“Risk markets need more ammo if they are to stay up,” Bill Gross wrote on Twitter last week. He and Goldman Sachs’ strategist are suggesting that investors should be prepared for additional bond purchases by the Federal Reserve. A sluggish economy in the US and a Europe in disarray obviously influenced their opinions. But I suspect a 4.5% decline in U.S. stocks since the first of May and a recent sell-off in commodities added urgency to their predictions.
Debt was the single most important element that led to the credit crisis in 2008. Growth in debt over the past decade greatly exceeded growth in GDP. In fact, debt has been growing as a multiple of GDP for the past forty years. According to data from the St. Louis Fed, in 1970 U.S. GDP was $1.0 trillion, supported by $1.6 trillion in debt – a ratio of 1.6X. By 2000 that ratio was 2.8X. And by 2008, the ratio had expanded to 3.7X, with GDP of $14.4 trillion and total debt of $53.6 trillion. Obviously, De-leveraging will have a deleterious effect on growth.
In response to the credit crisis in the fall of 2008, the Fed’s balance sheet increased from roughly $860 billion, where it had been at the beginning of 2007 to $2.226 trillion at the end of 2008. The increase was a necessary response to the failure of Lehman, the forced merger of banks like Merrill Lynch, the government take over of AIG and GM, and the near collapse of Goldman Sachs and Morgan Stanley. During the last three months of that year, a little more than $1.5 trillion was lent by the Fed to the banks. During the month of December, Federal Reserve lending to banks reached its cyclical peak of $1.56 trillion. The TED spread (LIBOR over Three-month Treasuries), which had peaked in October 2008 at 465 basis points had declined to 131 basis points by year-end 2008. While markets knew it, though Washington still remains clueless, the credit crisis had been contained.
The subsequent decline in lending to banks (today at $220 billion, an 80 percent decline from three and a half years earlier!) was more than offset by the Fed buying Treasuries, Agencies and Mortgage Backed Securities. While one can conclude that the credit crisis was over before Mr. Obama became President, the recession was not. Thus the Fed’s purchases over the past couple of years have been aimed at priming the economic pump, by keeping long term rates low. However, in keeping Fed Funds rates at near zero, banks gained more liquidity than they needed.
In a De-leveraging economy, which is what we have (and need to have), there is less need for monetary easing than there is for fiscal reform. Unfortunately, there has been none. There is plenty of blame to go around. The US Congress has been of little help. But most of the fault must lie with the President. He sits at the desk where the buck is supposed to stop. However, Mr. Obama wasted his honeymoon period by focusing on ideological issues – healthcare, card check, green energy, etc. – instead of focusing on the economy. Who can forget Rahm Emanuel’s cry that a crisis is a terrible thing to waste?
In the meantime, the Fed has been providing essentially free money to banks that do not have loan demand. It should not be surprising that JP Morgan searched for investments, or trades, in conventional places. The bank, according to the same reports, has $1.3 trillion in deposits, but loans of only $700 billion. Why the Fed felt the need to provide additional free funds to banks without loan demand is beyond my understanding, and is a question worth exploring. It is generally expected by depositors, who receive little if any return, that their money will be invested in safe instruments. An irony is that the Fed, because of QE2, in fact placed themselves in competition with banks for low-risk investments – longer dated Treasuries, Agencies and Mortgage Backed Securities. Arguably, the Fed effectively created the environment that caused banks to seek higher returns with distinctively unconventional derivatives and securities.
Additionally, the Fed’s actions have had the consequence of hurting those living on fixed income, seniors and savers. Those unfortunate souls have seen their income decline, in some cases, as much as 80%. Dollar depreciation may not bother the Federal Reserve, but it is deadly to those living on fixed income.
It could be argued that the Fed stepped in because the US Congress and the President failed to act. But common sense says that lowering the price of money won’t help in a De-leveraging environment. If the consumer is 70% of our economy and is De-leveraging, as he should, reducing the price of money does not create more demand. What the consumer needs is confidence that he can keep his job, or find one, and that the value of his money will be maintained. What business needs, in order to create jobs, is confidence that tax rates, at whatever level, will be permanent, that the angst over healthcare reform will be laid to rest, and that regulation will be fair and easily understood.
The only possible positive fiscal effect on the economy of low interest rates is that it creates Dollar weakness, and thus may help exports. But the price being paid to possibly help a relatively small segment of the economy seems inappropriately high. Too many seniors and savers have been hurt, and too many speculators – individual and corporate – have been helped or rewarded.
Now the Fed has raised a trial balloon about a possible third round of easing, driven it would seem, by the recent decline in asset prices, both financial and commodity. While such easing may provide temporary relief to the stock market, it is the wrong response for several reasons. First, it is akin to pushing on a string. Banks have plenty of liquidity. There is little demand for loans, as consumers gradually persist in De-leveraging, again, as they should. An emphasis on monetary easing is a Santa Claus policy for banks, while Congress and the President should be focused on fiscal policy – tax reform and the Grinch-like, but necessary cuts in entitlement spending that will have to be made at some point. Easing money today serves to detract from the unpleasant fact that if nothing is done, January 1, 2013 will witness the biggest tax increase the U.S. has ever experienced, a fact that will be of increasing interest to equity and bond markets as the year unfolds.
The President can argue that the Bush tax cuts were meant to be temporary, which they were, and all he is doing is letting the cuts lapse. As logical as that argument may be, it is the behavior of people that is critical to the success of any policy, and rescinding a “temporary” tax cut that has been in place for ten years will be considered a “permanent” tax increase, which it will be. The tax increase will include a tripling of the tax on dividends and a doubling of the tax on capital gains, while raising taxes on ordinary income, along with a host of new taxes to pay for the Affordable Care Act. Combined, the increases will have a depressing effect on what amounts to an anemic economic recovery, and on capital markets, the life blood of job creators.
There is little question that our economy continues to struggle. Dissonance in Europe does not help. The Federal Reserve deserves credit, as does Treasury, for staving off what could have been a catastrophic collapse of financial markets three and a half years ago. Both agencies responded quickly and effectively. But monetary expansion has done little for economic growth in the years hence. Taking the period from the first quarter of 2008 through the third quarter of 2011, the Federal Reserve expanded its balance sheet by $1.8 trillion. The increase in GDP during that time? $86 billion. A 0.05% return over three and a half years should be unacceptable. It is time to turn to fiscal policy.NOW>