I intended to start this with a graph showing total US debt levels as divided into household, corporate, and government sectors. Most are older, here’s the best I could find: so far:
I’m going to continue anyway because if I spend all day searching for it, I’ll never get this written. The point is that debt levels have not really reduced from their 2009 peak. That being said, I’ll move on to explain Fed policy in general terms and why it needs to change.
What is the Federal Reserve doing?
The Federal Reserve is holding very low interest rates for a number of reasons. They provide liquidity to banks and the financial sector to try to jump-start the economy when things slow down. This works in a traditional debt cycle because when people and businesses are tightening down to pay off debt, they have less money to spend, and GDP which measures total spending levels begins to decline. This has negative implications for employment as well as asset values. The goal is to provide money for people to spend so that the spending levels, or GDP, will continue to grow.
Central banks tend to fear a deflationary cycle because it tends to mean falling wages, rising unemployment, and a growing inability to meet debt burdens leading to a crash.
In order to avoid deflation, they try to boost “liquidity” in the system. As
“Helicopter Ben” once said, you can always avoid deflation through central bank policy because if necessary you could have helicopters simply drop money into the system.
Unfortunately, the policy of easy money is not causing the “inflation” they want as the velocity of money (or fraction of money in the system spent) continues to drop.
Why isn’t this policy working?
The main problem with the economic theory behind the actions of the federal reserve is that they never question where the money goes. Many in the elite financial/political/economic circles think this way, just like in 2008 when Obama was pushing his stimulus package … the Republicans were decrying the overall levels of spending and debt, Obama famously said “but that’s the whole point,” and questions were never really asked about where the money was going.
So where does the money go when the Federal reserve increases liquidity?
It seems obvious from the graph here that the easy money is going straight to the top income tiers and leaving everyone else behind. It gets worse as you can see the share of the 3rd quintile and below is actually declining!
When the federal reserve increases liquidity, the money goes first to the largest banks, such as JP Morgan Chase, Wells Fargo, Citibank, and Bank of America, who are entrusted to spread the money throughout the system. They in turn put it into large corporations to do takeovers and stock buybacks, hedge funds such as Black Rock which pour it into rental housing, stock markets and debt markets.
Anyone who reads about the hyperinflation of the Weimar Republic sees the well known conclusion that inflation benefits those with first access to the newly created money at the expense of everyone else. At a time when wages are still falling (median nominal incomes were near $60,000/year in 1998 versus about $51,000/year now) we see huge gains in not only asset markets, but in costs of food, rent, and gasoline.
Yes everyone, I included gasoline – because even though oil is near a 15 year low, gasoline in southern California is not budging below $2.50 a gallon, which is still more expensive than it was in parts of the early to mid 2000’s. If oil merely normalizes, gas will again quickly shoot right back to the $5/gallon range. I realize this is partly a tax issue but these cannot all be ignored, as many have seen the ironically named “Affordable Care Act” more than double both their health care premiums and deductibles while forcing you to purchase the plans anyway or pay a stiff tax penalty.
What are the implications of this liquidity in the financial sector from the standpoint of business growth?
It is clear that productivity is not really increasing – nor can it really as demand in the overall economy declines. What is really happening in the business sector is actually downright scary.
Essentially, “free money” or near-zero percent loans, is being given to the financial sector, which is using it to transfer large swathes of the economy into their direct ownership. On the surface, stock market and bond market price increases would seem to be good for thinks like middle class retirement funds – which used to be the core of lending to the business sector. Now, these middle class retirement funds are being destroyed because the central bank displaces the lending ability of these funds, and gives the gains instead to the uber-wealthy who get first access to the newly created cheap money.
Meanwhile, financial-sector bean counters have a very different view of running a business than traditional business creators or long-term owners. The tenure of a CEO in a publicly run company is typically less than 5 years, during which they first write off a bunch of losses to “ratchet” down the stock price, then give steady paper earnings increases over the next few years, typically by “farming” out the assets – charging for things that were once free, raising prices, etc. These short-term policies alienate customers over the long term, but all they need is a few years of gains, then they can leave and cash out a fortune in stock options – their primary form of compensation.
Are the actions by the federal reserve – specifically near-zero interest rates and massive quantitative easing – really unprecedented?
Actually no. The bank of Japan has been using this approach continuously since their big asset bubble collapse in 1989. The results are well documented… a nearly stagnant GDP for 27 years, an artificial ceiling with a large economic underclass (about 50% of the Japanese work force is classified as temporary or seasonal, with low pay, low reliability, and practically no benefits), rising prices (the cost of living in Japan is notoriously high), etc. Debt levels continued to climb and economic analysts such as Reinhard and Rogoff, John Mauldin, and many others continue to predict a catastrophic collapse, most likely in the form of hyper-inflation.
If these results are well documented, why does the US Federal Reserve follow the same path?
The US Federal reserve is very much a political animal. Unfortunately, the politicians in the United States are typically all from the top 2 quintiles who are benefitting tremendously from current policy. Ask Hillary or Obama, and they will continually assure you how well the economy is humming along. The elite republicans are often even worse. They live in a shallow bubble that gets more and more isolated from the rest of the country, hence the unforeseen popularity of outsiders such as Bernie Sanders and Donald Trump.
Should the US Federal Reserve do nothing? Is there anything it can do to improve things?
The most important role of the US Federal reserve has always been the “lender of last resort”. Their lending did prevent a major catastrophe back in 2009, when the contagion of bad assets threatened to destroy the entire financial sector – including the savings of individuals as well as the running capital necessary for real viable main street businesses to function.
However, there is certainly more they can do to combat deflation, but they have to start looking at WHERE THE MONEY IS GOING.
Right now the federal reserve policies make the current imbalances of the system worse. Debt increases, rents go up, wages go down, and social unrest results – in short the deflationary spiral they so fear is being exacerbated on main street by their very actions to curtail it!
What policies could the Federal Reserve do to comabat inflation?
If the federal reserve gave EVERYONE access to the new money rather than siphoning it through the wealthy elite, then it actually would increase liquidity in the system, make debt obligations easier to meet, and help rebalance the economy.
If the Federal Reserve simply assigned money to every US citizen in equal amounts – redeemable at any bank by social security number – it would do just that.
What about negative interest rates?
Negative interest rates are an extremely dangerous policy tool. It not only continues the trickle-down policies of filtering money through the financial elite, but it encourages hoarding of cash. In Europe, you even hear talks of banning high value bank notes in order to prevent this. It will also devastate the retirement funds of the middle class and lead to the collapse of many public and private pension plans.
Israel is talking about moving to a fully electronic currency. Would that make negative interest rates more effective?
Unfortunately no. Gold and Silver have been traditional currencies for years, and currencies from other countries would simply replace local bank notes, which could result in a currency collapse.
In addition, I urge policy makers to read “Shadow Cities” and “Stealth of Nations” and seriously consider the implications to the shadow economy as well as the size and importance of it. Throughout the world, too much of the political and financial elite tend to ignore these or think of them as illegal things such as drugs and prostitution. In reality, it is the last hope of many for survival as employment in the formal economic sector shrinks. The shadow economy is people turning to lawn-mowing, housekeeping, landscaping, selling food at farmer’s markets, ongoing garage sales, and so on. This sector tends to grow both as people get more deserate and as the legal and financial impediments to starting a formal and licensed business become harder to overcome.
Major revolutions happen when you get enough people with nothing to lose. Countries in emerging markets often find that food price spikes cause major instability – as many would rather die fighting a society that spurns them rather than starve. This is the unfortunate reality of the lower tier of society in much of the world. Countries who ignore the importance of the shadow economy as the last support to feeding the lower class do so at their peril.
I still believe that we are far from this in the US, and that the democratic system, while biased and flawed, will be able to produce the required change before things get to that point. However, I strongly urge those with an ear in policy to consider the situations of the middle and lower classes, and to take a deeper look into what current policies are actually doing.