As described in Part 1 (see here), the financialization of the US economy created a fragile economy well ahead of the arrival of COVID-19. The turn toward finance (financialization) began during the 1980s and matured during the 1990s and 2000s, as constraints were removed from financial markets. In response to the increase in financial instability, the Federal Reserve responded with the “Fed Put,” an asymmetric monetary policy that protected investors from downside risk. This encouraged investors to accelerate risk-taking. A series of debt-induced boom-bust cycles (see below) continued to build up until the global financial crisis in 2007-2009.
Although it acted aggressively in response to the global financial crisis in 2007-2009, the Fed failed to anticipate or take pre-emptive action against the massive buildup of debt and overvalued asset prices that created the crisis in the first place. Others have noted that the Fed was fire warden and arsonist – hard to disagree. The analogy drawn in Part 1 was to snow falling ahead of an avalanche. It is not the final snowflake that causes the avalanche, but the process that builds up over time. The Fed was caught napping – given the generalized Washington Consensus view of market efficiencies and self-regulating financial institutions – as the crisis unfolded. And for better or worse, the Federal Reserve is uniquely positioned with tools it can use.
Unfortunately, the models used by mainstream economists ignore the role of money, banks, credit and finance (for more discussion of this topic, see here). These models failed to anticipate the crisis and the ex post analyses likewise provided little understanding of the underlying dynamics. Mainstream economists were convinced, given faith in efficient markets and self-regulating financial institutions, that deregulation was the proper policy. Oops – obviously, this belief system failed to match up well with real world events.
The Obama administration was handed an extraordinary opportunity to reverse the financialization process. It could have introduced structural and regulatory constraints similar to those imposed during the Great Depression, including restrictions on speculative activities by banking institutions that are authorized to create money (see here). The Volcker Rule moved modestly in this direction, but it ended up severely weakened, especially when compared to the structural separation of commercial from investment banking imposed under The Banking Act of 1933.
Prior to 2007-2009, middle-class homeowners benefited from the “wealth-effect” due to rising real estate prices. However, from 2007-2010, they lost more than 40% of their net worth and as of 2016, were still 30% underwater. The decision by the US Government not to provide relief to many of these households contributed to the very weak recovery that followed. Given their underwater balance sheets, these households had little choice but to service debts, which made them less able to drive growth in aggregate demand.
Over the past decade, in part given weak growth in aggregate demand, US corporations bought back more than $5.3 trillion of their own stocks and paid dividends to existing shareholders. Both of these actions helped lift share prices (per the chart below).
The Fed’s use of Quantitative Easing (QE) from 2008-2014 and again in 2019 provided an additional source of stimulus to US stock prices (see chart below). When the Fed went on hold in 2014 other global central banks kicked in as QE metastasized. The Fed’s turn toward Quantitative Tightening (QT) and higher interest rates ended in tears in December 2018, as stock prices fell sharply, forcing the Fed to reverse course a month later.
Real growth in the US economy was held back by slow growth in net domestic fixed investment, in part given the decision by many US corporations to buy back their stock instead of making core investments.
Source: FRED, Author
The Fed has failed to properly understand the impact of declining interest rates in a financialized economy. They assume that falling interest rates will generate increased productive investments. However, this clearly failed to occur over the past decade. Why? The best way to understand is to examine how credit is utilized. When credit is used to finance productive investment, the result tends to be growth in employment, wages and incomes. However, when credit instead is used to finance speculative investments in already existing assets, the result may be higher asset prices and capital gains, but from a societal standpoint, this is a zero sum process. Nothing has been created. (For discussion of this topic, see here). The shift toward financialization has fueled rising speculative use of credit that resulted in an increasingly fragile financial system.
In brief, the US economy was vulnerable well before COVID-19 arrived, in some measure due to the failure to provide middle-class households with debt relief during the global financial crisis. Over the past decade, with stock buybacks and dividend payments raging, and with ownership of stocks highly concentrated (the top 10% of US households now own 88% of all US stocks) inequality has reached peak levels last seen in 1928, on the eve of the Great Depression.
In March and April 2020, the US Government and Federal Reserve passed the CARES Act and took other actions to stabilize the US economy. This included fiscal spending that put money in the hands of non-financial businesses (PPP loans) and US households (unemployment insurance plus $600 per week, and a one-time payment of $1,200). These steps kept aggregate demand afloat from April until July. However, if these programs are not renewed, given the pandemic, which does not appear about to subside, we may witness the collapse of aggregate demand in Fall 2020, whether or not there is a second wave to the pandemic. As Marriner Eccles (Fed chair during the Great Depression), Keynes and Hyman Minsky recognized, an economic system is not capable of rebounding on its own when faced with a collapse in aggregate demand. It is wishful, ideological thinking to think otherwise.
Gold is a very attractive investment today, despite elevated valuations. The lack of a yield paid to owners of gold is much less of an obstacle now, given the near-zero nominal rates (and negative real returns) paid on bonds. The price of gold recently surpassed $2,000 and silver has rallied as well. The price of gold tends to do well when market conditions become extreme. In an inflationary period, the price of gold tends to rise versus financial assets (stocks and bonds). And in a deflationary period, where everything else is getting crushed and the central bank prints money, gold should fare well. The main environment where gold tends to do poorly is when the economy and financial markets are relatively stable, which today is little more than a distant memory. Needless to say, there will be bumps in the road with gold, though the long-term (3-5 year) case for holding gold looks compelling right now.
Another asset class that might appear attractive is long-duration bonds (TLT). This asset class has been perplexing investors, including me, for decades. Yields on long-term bonds have consistently fallen for three decades now. In fact, roughly $17 trillion in global bonds in 2019 were priced at negative nominal yields, meaning the issuer of the bonds effectively gets paid by the holder, strange as that might sound. This is clearly an upside-down world, though in some measure it reflects how weak growth actually was in 2019, before COVID-19.
Jerome Powell has stated that he opposes negative interest rates. His reasons include the consequences of negative nominal rates for money markets and derivatives, which are a far larger component in the US financial system than they are in Europe and Japan (where most bonds with negative interest rates currently have been issued). In my view, the Fed does not intend to let interest rates go negative, though it is always entirely possible that conditions can get out of hand. However, there are plausible policy alternatives that may be more appealing to the Fed.
Helicopter Money: Central Bank Digital Currencies, et al
There has been much discussion recently of helicopter money, as described by Milton Friedman and later Ben Bernanke. This can take any number of forms, but the idea behind helicopter money is to get money directly into the hands of unemployed people who will either spend it or use it to reduce debt.
Recently, Bloomberg conducted an interview with two former Federal Reserve economists, Simon Potter and Julia Coronado (see here). They have proposed “Recession Insurance Bonds” that are based on the creation of Central Bank Digital Currency (CBDC). Congress would grant the Federal Reserve the right to create zero coupon securities that are a “contingent asset” for households in case of a recession. In a severe recession, the Fed would issue digital dollars to the apps of the unemployed, which activates the zero-coupon bonds. According to Potter and Coronado, this will get digital cash to households in need without the need for the banking system to get involved (and without the creation of central bank reserves that never leave the banking system). The CBDC could go directly from the Fed to the recipients who can spend them or use them to pay down debt.
Helicopter money proposals may sound insane but allowing aggregate demand to collapse could have consequences that are far more severe, including a second Great Depression. These helicopter money proposals will, it is believed, stimulate short-term spending, keep aggregate demand from collapsing and perhaps finally cause inflation to rise. And in the absence of any action by Congress and the administration, this may be a case of the “least-worst” outcome, especially should the crisis intensify, and liquidity risk transitions to insolvency risk.
If inflation rises, the Fed will likely buy bonds in an effort to keep yields from rising, given the massive amount of private sector debt outstanding. Alternatively, if yields rise, a financial market crash may follow, given the rickety debt structure that has been sustaining overvalued asset prices. If inflation occurs and yields are not permitted to rise, the US dollar might take a tumble.
After thirty years of continuous declines in long-term bond yields, investors may be waiting for negative bond yields that will generate capital gains. The presence of negative real yields outside the US perhaps underscores this belief. However, it is entirely possible that bond yields may remain in a fairly tight range. The Fed will keep yields from rising too much, given the debt overhang and the possibility of a financial crisis. But the Fed does not appear willing to allow nominal yields to go negative, either, and it may not need to, given alternative tools.
Accordingly, perhaps the best case for long-duration bonds is that holders will receive the yield (generally less than 1% and negative in real terms). Capital gains from yields going lower are unlikely, assuming I am correct (and I might not be, though I try to imagine potential risks that might emerge). Of course, the main source of uncertainty is the timing. For the Fed to create helicopter money, a simple legislative fix may be needed that will allow the Fed to directly purchase US Treasury issues (instead of having to work with the primary dealers).
The Fed claims that it is reviewing use of CBDCs and that it will take at least several years before anything is done. That may well turn out to be correct. Are there other ways the Fed can create helicopter money? Collaboration with the US Treasury as was done during World War II? In any case, I would not bet on the next downturn being several years out. In my view, the Fed will find other ways to get helicopter money to the people who truly need it, perhaps by creating a Special Purpose Vehicle with the US Treasury that explicitly focuses on that objective.
Conclusion: Part 2
Part 1 acknowledged that the Fed has been instrumental in facilitating the financialization process. It supported deregulation of finance, created the Fed Put, bailed out AIG and other financial sector participants and launched QE. All of these steps have contributed to the financialization process that has redistributed enormous amounts of income and wealth from the bottom 90% to the top 10% of US households.
Despite Mr. Powell’s sincere and (I am certain) well-intentioned expression of concern about inequality, the Fed has no one but itself to blame for the financialization process. It had the tools to combat it, including use of selective credit controls (margin requirements, loan-to-value ratios, etc., which were deployed during the 1940s and 1950s). Remaining on the current financialized road will have disastrous consequences for most US households, especially those outside the top 10%.
Part 3 will examine long-term measures that could address the financialization path. Comments welcomed – the view of future policies is highly speculative and nothing here is necessarily set in stone. I look forward to feedback. Thanks!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.