by Willis L. Krumholz
The American economy is growing too slowly. The unemployment rate is down, but labor force participation is at the lowest level since the late 1970s. Too many new jobs created over the last eight years have been low-paying or part-time service jobs, not high-paying careers. The result is flat-lining incomes in Middle America, and the very real prospect of a reduced standard of living for many Americans. Blame the malaise on bad monetary policy.
Jeb Bush or Marco Rubio could repeal and replace Obamacare, repeal Dodd Frank, overhaul the tax code, and cut the regulatory state down to size, and America still wouldn’t achieve sustainable 4 percent growth. It is imperative that conservatives understand this.
As life gets harder for the working class because of our slow growth, voters will demand more wage protection, less immigration, and less free trade. Enter Donald Trump, stage right, and Bernie Sanders, stage left. If a bubble blows up and bursts because of bad monetary policy, as happened in the 2000s, markets are blamed, and voters turn to, Trump, Barack Obama, or Sanders, who offer easy—but dangerous—solutions to complicated problems.
If conservatives care about winning elections and having a lasting effect on the country, they would do well to know the monetary state of our nation. Our recovery since the financial crisis stands out for being both the slowest on record since World War II, and a time of unprecedented monetary experimentation.
What QE and ZIRP Have Done to Us
Through a program called quantitative easing (QE), the Fed has purchased U.S. government debt and mortgage backed securities (MBS) using newly minted money, expanding the value of the securities the Fed holds from under $1 trillion before the crisis to over $4 trillion now. The first round of QE attempted to push down short-term rates. Later, when the Fed had bought up all available Treasury bills (short-term government debt), it began to purchase Treasury bonds (longer-term government debt) and MBS, which meant to push down long-term rates.
QE actually increased the yield of ten-year Treasurys, probably because it raised inflation expectations. At the same time, the difference (the spread) between yields of high risk corporate debt versus U.S. Treasurys became smaller (see graph above). This decreased the cost of borrowing for U.S. companies, especially for those considered less likely to pay the money back.
QE1 started in December 2008, and Q3 was ended in October 2014. Many believe QE’s biggest accomplishment was fueling the bull-run in equities that occurred during this time, a bull-run that has largely ended since.
Even after QE ended, the Fed’s asset purchases have had a more important, long-lasting impact. The purchases brought the fed funds rate close to zero, which is referred to as the zero interest rate policy (ZIRP). Before the financial crisis, the Fed changed monetary policy by targeting a rate—the fed funds rate—at which banks would lend to each other in the overnight fed funds market. The fed funds market existed because banks are required by law to hold a certain percentage of their deposits, known as reserve requirements, at the Fed.
When a bank was short its required reserves for the day, it would have to borrow in the fed funds market from another bank that had extra reserves. The Fed manipulated this market for overnight lending between banks by 1) changing the percent of deposits required to be held at the Fed, or by 2) expanding or contracting the supply of reserves available by buying or selling Treasurys. The Fed would use these levers to move the interest rate available in the fed funds market to the Fed’s targeted fed funds rate.
After QE, this all changed. When the Fed bought government bonds from the banks during QE, it credited banks’ accounts at the Fed, causing a record $2.5 trillion in excess reserves to pile up. This de-fanged the Fed’s normal monetary tool, the fed funds rate, as banks’ cash sitting at the Fed far exceeded their reserve requirements, causing the lending market between banks to all but dry up. All the extra money in reserves has kept the short-term interest rate at which financial institutions lend to each other at zero, or close to zero (supply is high, and demand is low, so the cost of money is low).
Why are banks sitting on excess reserves? To reduce the risk of over-inflation, the Fed started paying banks 25 basis points (bps), or 0.25 percent, in interest on reserves (IOR) since Q3 2008. This increases the return on cash, and reduces the incentive to move the money around, which reduces the velocity of money relative to the monetary base (see below). Today, IOR also acts as a magnet for the fed funds market—banks won’t lend their excess reserves to other banks for lower than 25 bps, because they can get 25 bps risk-free from the Fed.
In practice, non-depositary financial institutions—financial companies that don’t have access to IOR at the Fed—undercut the Fed’s 25 bps, so the fed funds rate floats between 0 and 25 bps. This affects the interest rate available on a house, a car, or on a company’s debt.
Here’s the Economy the Federal Reserve Has Made
To assess the outcomes of Fed policy, look at what the Fed said would happen: QE and ZIRP meant to reduce the cost of debt, which would pep up aggregate demand and business investment, which was supposed to cause a recovery in the labor market. Once the labor market recovered, wages would increase, which would push up inflation, allowing the Fed to raise rates.
Instead of using the newly raised cash for increased capital expenditure, such as to expand the business or increase worker productivity, companies have used much of the debt to buy back shares.
In reality, the results of this monetary experiment have been underwhelming, and even dangerous. For one, it has led to low business investment, productivity, and wage growth. The Federal Reserve did indeed lower the cost of debt, which caused corporate debt issuance to surge, to the point where corporate debt outstanding the world over has reached eye-watering levels. Instead of using the newly raised cash for increased capital expenditure, such as to expand the business or increase worker productivity, companies have used much of the debt to buy back shares.
Smaller businesses without access to the bond market, the engine of jobs growth in America, have also been unwilling to borrow or invest. Some see a supply problem. They point out that banks are no longer lending to small business like they used to, and blame either low rates or Dodd-Frank. This might explain some of the decline in bank lending to small business, but most metrics point to reduced demand for credit among small business owners. Either way, business investment across the board remains low, in spite of cheap debt.
Apart from the forces of technological change, business investment probably is the biggest driver of future wage growth. When businesses invest, they might expand and hire more workers, which tightens the labor market, increasing pay. Businesses might also use their investment to become more productive, which also increases the pay of their workforce—workers are more valuable if their productivity increases. In turn, weak investment restrains both economic output and wages. Business investment dropped in the recession, and has never fully rebounded during our current recovery.
There’s also the problem of fickle consumerism. U.S. consumer spending is on the uptick since the crisis, but this isn’t necessarily a good thing. While pay growth is slow, the cost of living has risen faster than wages for many people. Although the Fed’s preferred inflation gauge remains well below the Fed’s arbitrary 2 percent target, rent-inflation is at 3 percent, and the year-on-year increases in food prices have tended to be high as well.
Two worrying areas stand out: auto loans and student loans. Watch out below for stocks related to these sectors in the years ahead.
The risk is that consumers are maintaining their cost of living by increasing their debt. Overall, consumer debt is closing in on its previous peak, seen right before the Great Recession. Two worrying areas stand out: auto loans and student loans. Watch out below for stocks related to these sectors in the years ahead.
If consumers are using credit cards for groceries and rent, and not for non-necessities, this translates into what we are seeing in the retail sector. Macy’s stock is down over 36 percent since the beginning of 2015. Kohl’s is down 16 percent, Sears is down 37 percent, and Wal-Mart is down 28 percent.
The U.S. labor market is also still experiencing its lowest participation rate since the late 1970s. Unemployment has been down because so many are staying out of the workforce. Worse, a large portion of new payrolls have gone to the low-paying service sector, or to part-time work, and not to high-paying jobs.
For example, after a tepid jobs report in August and September, the media hyped October’s jobs report. Unreported was the fact that the vast majority of new payrolls went to those 55 years and over (378,000, seasonally adjusted), while working-age Americans lost jobs. Payrolls for those aged 25-54 declined by a seasonally-adjusted 35,000, or a non-adjusted 30,000. The November jobs report was better, but those employed part time who would like to work full time increased by over 300,000.
Further, an important index that measures U.S. factory activity, the ISM Manufacturing Index, suddenly collapsed in November to the lowest level in six years, the biggest monthly drop since the depths of the financial crisis. In the latest jobs report, the economy continues to shed manufacturing jobs. President Obama talked about leading a manufacturing renaissance. In reality, he is presiding over a manufacturing recession.
The Fed Won’t Hike Rates Enough
The Fed looks at our economy and sees a recovery. Because of this, the Fed keeps floating the idea of hiking rates, with the market now thinking it will on December 15, its next meeting. The Fed has, however, been reluctant to hike rates all year. Despite all the talk of a recovery, low wage growth and low inflation have given the Fed the excuse to keep ZIRP.
ZIRP dooms us to Japan-style stagnation, low wage growth, and increased inequality.
In the mind of progressives such as Vox’s Matt Yglesias, ZIRP is the greatest thing since sliced bread. Rates should be kept at zero for as long as possible, as long as there’s no inflation, because ultra-low rates boost economic growth. In the mind of others who are slightly more reasonable, such as Larry Summers and probably Janet Yellen, the Fed should start to hike very slowly, but only so they can lower rates if another recession comes along.
Even if the Fed does hike soon, however, it will only do so by 25 bps, which means the federal funds rate would float between 25 and 50 bps, instead of between 0 and 25 bps. This is hardly an increase. The fed funds rate was 500 bps higher 10 years ago.
The problem with thinking ZIRP is great until inflation rears its ugly head is that ZIRP dooms us to Japan-style stagnation, low wage growth, and increased inequality. When rates are ultra-low, unproductive firms continue to binge on capital, even though these firms would be put out of business if the Fed didn’t manipulate rates. The lower rates go, the greater the share of savings directed to unproductive areas. This is called malinvestment. The recent fracking boom provides a good example.
Low Rates Cause Wasted Investment, Slowing Growth
The Fed’s ZIRP and QE caused the dollar to decline, which increased the price of oil and natural gas measured in dollars. At the same time, cheap debt increased economic activity, especially in emerging markets, increasing the demand for energy, as it also decreased the cost of production for frackers. Money was poured into fracking, and production was ramped up.
It was only a mirage, caused by the Fed’s central planning, which screwed up price signals for producers.
When QE ended, the dollar surged, reducing the price of oil measured in dollars. At the same time, demand from emerging markets fell, and debt became more expensive for high-risk producers. There’s nothing wrong with fracking—it’s a great example of American grit and ingenuity—but too much money was invested in fracking to take too much energy out of the ground. This is called overcapacity. Producers thought that they were meeting consumers’ preferences, but they really weren’t. It was only a mirage, caused by the Fed’s central planning, which screwed up price signals for producers.
The story of fracking’s boom and bust played out economy-wide. Because the Fed has changed price signals and tricked producers and investors into malinvestments that don’t match consumer preferences, the Fed has misdirected capital from the next proverbial Apple to the next proverbial Solyndra. The companies that would fail without the easy money are known as “zombies.” Zombie firms eat up too much capital and are slow to hire or grow, dragging down the economy as long as they live.
Zero Interest Rates Mean Slow Growth
Here’s another way the Fed’s policies manifest themselves in slow growth: the Fed’s distortion of price signals doesn’t trick all producers. These producers, possibly burned in the past, don’t expand. Maybe the price signals are real, maybe they aren’t, but there is no certainty, and business thrives on certainty.
Maybe the price signals are real, maybe they aren’t, but there is no certainty, and business thrives on certainty.
This might explain why so many large corporations have borrowed on the cheap and used the money to buy back shares, or have been sitting on loads of idle cash. Small business has also been reluctant to invest, which is especially worrying because of the important role small business plays in American job creation. If business owners know we are in uncertain times, and that ZIRP will have to go away at some point, they might hold back on long-term projects. This suppresses wage growth.
ZIRP has also decreased the opportunity cost of holding cash. In normal times, if you aren’t putting your cash to work, you are missing out on returns. Returns are so low because of ZIRP, that there is little cost to sitting on piles of cash. This makes it more rational for businesses to hold back on investing, which helps explain all the cash sloshing around in excess reserves or on corporate balance sheets.
By the way, ZIRPs effect of increasing the demand for cash might also explain why the Fed keeps missing its inflation target. John Maynard Keynes wrote in his “General Theory” about a phenomenon he called a liquidity trap: A liquidity trap occurs when, at the zero-bound, injections of new money (asset purchases by a central bank) are rendered ineffective, or even deflationary, because the opportunity cost of holding cash is zero when nominal rates are zero. When the Fed started paying 25 bps of IOR on banks’ reserves in Q3 2008, this only further reduced the opportunity cost of holding cash to “below zero,” at least for banks.
In normal times, if you aren’t putting your cash to work, you are missing out on returns.
Sen. Rand Paul was dead on at the last Republican debate, where he pointed out that the Fed is the primary contributor to income inequality. He took some flak for his statement, as several pundits cited a bogus study that claims to show how the Fed has a “positive” impact or no impact on wealth distribution. The study seems to ignore that many low-income Americans don’t own a home.
It is not hard to understand how the Fed contributes to inequality. Low rates increase prices of assets, such as homes, stocks, or bonds. If you don’t own any assets, and you’re paying rent that is going up 3 percent a year, you’re falling behind.
Conservatives, Don’t Waste This Crisis
Not only does ZIRP impede today’s economy, QE and ZIRP have set the table for a recession, probably coming in 2016. ZIRP and QE have sent more dollars chasing after the same financial assets, causing a large bubble in bonds, equities, real estate, and privately held tech companies. As soon as the easy money goes away, the valuations of these assets will decrease dramatically, causing a recession.
QE and ZIRP have set the table for a recession, probably coming in 2016.
Think back to the boom and bust in the energy industry. That is about to play out across the economy, in multiple sectors. To the extent that there’s economic activity predicated on easy money, taking the punch bowl away will cause that economic activity to go away. Maybe we can put off a recession, but doing so will mire us in Japanese-style stagnation.
Supporters of endless easy money, like Yglesias, will blame the inevitable downturn we face on the Fed tightening too soon, or too little government stimulus. Progressives cheerlead government bubble-inflating, blame markets for the inequality it causes, then blame markets when the bubble bursts. Yglesias, for example, clamors for low rates and homeownership for all, and uses the nasty side-effects of his own pet policies to point to the need for more government. More government is always the answer.
Conservative who subscribe to market monetarism, such as Ramesh Ponnuru and James Pethokoukis, also make the mistake of blaming every downturn on tight money. They fail to see that a downturn is necessary to return to stronger growth. A downturn is already in the cards, precisely because the Fed has manipulated the money supply. All the excess capacity in the oil patch equals resources and capital that could be better used elsewhere, and realigning resources and capital to its most productive use means firms go under, which is painful.
Maybe we can put off a recession, but doing so will mire us in Japanese-style stagnation.
At the same time, monetarists are right to point out that too tight of money, in the form of the Fed paying IOR to the banks, probably made the Great Recession worse. Ted Cruz mentioned this at the last Republican debate. The takeaway should be that the central bank messing with the money supply through easy money or tight money causes harm.
The solution lies in allowing the market to set rates, not central planners. ZIRP and IOR should end. Rates would probably rise, but by how much I don’t know, as the market would decide. This would surely cause a recession, but the recovery would be quick, strong, and naturally redistributive.
U.S. policymakers should also use the upcoming crisis to end the Fed, and replace it with free banking, a system where banks issue their own currency, and with no reserve requirement at the Fed. Free banking would reduce the excesses of the business cycle that central banks fuel today. Doing so would force Washington to drastically cut back on spending, which would be a plus for economic growth. As a former Treasury secretary said, never let a crisis go to waste.