October 08, 2020
by Jean-Luc Baslé for The Saker Blog
Wall Street is forever rising. The S&P500 index rose to 3,581 on September 2nd, 2020 – the highest level it has ever reached since its creation. This makes no sense. Wall Street is a reflection of the state of the economy which is in recession since February[1], the worst recession since 1929. How can share prices rise when the economy is falling? To answer this question, let’s analyse the economic policy of the United States these past few years, taking Federal Reserve Chair Jerome Powell’s speech of August 27th, 2020 as our starting point. Going back in time, we see that American leaders ignored the fundamental laws of economics. We note that foreign leaders, such as the European Central Bank governors, followed the same path. We conclude that stock prices do not reach the sky, and that the United States is caught in a bind from which the only way it can extricate itself is through a dollar depreciation. This bodes ill for the American Empire. The dollar is one of its main pillars.
Jerome Powell questions the validity of quantitative easing
Depending on their editorial stand, the media understood Powell’s speech as a return to inflation, giving greater attention to unemployment. But this summary ignores the essence of the message which questions the validity of quantitative easing – a policy followed by the Federal Reserve since November 2008. This is what Powell said: “With interest rates generally running closer to their effective lower bound even in good times, the Fed has less scope to support the economy during an economic downturn by simply cutting the federal funds rate.” In short: pushed to its limit, quantitative easing loses its capacity to alter employment and inflation. Quite logically, Jerome Powell and the Federal Open Market Policy (FOMC) call for a softening of the rules governing inflation and employment: “appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time”, and “a strong labor market, particularly for many in low-and moderate-income communities”.[2] This was understood as a return to inflation which it is not. It is an attempt to rescue quantitative easing while waiting for a return to more traditional economic policies.
By dropping surreptitiously quantitative easing, Jerome Powell is sending a message to Congress: economic policy cannot rest solely on monetary policy. Congress has at its disposal another tool: the budget. Over the past thirty years, priority has been given to monetary policy for several reasons. For conveniency reasons: monetary policy is essentially defined by one man, the Federal Reserve Chairman with the FOMC congruence. Budgetary policy, on the other hand, is defined by Congress and the President. It takes time for the two to agree, especially if Congress is split between a Democrat and a Republican majority. For efficiency reasons: changes in monetary policy are felt quite rapidly in the economy: six months to a year. It takes a lot longer (one to two years) for changes in the budget to be felt. For practicality reasons: budgetary measures imply taxation or indebtedness. Taxation is not very unpopular with the electorate, and indebtedness, if overused, leads to higher interest rates and slower economic growth. For all these reasons and the more theoretical ones set out by Milton Friedman and the monetarists, monetary policy became the policy of choice for the last thirty years, with quantitative easing being its most advanced form.
Priority being given to monetary policy with the budget playing second fiddle, the budget deficit should have come down and, with time, turned into a surplus. It did not happen. Worse, it has grown over the last twenty years to reach -4.6% in 2019. The initial figure expected for 2020 (-4.6%) will be substantially larger due to the Covid-19 virus. The $2,200 billion CARES Act approved by Congress in March to provide much needed relief to individuals, families and businesses, will translate into a much higher deficit, and a much higher level of debt.
Quantitative easing and the economy
Excessive money creation by central banks is anathema to financial markets since it is synonymous to inflation, higher interest rates, slower growth and the collapse of the stock market. It must be prohibited at all cost. Yet, that’s what quantitative easing is all about, and quantitative easing saved Wall Street and the economy after the 2008 subprime crisis. How can this be? In the fall of 2008, banks’ balance sheets were loaded with corporate bonds whose market value were well below their face value. To avoid a collapse of the market, the Federal Reserve bought the bonds, in effect replacing junk bonds with cash on banks’ balance sheets. The Fed’s bailout commitment totaled $29 trillion.[3] In view of this amount, it is no wonder that the program worked… to Wall Street’s satisfaction. Trust returned, the economy took off, and shares regained and exceeded their previous values. All is well and good, except the Federal Reserve exceeded its mandate. Its job is to provide the liquidity the economy needs to grow and achieve full employment without generating inflation. Under normal circumstances, the banks whose equity was washed out by bad investments, due to senior management’s poor decisions, should have been allowed to fail. To avoid a collapse of the economy, the government would have bought the banks’ shares at their market value, fired the management, and re-introduced the banks on the stock market once their business was back to normal. But these were no “normal circumstances”. Neither Congress which oversees the Federal Reserve policy, nor Barack Obama who was anxious to move past the crisis, blamed the Federal Reserve for outstepping its legal framework. As for Wall Street, it had every reason to rejoice. Not only was it saved from total collapse, but within five years the market value of its stocks, as measured by the S&P500, exceeded its pre-crisis value. It has more than doubled (graph 1).
The Federal Reserve’s quantitative easing did not result in a depreciation of the dollar, as could have been expected. In fact, the subprime crisis strengthened its value somewhat, as it was perceived by foreign investors as a safe haven to protect their wealth in a tumultuous environment. This strength of the dollar and the relative stability of foreign exchange market is also due to the interconnexion of world’s economies. The subprime crisis first emerged in the United States but spread rapidly around the world. Faced with a potentially damaging economic crisis, world leaders of the largest twenty economies – the G20 – met in Washington DC on November 14-15, 2008, i.e. only two months after Lehman Brothers’ bankruptcy. Asian and European central banks agreed to espouse the Federal Reserve’s quantitative easing policy. Money creation around the world being essentially the same in relative terms, currencies retain their value in relation to each other, as shown by graph 2 (note: exchange rates are expressed as an index, and the value of the pound sterling and the euro have been inversed to make them comparable to the yen and yuan).
Money creation saved Wall Street without depreciating the dollar, but what about employment? The United States’ performance is excellent. The December 2019 unemployment rate is 3.5% – a rate lower than all other advanced economies with the exception of Germany and Japan. The picture is less rosy if one looks at it from a different angle: the length of time it takes to return to full employment. It took 15 months after the 1973 recession, 30 months after 1990, 46 after 2001 and 75 months after 2008, i.e. over six years (graph 3). Quantitative easing which served Wall Street so well, did little for Main Street. Of course, as noted by Jerome Powell, there are other factors to be considered besides monetary policy when studying labor issues. Nonetheless, the conclusion is inescapable: quantitative easing worked better for Wall Street than it did for Main Street.
What about inflation? Ever since Federal Reserve Chairman Paul Volcker put a brutal end to stagflation[4] in letting the overnight rate go over 21% in June 1981, inflation has been subdued. Quantitative easing which is an inordinate increase of money in the economy should have, according to the quantity of money theory, led to inflation. It did not. The large quantity of money injected in the economy by the Federal Reserve had no impact on the price level. Graph 4 compares the velocity of money[5] with the Consumer Price Index – the velocity (blue line) is inversed to underline its exceptional rise in the last few years. Full employment did not lead to higher prices either. Jerome Powell observes that “the historically strong labor market did not trigger a significant rise in inflation”, as the Phillips Curve[6] would predict. He then notes that “inflation that is persistently too low can pose serious risks to the economy”. Clearly, the United States is in a peculiar situation where neither money creation nor full employment translates into higher prices, as economic theories tell us. Several hypotheses may explain this abnormality.
The fairly rapid opening up of the American market[7] in the early 1990s, followed by the creation of the World Trade Organization in 1994, shaped a new environment in which the procurement of a given product was no longer restricted to the home country. Bilateral trade relations among advanced nations became global to include developing nations, such as China which joined the WTO in 2001. Competition among manufacturers became global, pushing prices down. Corporations offshored their production to take advantage of lower wages in developing nations. This weakened the negotiating power of trade unions who were faced with an unpalatable deal: accept lower wages or lose jobs to the Chinese. The digital revolution also played a role in bringing costs down with many firms “rightsizing” their labor force thanks to the adoption of the personal computer. Finally, Ronald Reagan’s decision to fire 11,000 air controllers in 1981 had a tremendous impact on middle income employees who realized status did not protect them anymore: they could lose their jobs as easily as manual workers could. These events put an end to what was known as cost-push inflation – an overall increase in prices due to higher labor and raw material costs.
Increased energy efficiency, as measured by the ratio of oil consumption to GDP[8], also helped contain inflation. The ratio doubled over the last twenty years. While a barrel of oil produced $450,000 of economic wealth in 2000, it produced $920,000 in 2019. This is why the rapid rise in oil prices over the last fifteen years had little if any impact on the state of the world economy, as opposed to shocks inflicted by the 1973 and 1979 price hikes.
In summary, inflation remained subdued due to globalization, the Reagan and digital revolutions, and energy saving. These watershed events spare the United States a rise in price levels that quantitative easing would normally have brought up. Quantitative easing is not inflation-free, it benefited from exceptional conditions. With respect to employment, the Federal Reserve’s performance is dismal when compared to previous periods. But Wall Street has every reason to be satisfied with it.
The Federal Reserve’s monetary policy in the recent past.
The decoupling of quantitative easing and inflation partially explains why Jerome Powell is distancing himself from this much vaunted but, in truth, inefficient policy. Besides the dual, yet incompatible inflation-employment objective Congress assigned to Federal Reserve, he must also watch over the largest banks’ financial health to make sure it remains strong. In fact, this was the main role the Federal Reserve Act assigned to the Federal Reserve in 1913. This duty is crucial. Economic crises often arise from a bank failure, as was the case with Lehman Bros.’ bankruptcy in September 2008. From this standpoint, Jerome Powell deserves our praise for he averted two crises in the recent past even though one may argue about the reasons they were conducted.
The first rescue took place in September 2019. Without warning, interest rates on the “repo” market shot up to 10% in mid-day on September 17th., 2019.[9] This market is a corner stone in Wall Street’s architecture. If it fails, the whole structure crumbles. The Federal Reserve had to act promptly to calm the market down. This is what it did in injecting $41 billion into the market that very day. Interest rates plummeted. On September 18th, they had returned to their September 16th level. The cause of this ephemeral panic remains a mystery. But the fact that the Federal Reserve had to keep intervening for several months, leads one to conclude that structural causes might have been at work.
This incident was the prelude of a much worse crisis which was averted thanks to the combined effort of the Federal Reserve and Congress. On February 19, the S&P500 reached a new high: 3,386, then dropped abruptly reaching its lowest level in the year: 2,237 on March 23, i.e. a 30% fall in 36 days. This time, the Federal Reserve was slower in reacting. It’s only on March 11th, nearly a month after the stock market began to tumble, that it began injecting liquidity into the economy, propping up the stock market (graph 5). On March 13th, two Congressmen from the Democratic Party offered to help people who lost their job due to the pandemic. It took the form of The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act for short, which was unanimously approved by the Senate on March 25th and signed by Donald Trump on the 27th. It took only 15 days to ratify a law granting $2,200 billion, or about 10% of the gross domestic product – the largest amount ever approved in the history of the United States – to dodge an economic crisis in the making. Considering that by March 11, only 37 people had died from the virus while the S&P500 had already lost 19% of its value, one may question the politicians’ motivation. Was it the Covid-19 or was it Wall Street which led them to act decisively? Generous as it is to the unemployed, the CARES Act is equally generous to corporations which already benefited from the Federal Reserve’s action. Wall Street resumed its rise.
May the stock market rise to the sky? One is tempted to believe it when considering its performance. Could investors be the victim of an “irrational exuberance”? Not so, say some analysts who attribute the market rise to the “big tech” corporations (Google, Amazon, Facebook, Apple, Microsoft), also known under the acronym GAFAM. They account for about 20% of the market value and they are pooling up the market. But, excluding them from the S&P500 would mean excluding them – as well as other outperformers such as Tesla, Netflix, Nvidia, or Salesforce – from the American gross domestic product. One cannot dissect the market according to one’s view. The market is a reflection of the economy at large: the more profitable the corporations, the higher the value of their shares. Right? Wrong. Over the last few years, the stock market is disconnected from the economy. Net income has been flat since 2017 while share values gained 43% (graph 6). This makes no sense. The market is acting irrationally. It’s a matter of time before it corrects itself.
Returning to orthodoxy
In the 50’s and 60’s, the American government was a paragon of virtue. The budget was in quasi-equilibrium. There was little debt, no inflation, and the workforce was fully employed. Things have changed since then. The deficit is rising, the debt is growing ever-larger, and employment is not what it is purported to be. In the trio it makes up with the Federal Reserve and Wall Street, the federal government is the most important element for it defines the economic policy.
This brings us back to Jerome Powell’s speech. A lesser importance granted to monetary policy, as he posits, means a great one given to budgetary policy, assuming of course that the government has the latitude necessary to do so. This is not the case. The deficit is on a downward slope ever since the late 1960s, with the exception of a four-year gap from 1999 till 2002[10]. The federal debt rose from 40% of GDP in the early 1980s to 107% in December 2019. The combined Federal Reserve/CARES Act rescue package pushed it up to 137% as of June 30th – a level higher than at the end of World War II (119%). Giving a greater role to budgetary policy means either higher taxes or more debt, or both. Taxes have never been very popular with the electorate, and the federal debt reached a level beyond which the United States’ credit rating may fall and the value of the dollar may drop. Authorities are caught between a rock and a hard place: monetary policy lost its effectiveness at a time the budget deficit should be reined in.
With 29.7 million unemployed (including the 13.6 million “gig” workers with no insurance coverage), the situation could quickly become worrisome, politically and socially. Aware of the danger, members of Congress had hoped to prolong the CARES Act for the unemployed, but electoral rivalry with the upcoming presidential election quickly set in and any attempt to maintain some of the benefits of the CARES Act were doomed to failure. On August 8th, Donald Trump signed an Executive Order granting $300 a week to unemployed people – humanitarian and electoral reasons no doubt explain his decision. The Center for Control Disease and Prevention declared a moratorium forbidding tenant evictions until the end of the year, bringing some relief to the most vulnerable families. Praiseworthy as the decision might be, it carries a risk: bankruptcy for real estate owners who, deprived from rental revenues, may not be able to reimburse their bank loans. In turn, this may weaken the banks’ financial health and be the cause of a crisis.
The situation is becoming inextricable. The on-going deterioration of the economy increases the budget deficit and the public debt beyond reasonable levels while monetary policy has lost its effectiveness. The government’s two main levers to direct the country’s economic policy have become ineffectual. Due to the presidential election, no new measures are likely to be implemented between now and February or March – a time lapse during which the economy is likely to deteriorate further.
To prevent such an unwelcome development, Ms. Loretta Master, president of the Federal Reserve Bank of Cleveland suggested on September 23rd to credit every American’s bank account with “digital dollar” directly from the Federal Reserve. Her proposal was well received. Market analyst Wolf Richter calculates that a $3 trillion transfer would translate into a $28000 sum for a household of two adults. This would prop up consumer spending and pull the American economy out of recession. But it would also create inflation and depreciate the dollar. A digital dollar is a dollar. Ms. Master’s proposal is another form of money creation. The total of the Federal Reserve’s balance sheet which amounted to 40% of the gross domestic product in the 1960s, rose to 100% in December 2012. It now stands at 125%. Is the United States on its way to repeating the Wehrmacht Republic’s mistakes of the 1920s? What will happen to the dollar, if the Federal Reserve pursues its money creation policy? And what will happen to the United States’ credit rating?
Icarus’s wax is melting
Whatever measures are eventually agreed upon the public debt will rise. Who will finance it? About 70% of it is presently financed by the American public, federal agencies and the Federal Reserve. The remaining 30% is financed by foreigners. The percentage is dropping. In the summer of 2012, foreign investors held 34% of the public debt. The trend is likely to continue if we use gold prices. Gold is a yardstick of investors’ confidence. For several years, worried investors have been exchanging their dollar-denominated U.S. Treasury holdings for gold, pushing up its price. Graph 7 is most interesting in that it shows the investors’ change of mood. Following the 2008 subprime crisis, they put their financial assets into dollar and gold. Today, they are moving out of the dollar into gold. This is not a good sign for the dollar.
Meanwhile, the stock market is fumbling. After reaching its highest value ever on September 2nd (3,581), it is falling. Share values, like Icarus, do not rise to the sky. If the stock market fall continues which is most likely due to the state of the economy, the American recession will translate into a world recession, since the U.S. economy accounts for 15% of the world economy. In turn, the world recession will aggravate the American recession in a vicious circle analogous of the Great Depression. This could mean the demise of the American Empire.
Jean-Luc Baslé is a former Citigroup (New York) Vice President, Columbia University graduate, Princeton University graduate, 20 years in the United States, author of “The International Monetary System: Challenges and Perspectives” (1982), “L’euro survivra-t-il ?” (2016).
- National Bureau of Economic Research. ↑
- “New Economic Challenges and the Fed’s Monetary Policy Review”, Jerome H. Powell – August 27, 2020. ↑
- $29,000,000,000,000: a detailed look at the Fed’s bailout by funding facility and recipient. James Felkerson, Dec. 2001. ↑
- Stagflation is an unusual combination of inflation and recession (unemployment). ↑
- The velocity of money is the ratio of money to the gross domestic product. ↑
- Higher level of employment leads to higher wages and higher inflation. ↑
- In the 1960s, U.S. imports amounted to 5% of gross domestic product. They averaged 16.5% in the last decade. ↑
- Gross domestic product ↑
- A repurchase agreement “repo” is a short-term secured loan: one party (usually a financial institution) sells securities to another and agrees to repurchase them within a short period of time. ↑
- This was due to the “peace dividend”. ↑
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