, the Fed’s balance sheets exploded from a few percentage points of GDP to nearly 20% of GDP in just over 3 years.
The most recent announcement has the Fed purchasing $40 billion of Mortgage Backed Securities (MBS) every month in addition to current programs to purchase long-term treasuries amounting to another $45 billion/month. The announced purchases of bank assets by the Fed through the end of ’13 is expected to total $735 billion, which is an equivalent to half of banks’ current holdings of MBS, resulting in the total expansion of the Fed’s balance sheet since ’08 from $860 billion to $3.6 trillion. The Fed’s balance sheet will expand yet again, most likely towards 25% of GDP by the end of 2013, barring any additional unannounced activity and assuming continued economic growth.
More importantly, the open-ended nature of the policy, is taking us into a new era of ‘whatever it takes’ to keep the current status quo alive. Not only did the Fed say that the large scale asset purchases with newly printed money “would continue until the labor market improved significantly,” but
the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
It is entirely clear that extreme monetary policy is not about improving the real economic variables that effect most Americans. It is not about employment, it is not about growth, it is not about price stability for consumers. The Fed has now said as much. Monetary policy is protecting the status quo of an overly indebted, overly financialized economy. Monetary policy is about picking winners like banks, their executives, and their co-symbiotic relationship with politicians regardless off the impact on the losers.
Who loses with QEn+1?
Savers. Those on a fixed income. Investors who await cheap asset prices to increase the probability of worthwhile returns. The increasingly poor and poorly-equipped working class who is dependent upon policy makers focused on the wrong things. Consumers who spend an ever increasing portion of their stagnant wages on food, gas, and energy.
Research by former Fed President William F. Ford suggests there is a significantly negative impact on the very things the policy portends to aid, growth and jobs.
Globally, there are other losers too. Rising social and geopolitical uncertainty caused by rising commodity prices and growing income disparity goes hand in hand with the Fed’s efforts to blow life into a dying paradigm.
Bringing It All Home
A popular line of logic/analysis goes something like this: well, the Fed is going to print money and suppress interest rates, that is going to push the prices for all assets higher so buy stocks, gold, commodities, high yield debt, etc. Risk On! Cash and treasuries will be the only sure loser, the logic goes.
That is a dangerous speculation to make. It is not yet clear that the Fed is willing and/or politically able to print all the money it needs to expand the monetary base sufficiently to prevent nominal asset prices from falling. In previous debt deflationary episodes (for which we have data) such as the U.S. in the 1930s and Japan more recently, it has taken a combination of declining asset prices and expanding monetary bases (through currency debasement/money printing) to arrive at a more fully reserved (and solvent) banking system. This has typically looked like a 1:1 relationship between the monetary base and all outstanding bank loans. If the Fed wishes to prevent material declines in asset prices and nominal GDP it would have to expand the monetary base by expanding its balance sheet to something like $7 trillion! That would be the equivalent of 6 additional QE programs of the magnitude we’ve seen so far. That is what it would take to put enough cash into the banking system to directly or indirectly fund the fiscal deficits to keep GDP from contracting and price deflation from taking hold. I don’t think we know yet whether the Fed has the mandate or political will to trash the purchasing power of the dollar so unabashedly. And certainly the consequences for global trade and geo-political instability are great.
As an aside, a relatively harmless way to increase the monetary base would be for the Government to recognize gold as base money, a reserve asset apart from from currency. The Government could mark its 8,133 tonnes of gold to market, instead of at $42/oz which would put the current value just shy of $500 billion. Then allow the market to work and assign whatever price to gold it wishes with its new found understanding of gold role as monetary asset in Government policy. With a $7 trillion monetary base, even a ~20% role for gold as part of the monetary base (as it has now, marked to market), you are looking at gold around~$4,500/oz . No wonder gold goes up as a result of QE!
QE can affect nominal asset prices, but cannot prevent real losses from taking place and value being restored to markets so long as we continue to operate in a mostly democratic, capitalistic and market-based system. Of course, there are risks that we move far away from these paradigms too, but that topic is for another day.
The Fed cannot eliminate the effects of debt deflation and deleveraging. They can only try and shift burdens. And try they will. There will be money printing. It may not be enough to prevent substantial asset price declines or it may be too much to prevent a total collapse in confidence in the dollar and unacceptable inflation. Either way, they will keep doing what they know how to do until they get the results they want or ‘die trying’.
Asset values will decline in real terms, whether you choose to look at inflation, gold, or some other measure of the purchasing power of the dollar. Whether that decline is fast or slow, depends on future installments of QEn+1.
The sell off in the S&P 500 priced in gold is set to resume
The best way to navigate this sort of environment is to hold substantial allocations to gold and related stocks and cash. I made the bull case for mining stocks in a recent post Jumping Into the Abyss. When considering stocks, one must be very selective or avoid them all together. At the same time, one should be weary of their fixed income investments and be on the look out for the potential for negative real returns or adverse changes to the perceived credit quality of the issuers.
Over the coming quarters and years we will begin to see how the process of additional deleveraging takes place. We will find out if significantly lower nominal prices will be available and thus the cash will come in handy. If the Fed really does make its way to infinity and beyond, then substantial allocations to gold, not without its own risk, will help protect future purchasing and investing power.