Why Stimulus?
(The views and opinions expressed in this article are stictly those of the author.)
By Rock Cramer
There seems to be a good deal of confusion regarding what federal government “stimulus” means and whether or not stimulus has been successful. To help unravel the confusion, several questions should be answered:
1. Could the federal government be responsible for the problems in the national economy that stimulus is meant to address?
2. What are the underlying economic effects of these problems?
3. Is the federal government capable of determining what form of stimulus is “best” for the economy?
4. What are the observable consequences of the federal government’s attempts at stimulating the economy?
The following sections will offer answers to these questions and a few others.
BUBBLES, FREEDOM AND FREE MARKETS
When considering the problems that stimulus is expected to address we should be mindful of the high probability that federal government policies caused them in the first place. Ludwig von Mises and Friedrich von Hayek, “Austrian School” economists, have demonstrated that in all of recorded history, without exception, every economic “bubble” and the consequent depression, recession or disruption has had as its origin from or has been enabled by government (sovereign) intervention in free markets--generally by manipulating credit and interest rates. No one has yet refuted this thesis. Their work has mostly been ignored…for a reason.
These economists studied how free markets and prosperity evolved, how the “abstract rules” (traditions) of commerce and trade developed between individuals, groups and past societies (that had little knowledge of each other), bringing prosperity to those that participated. What’s fascinating is that they show this mostly occurred when governments were weak or distracted…not trying to control or influence markets with targeted policies and regulations. They make the case for what appears to be an undeniable truth: Value or usefulness determined by free markets, whether for goods, services or ideas will always result in the best outcomes for society because free markets, by their very nature, enhance freedom and prosperity. In other words, the collective wisdom of the many diverse and unassociated participants that a free market brings together will always be superior to the wisdom of a ruling few--a truth implicitly denied by today’s Ruling Class.
Nearly everything we do is motivated by self-interest (broadly understood). We learn from childhood that successful interaction and trade between and with others requires that we must abide by certain (abstract) rules of behavior, notably self-restraint. These learned rules and traditions are reflective of “NATURAL LAW,” the Golden Rule being a notable example. (Truly free markets provide an insurance policy for the Golden Rule by adding: “be prepared to suffer the consequences if you ignore this Rule or bet wrong.”) We learn that our “right” to have something or do something should not impose an unequal obligation on someone else. When unequal rights and obligations are mandated by government policies and regulations, those harmed not only fight for their rights, but society also suffers from loss of productivity (mild) to creation of “bubbles” (more severe).
“The prerequisite for the existence of such property, freedom, and order, from the time of the Greeks to the present, is the same: law in the sense of abstract rules enabling any individual to ascertain at any time who is entitled to dispose over any particular thing.”
F.A. Hayek, The Fatal Conceit (1988)
“We hold these truths to be self evident” reflects our Founders’ unqualified belief in “NATURAL RIGHTS.” It is not coincidental that as a society we have enjoyed the benefits of “American Exceptionalism,” unprecedented opportunity and prosperity for over two hundred years. Our Founders crafted a social contract that had as its primary objective the preservation of Natural Rights. One could say that our Constitution, until recently, was a successful attempt at codifying Natural Law for a complex society by “enumerating” federal government powers and limiting their abuse with “checks and balances,” a formula intended to impose self-restraint on the Ruling Class.
Our Founders also believed in “Federalism,” the division of authority between two levels of government which assigned only “few and definite” powers to the national government and reserved “many and indefinite” powers to the states. As a consequence, the idea grew that states should be the incubators of most new rules for our society--not the federal government. New ideas (laws) for governance and new rules (laws) affecting commerce should be tested by the many and diverse states. Laws that withstand the test of time by bringing opportunity and prosperity to citizens would be adopted by other states in the “free market” competition between states for citizens. Those that didn’t would be discarded. If we are free to move from state to state in search of the rules and opportunities (including jobs) most aligned with our own self-interest, our Natural Rights are indeed preserved, along with the “consent of the governed.”
There is little doubt that the federal government of today has seriously strayed from the governing formula envisioned by our Founders. The Commerce Clause (part of Article 1, Section 8 of the Constitution), for example, has been used since the late 30’s to justify virtually any activity the federal government might wish to influence or control if the activity can be determined to affect more than one state--which in our advanced society, according to the Ruling Class, is damn near everything. This and other “modern” interpretations of our Constitution have rendered the ninth and tenth Amendments in the Bill of Rights all but meaningless.
AMENDMENT IX.
The enumeration in the Constitution, of certain rights, shall not be construed to deny or disparage others retained by the people.
AMENDMENT X.
The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.
United States Constitution (Bill of Rights ratified 1789)
For our Founders, “life, liberty and the pursuit of happiness” (Natural Rights) are best preserved if the national citizenry can both vote at the ballot box and “vote with their feet” (from state to state). For “Austrian School” economists, free market trade between many individuals and groups using the learned abstract rules of commerce (reflective of Natural Law) is the proven best way to determine the relative value of goods, services and ideas and is how prosperity is achieved.
The concept of “free markets”, in other words, applies to both economics and governance. The synergism of governance that preserves Natural Rights and free markets that achieve opportunity and prosperity by adhering to Natural Law seems to be lost on our Ruling Class, including many highly educated economists. “That government is best which governs least.” should not be a discarded platitude. The Austrian School economists have proven, beyond a reasonable doubt, that government’s involvement in free markets should be LIMITED TO CODIFYING AND ENFORCING the abstract rules of commerce that have been proven and accepted by free markets: contract law, commercial law, bankruptcy law, etc. Most important, however, is that these laws must be simple, straight forward and unencumbered by government regulations that reward some groups and penalize others by shifting risk and reward away from the self discipline and self restraint that truly free markets would otherwise force upon participants. Free markets don’t work, in other words, if risk of loss is reduced or eliminated by government policies.
“Protection of several property, not the direction of its use by government, laid the foundation for the growth of the dense network of exchange of services that shaped the extended order [society].”
F.A. Hayek, The Fatal Conceit (1988)
That the United States today enjoys the highest standard of living of any other country, that the dollar is the currency of world trade and that the US is the lone world “superpower” are testimony to the wisdom of our Founders…and the opportunity for (mostly) free markets to flourish within our Constitutional structure. In both politics and economics, in other words, we are best governed and made most prosperous by laws and abstract free market rules that have withstood the test of time, that have been tested and accepted by the “extended market order”--not laws and rules determined by a ruling few driven by short term agendas and du jour notions of “justice.”
If we look at federal government “stimulus” through the lenses of either the Austrian School economists or our Founders, there just isn’t much there. Other than reducing what government takes from its citizens (taxes), the slate is mostly blank. It’s very difficult to justify government stimulus on either economic grounds or Constitutional grounds. But herein is the not so difficult riddle for our time: some form of stimulus may indeed be necessary if market distortions created and fueled by government become so extreme that one or more of many markets collapses or is about to collapse from the burden. This is what we witnessed in 2008, just like every other depression or recession in our history…just as the Austrian School economists demonstrate and predict.
CREDIT SAFETY, MONEY VELOCITY AND REGULATORS
Indeed, as Jason Zweig points out in a recent Wall Street Journal article: Over 70 years ago “…an economist named Melchior Palyi predicted key causes of the 2008-2009 financial crisis with precision that makes a modern reader’s hair stand on end.” The 1936 Banking Act mandated that federally regulated banks could no longer hold securities that weren’t rated “investment grade” by at least two federally certified rating firms. Palyi, an (Austrian School) economics professor at the University of Chicago and formerly chief economist at Deutsche Bank, warned that responsibility for credit safety was being shifted from (the many) bankers to (three) ratings firms and therefore credit risk would be shifted elsewhere… ultimately to taxpayers as we have witnessed. In 1938, he also warned that new government policies directed toward universal home ownership would “make the population fixed to the ground” by “overburdening them with housing costs.” Sound familiar?
Credit “safety” actually has two components: credit “risk” can theoretically be measured and calculated, the odds of default and liquidation value can be determined on an actuarial basis depending on the borrower’s strength, collateral asset value, etc. Credit “uncertainty,” however, cannot be measured. What if the Federal Reserve (the Fed) ignores the fact of highly accelerated, indeed unprecedented, credit growth in one sector of the economy? This provides the “liquidity” necessary for a run up in that sector’s asset values (in this case, developable raw land and houses). The process is a self-sustaining cycle: Excess credit fuels the increase in asset values. Higher asset values justify more credit and so on until market forces finally explode the bubble in asset values and the market collapses. This happened in the home market in late 2007; just as it happened in the housing and commercial property markets in 1991; just as it happened in stocks in 2000; just as it happened in the worldwide 1929 stock market crash (that von Mises predicted) for the same reason.
Why do market bubbles continue to repeat in history? Why have they occurred with increasing frequency in the in the past sixty years? It’s all about how the federal government tries to “REGULATE” FREE MARKETS BY SHIFTING ACCOUNTABILITY and therefore the consequences of failure and poor judgment, away from the responsible participants. As Palyi points out, it’s often about how responsibility for credit safety has been shifted away from those who actually originate the credit.
The recent housing market collapse provides a fine example. From 2001 to 2007, house prices doubled in many regions (the national average increase was 56%) The cumulative increase in the Consumer Price Index (CPI) over the same period was less than 20%. Someone somewhere was creating a massive amount of liquidity (credit) in the housing market in order for prices (home values) to go up so radically in so short a period. The culprits are Congress, the mortgage financing creatures it created and enabled (“Fannie Mae,” “Freddie Mac”, FHA, etc.), the risk shifting financial regulations derived from laws it passed and the mandates it imposed on mortgage originators to reduce borrower qualification requirements to little more than a heart beat--all in the name of “affordable housing.”
The “Agencies,” Fannie and Freddie, (with implicit federal government guarantees) acquired over $6 trillion in single family loans from 1993 to 2008-- creating massive liquidity using leverage ratios that exceeded 30 to 1. The big commercial banks, through their “off balance sheet” “structured investment vehicles” (SIV’s) were also playing in this high leverage credit sandbox as well as the investment banks (Goldman Sachs, Lehman Brothers, Bear Stearns, etc.). One could hardly describe this as anything but “Quantitative Easing” on steroids for home financing. They were slicing and dicing home and commercial mortgage debt into mortgage backed security “derivatives” (MBS’s) that the THREE rating agencies were blessing with undeserved credit ratings, most often “AAA” and “AA.” High credit ratings not only made these MBS’s eligible to be (government approved) bank capital reserves, but the high ratings also meant that pension funds, foundations, endowments and other investors could purchase them for their “fixed asset” portfolios (presumably the least risky investment), thus providing even more liquidity for mortgage creation.
The Fed can claim (as it does) that it didn’t fuel the housing bubble with too much dollar liquidity because the “price deflator” version of CPI and the personal consumption expenditure (PCE) index both averaged less than the Fed’s “inflation target” of 2% per year over the entire seven year period. Austrian School economists would point out that the Fed’s annual 2% inflation target itself leads to market distorting bubbles over time (by masking the effects of increasing government and private debt). For the discussion here they would point out that if (dollar) liquidity was actually stable (the presumed job of the Fed) and housing prices went up this much in so short of time, then the prices of other things would necessarily have to go down i.e., “deflate” because their values would have to be worth that much less to consumers relative to houses. That, of course, didn’t happen. So what gives?
We had what the Fed claims to have been a stable money supply i.e., low inflation. But liquidity has two components: the money supply AND the “VELOCITY” of money--roughly, how many times some measure of money supply turns over in the economy during the year. Simplified, this is controlled by the Fed funds and discount rates and reserve requirements, how many times a dollar of reserves can be loaned by a bank. Reserves are more or less a regulated bank leverage ratio, historically between 12 to 1 and 5 to 1. In conjunction with other bank regulators, the Fed sets and monitors these rates and reserve requirements. The process is more complex than described here but the basic theory is that if the money supply and the velocity of money are managed through the regulated banking system, inflation will be controlled. In any case, the Fed assumes that this works on a national aggregate basis. The warning signs are not so obvious, however, when inflation is concentrated in one sector of the economy, even one as big as housing.
Liquidity creation for mortgages and the associated run up in home and commercial asset values were effectively OFF THE RADAR SCREEN for the Fed, the three rating agencies and all the other federal regulatory bodies charged with oversight of banking, securities, housing and commercial property. Why? Because a very high velocity of money with excess credit creation in one sector of the economy (housing) is mostly a “NATIONAL BALANCE SHEET” phenomenon. Homeowner net worth goes up and mortgage and consumer credit go up. If asset values and available credit go up in tandem, they have little effect on the cost of living and other traditionally monitored inflation indicators.
The MBS derivative sandbox obviously had no adult supervision. Where were the regulators? What is the point of all the volumes of regulations and legions of regulators that demand compliance from anyone participating in these markets? Do we really need a “Systemic Risk” regulator to tell us when aggregate credit in the U.S. economy rises from 225% of GDP to over 350% of GDP (as it also did in the 90’s stock market run-up)?
The problem has never been too few regulators and too few regulations, quite the contrary. Too many regulators become a “Who’s on First” skit. Massive regulations provide nothing more than an illusion of security. Bureaucrats have no skin in the game. Motivated self-interest will always be way out in front of them. Only “stakeholders” (debt holders, equity owners, employees and high dollar depositors) are capable of policing “corporate excess.” This means no “bailouts” in any form and no regulatory illusions of risk mitigation or of uncertainty mitigation. Self-discipline and self-restraint go out the window when government goes beyond the boundary of simply enforcing the abstract rules of commerce which are mostly about ACCOUNTABILITY AND TRANSPARENCY. Government, in other words, should just allow free markets to work and enforce the rule of law.
So let’s see…the federal government usurps states rights by creating Agencies and regulations that remove oversight and credit safety in the home financing market from state and local governments…almost certainly unconstitutional from the perspective of our Founders. From the perspective of Austrian School economists, this allowed the diverse and unassociated credit safety decisions of the very many mortgage originators (local banks, savings & loans, mortgage brokers, etc.) that could pose no “systemic risk” to our nation to be concentrated in the hands of a very few that could and did. In the meantime the Fed and all the regulators were asleep, oblivious to what was going on in the housing credit and securities markets. A more perfect testimonial to the wisdom of our Founders and free market economists would be hard to find.
THE NEW REALITY AND ITS PROBLEMS
So where are we now? What were (and are) the particular national economic problems that government stimulus was and is presumably meant to address? First are the obvious ones: houses and associated commercial property and developable land must DEFLATE. If these assets were 50% to over 100% higher than historical norms would suggest they should be, they would have to lose at least 25% to more than 50% of their value…simple math. It’s unlikely that the market “bottom” has yet been found in many regions for both homes and commercial buildings. Indeed, as late as the fall of 2010, the Case-Shiller index of home prices is still nearly 20% higher than the historical trend line.
Another obvious problem with the U.S. economy is that households (consumers) have lost a very significant portion of their net worth. The heady days of the housing run-up gave consumers an artificial confidence that justified buying more “stuff” and reassured them that their new consumer debt was manageable. The new reality has consumers retrenching, i.e., spending much less and saving more…in an economy that’s mostly driven by consumer demand. One must “suspend disbelief” to accept the notion that the attempts at government stimulus we have seen, dreamed up by a ruling few, are capable of overcoming a structural demand change in the U.S. economy of this magnitude.
The last problem that should be obvious is that housing credit must DEFLATE; this credit market must go through a process of “deleveraging.” As asset values crash in deflation, so must go the associated debt owed on them. It’s a certainty, whenever underlying debt exceeds deflated asset value. Today, it is estimated that 11 million home borrowers are “underwater,” about 23% of all U.S. households with a mortgage. Until housing and commercial asset values find a bottom, the associated mortgage debt must continue to deleverage. Then there are the not so obvious problems: liquidity issues--again, the velocity of money.
The “liquidity” crisis in finance and banking begins in early 2008 with the collapse of Bear Stearns, the beginning of our “Great Recession.” There were several government attempts to stop the bleeding. These notably included the “Bush Stimulus” ($152 billion authorized) which was primarily tax reductions and credits (remember the $200 checks?), the Treasury underwriting and brokering of the Bear Stearns takeover in March and the Treasury takeover of Fannie Mae and Freddie Mac in early September. Then on September 15, 2008 Lehman Brothers officially tanked after weeks of trouble. The Bush Treasury under Paulson decided not to bail them out. On September 18, the Federal Reserve observed a heavy draw down of money market accounts (technically not guaranteed by deposit insurance), $550 billion in an hour or two. If true, this could have been described as a “national electronic bank run” without much exaggeration.
In any case, financial markets seemed to freeze because the big players in finance and banking were literally shocked that the Treasury allowed Lehman to go under. Lehman was assumed to be a card carrying member of the “Too Big To Fail Club.” Once Lehman went under, no one trusted the value of anyone else's financial assets (who would be next?). Home mortgages in Phoenix, Arizona, or Riverside, California, could be part of a mortgage backed security (in some derivative form) rated “investment grade” by the rating agencies. It could therefore be an authorized “financial asset” in bank regulated capital reserves. Very few had any idea what these MBS’s really contained. But it gets worse.
In 2008 there was an excess of $17 trillion in “credit default swaps” (CDS’s) outstanding. These are “insurance” contracts that presumably guarantee the performance of debt, i.e., that the revenue stream continues unabated until the debt is fully paid. On top of that were more than $40 trillion of “naked swaps” worldwide that had mostly originated in the U.S. We assume that the buyer of an insurance policy owns whatever it is that is being insured. A naked swap, however, is an insurance policy on a financial asset owned by someone else, roughly equivalent to Bob buying an insurance policy on Bill’s take-home pay from employment. Bob buys insurance that Bill will keep his job. This is where the real money was made by those who recognized the housing market would collapse.
CDS’s and naked swaps were offered and bought on virtually any kind of credit derivative as well as commercial paper (mostly interest rate and currency swaps), but many derivative “tranches” of MBS’s were “insured” by their owners and bets were made, one way or another, by others with naked swaps. One might say that the whole business of CDS’s and naked swaps is a free market attempt to place a futures value on financial assets of mostly unknown composition (in addition to or in spite of the quality ratings by the three rating agencies). The problem with these, however, was that no “clearing house” existed. THERE WAS NO TRANSPARANCY. Insider knowledge was king. Virtually anyone could issue them or buy them one way or another. The big investment banks typically bought and sold these insurance policies on behalf of clients and themselves. AIG ended up being the penultimate sucker in this hedging and gambling scheme. Little known by the voting and taxpaying public, this “private placement market” with no transparency was several times larger than our annual gross national product. Regulators and regulations weren’t of much use in this big sandbox either…for all the same reasons.
Though the money supply hadn’t changed, the velocity of money went to near zero because the big banks specifically and all banks generally knew that their capital reserves were heading south, in some cases to less than zero; i.e., many of these banks were technically bankrupt.
STIMULUS--ANOTHER WORD FOR BAILOUT
Late in the day on September 18th Paulson and Fed Chairman Bernanke asked Congress to approve $700 billion for the Troubled Asset Relief Program (TARP). Not until October 4th, however, did the TARP bill pass…with an additional $110 billion of “earmarks” added by Congress. Many claim that TARP was a success, even before any funding was authorized by Congress. The Fed, however, had already been providing overnight and short term loans as “lender of last resort” since before Bear Stearns’s collapse. At its peak the Federal Reserve was supplying in excess of $3 trillion worldwide. If there was a “run on the banks” it settled down to a manageable level as soon as it was known that the government would formalize the bailouts with TARP, i.e., that no more of the Too Big to Fail Club would go down.
TARP was initially requested and funded as a vehicle to purchase “troubled assets”, specifically MBS’s, from banks to provide the liquidity to cover deposits withdrawn and capital markdowns. But there were two problems. What price should the Treasury using TARP funds pay for MBS’s? Any realistic discount from face value would further destroy big bank capital reserves. The second problem was all the associated CDS’s and naked swaps sitting out there, “insurance policies” poised for big claims. So in mid November, Paulson (with Geithner on board) decided to use TARP funds to provide “convertible” loans and buy bank stocks (including AIG) deemed “too big to fail.” As of the 2010 election, there is believed to be at least $250 billion of unused and repaid TARP funds available to the Treasury to use as the Obama administration pleases for virtually any purpose...as it did with the GM and Chrysler bailouts. Was the TARP stimulus necessary? Probably not, but how can we know?
What we do know is that all the remaining big players in the sandbox got bailed out by taxpayers. The Fed, acting as lender of last resort, was AT THE SAME TIME PROVIDING AN EXCESS OF FOUR TIMES authorized TARP in short term loans to allow the banks to unravel their swaps and write down their MBS derivative portfolios at interest rates near zero. Austrian School economists would point out that these Fed loans should have been made at “penalty” interest rates.
The federal government does not have and never has had the Constitutional authority to bail out anyone. Nor is what was done even good economics. For national security reasons, however, it should have the authority to make sure our financial infrastructure has sufficient dollar liquidity in times of crisis, mostly the Fed’s job. Indeed that’s what the Fed had been doing since long before TARP. Anything beyond this creates a “moral hazard” for corporate bank stakeholders-- the belief that they can continue to get away with “privatizing profits and socializing losses,” i.e., be bailed out by taxpayers.
Next came the “Stimulus Bill” (in excess of $800 billion) signed into law by President Obama on February 17, 2009. With the exception of the roughly 30% identified for personal and business tax relief, the Stimulus Bill could only be described as a massive collection of earmarks. At least 50% was to go to state and local governments, effectively postponing for a couple of years more realistic state and local budget discipline.
The Stimulus Bill was supposed to be a “jobs bill” with the President’s economic advisors predicting that unemployment would not exceed 7.9% if passed. Others have argued that government had to stimulate demand to reduce the severity of the recession, based on the flawed Keynesian “multiplier” theory of government spending. Still others claim that the Stimulus Bill was a necessary “stop gap” measure to bide time for the general economy to get going again, a version of the “jobs saved” straw-man argument that can’t be challenged because there is no realistic way to identify which jobs have been saved. The Stimulus Bill could truthfully be described as a GOVERNMENT BAILOUT with token tax goodies (ex: the $8,000 home buyer’s tax credit). Its failure, however, was predictable since it couldn’t possibly overcome the massive collapse in consumer demand.
In any case, each of the arguments for the Stimulus Bill falls on its face when compared to the ONE AND ONLY FISCAL STIMULUS policy that elected government officials have that is fully consistent with Constitutional principles and free markets: allow the people to keep their hard earned money, i.e., tax cuts. “Marginal income tax rate” cuts have been proven, by Hayek, Milton Friedman, and many others to be THE most stimulative of all the stimulus options available to government.
The only chance that the federal government had or has to overcome a nationwide collapse of consumer demand is some form of tax holiday, putting more money into the hands of consumers: for example, suspend ALL FICA taxes and reduce ALL personal and business taxes to 10%. (Corporations don’t pay taxes. People do in one way or another, the effect termed by economists the “incidence of taxation.”) Follow this up with permanent tax rates of 10% for corporations, capital gains and dividends (taxed items responsible for capital formation and therefore jobs). This is not only the proven best policy to recover in the shortest time; odds are very high that it’s the only one that can work. Fed Chairman Bernanke certainly knows this and has even hinted fairly often that the Fed’s MONETARY stimulus needed more help from the tax cut FISCAL stimulus available to elected officials.
RESCUED BY THE FEDERAL RESERVE?
“Economic growth may be, and has been, fostered for years by a turbulent expansion of private and corporate debts. When the latter burst at the seams, the government will not be able to step in to save the day and maintain the growth. It may have no untapped tax sources left, and it will have exhausted its debt resources--overdrawn on its own credit. What remains is recourse on the central bank. By then, money printing may smooth the liquidation process, at best; at worst, it will bring about a run on the dollar. In either case, a period of economic stagnation is bound to be the reward for a prolonged process of capital erosion.”
Melchior Palyi An Inflation Primer (1962)
Note that Palyi wrote this in 1962! Our Ruling Class seems to be baffled as to why boom and bust economic cycles repeat; but it continues unabated to amass power and decision making in the hands of a few to the detriment of the many.
As pointed out above, the Fed was actively providing serious amounts of short term “bridge” loans to maintain sufficient liquidity for the big banks. The Fed’s most often used method of monetary stimulus however, is to reduce the federal funds rate, the interest rate charged to member banks that borrow money from the Fed. In early September 2007, the fed funds rate was 4.75%. Beginning in mid September, the Fed reduced the funds rate ten times through December of 2008 to 0%-.25%. Under more normal economic conditions, this huge reduction in the funds rate would be considered very serious monetary stimulus. In the fall of 2008, however, it was deemed by the Fed to be insufficient to avoid the possibility of a “deflationary spiral.” But who knows this to be true?
Mortgage backed securities obviously had to deflate because houses and developable land had to deflate 50% or more in many regions to get back to market values that reflect historical norms. What if the possibility, indeed likelihood, of a deflationary spiral (in housing) is perpetuated by government stimulus itself? With the exception of tax cuts and some duty to provide sufficient financial sector liquidity, every other form of government stimulus distorts markets. In this case, rather than allow housing markets to find a “clearing price” bottom quickly, which might have taken down several of the big banks, nearly all of the Federal Reserve’s monetary stimulus has effectively postponed the day of reckoning…to the benefit of the big banks and our Ruling Class and to the detriment of most everyone else.
So in mid March of 2009 (not coincidentally, the beginning of the big rise in the stock market), the Fed began “Quantitative Easing” (QE)--“Helicopter Ben” Bernanke’s heavy-duty monetary stimulus (electronic money creation). By the early spring of 2010 the Fed had purchased approximately $1.75 trillion in U.S. Treasurys and MBS’s from Fed member banks, Fanny Mae and Freddie Mac. Within a couple days of the 2010 election, the Fed announced it would again start buying an additional $600 billion over the next eight months (QE2).
In order to determine the need for and success of Quantitative Easing, one must ask: What macro-economic problem is QE intended to address? There is plenty of money lying around. Business, particularly big business, is flush with cash. Why QE or QE2? ONCE AGAIN IT’S ABOUT THE VELOCITY OF MONEY. The money supply is not being used. Banks are not inclined to loan to the private sector because they are writing down the value of their MBS derivatives while trying to shore up their severely depleted capital reserves. Businesses with cash are not inclined to invest the cash, let alone borrow. Those short of cash face new borrower qualifications from banks trying to build capital reserves. Most economists, unencumbered by political agendas, would point out that the problems for businesses, and therefore job creation, are DEPRESSED CONSUMER DEMAND, but also REGULATORY AND TAX UNCERTAINTY: Obamacare, the financial reform bill, Cap and Trade, likely future tax hikes, etc.
What QE did and QE2 will continue to do is keep interest rates for government borrowing artificially low and buy time for the big banks to recapitalize…another form of bail out. How can it be that the big banks are making money now if they aren’t lending? There are two reasons. First is the “carry trade,” the difference between the interest rate a bank pays when it borrows from the Fed and the interest rate it gets paid when it buys U.S. Treasurys. Big banks can borrow at 0% to .25% and buy new Treasuries at 2.5% to 4%.
The second reason is Quantitative Easing itself, which is also a very sweet deal for the big banks. The Fed (theoretically “independent”) can buy Agency issued MBS’s from banks at near face value because they are “guaranteed” by the Agencies, now owned by the federal government. Also there is the “inverse” relationship between interest rates and debt (face) value that comes into play. For example, a 10 year Treasury note for $1,000 sold in September of 2007 that pays out interest at 5.25% is, in the fall of 2010, worth about $1070 because NEW 10 year Treasury notes now only pay out about 3.35%. The Fed is, in other words, buying OLDER debt from the big banks and Agencies FOR PRICES THAT EXCEED 100% OF ORIGINAL COST. That extra $70 (7%) can become a $70 billion (cash) capital gain when $1.0 trillion of OLD debt is sold to the Fed.
It’s no coincidence that the Fed’s monthly buying of older debt during QE and now QE2 is near equal to the new Treasury debt being issued, which the big banks are buying to shore up capital reserves. This is a beautiful scheme for those big enough to play in this sandbox. It also provides a convenient home for the near $1 trillion in new federal government debt being issued each year. When the music stops in a few years, the only one that will be left standing in this risk shifting circle is the taxpayer. One wonders what happens when the next huge bubble bursts…that being the deleveraging of the debt and unfunded liabilities of state and local governments. In any case, the Ruling Class seems to have the attitude of the Mad Magazine character Alfred E. Newman: “What, me worry?”
In the meantime, smaller merchant banks and community banks are dying because they can’t participate in all the big commercial bank bailout schemes; there are over 800 small banks now on the FDIC watch list. Quantitative Easing also punishes saving, particularly that of retirees, by keeping interest rates artificially low, although this does help those few able to buy a home or refinance. It also can create and has created artificial bubbles in bond values, commodity prices, and stock prices by injecting extra money into an economy that isn’t asking for more.
THE NATIONAL BALANCE SHEET ONCE AGAIN GROWS WITH LITTLE EFFECT ON TRADITIONAL MEASURMENTS OF INFLATION. Only this time, instead of it being contained in one sector (housing) it puts upward pressure on asset values in many sectors of the economy. This time, instead of the Agencies and big banks, it’s the public that’s taking on all the new Treasury debt PLUS the additional obligation at some future date to absorb all the debt the Federal Reserve has purchased with its QE and QE2 money printing schemes. Casino gamblers might call this “doubling down,” but that would be an understatement of both size and risk.
Was QE a successful stimulus? The answer might be yes if the purpose was to bail out the big banks, accommodate more government debt, and juice the economy with liquidity. Is it a necessary stimulus? The answer might be yes, BUT ONLY IF ELECTED OFFICALS REFUSE TO POVIDE FISCAL STIMULUS: REDUCE TAX RATES AND GOVERNMENT SPENDING. Did the Fed have the Constitutional authority to engage in QE? No (or it shouldn’t have, absent specific dollar by dollar Congressional authority to do so). QE2 is just more of the same.
So once again we witness the flawed decision making of our Ruling Class: bail out the few big banks, each of whom has been and will continue to be a systemic risk to our society (“too big to fail”). In the meantime, these same policies help drive smaller merchant banks and community banks to extinction, thus concentrating the systemic risk even further. Another (unintended?) consequence of artificially low interest rates is that pension funds, foundations, endowments and retirees that have a need or obligation to produce annual returns of 5% or more are forced to “rebalance” their portfolios from fixed assets (debt) to more risky investments: US stocks, corporate bonds, foreign stocks and “long only” commodity funds and ETF’s. Ergo, more government caused bubbles in these markets...just as Austrian School economists demonstrate and predict.
The recent election suggests that the voting public intuitively understands that something just isn’t right with all this federal government spending and manipulation of the economy and free markets. Congress created the housing bubble with its policies. The Fed fueled the housing bubble by holding interest rates too low for too long after the Tech bubble burst in 2000 and didn’t bother to “sanitize” the massive liquidity in mortgage financing created by the Agencies and investment banks. In the meantime Quantitative Easing dumps dollars into an economy that doesn’t need more liquidity, creating new bubbles in other markets.
In the past thirty months we have seen a number of serious government attempts at stimulus, all of which have raised the life mortgage on the innocent young; nearly all of which have no Constitutional authority and nearly all of which are poor macro-economic choices. Is the “new normal” a seven to ten year cycle of bubbles and crashes, compliments of the Ruling Class? Perhaps the Ruling Class is not so good at deciding what’s best for the rest of us. Perhaps the limited federal government envisioned by our Founders is indeed the one we should prefer.
Rock Cramer
December 2010
