The Federal Reserve has been playing fast and loose with the American financial system since the “great recession” of 2008, buying immense amounts of bonds and keeping interest rates near zero. The last 15 years have been so different from the previous hundred years that it is difficult to predict what will come next. Based on what happened in the 1990s dot.com market crash and the 2008 housing market bond crash, I am concerned that an unpleasant surprise is waiting.
One feature of the market has been unlimited liquidity. Money is readily available to anyone with credit because the Fed has been buying everything in sight. Since the Fed has been buying government and high-quality bonds as soon as they come on the market to soak up any excess, there has been no reason to raise interest rates to entice other buyers to buy them.
Because the Fed has been buying so many bonds for so long under QE, when it switches to disposing of bonds under Quantitative Tightening (QT) the result my be more significant than expected. QE has meant that the hond market has not been a truc market, matching willing buyers and sellers. The Fed has had its finger on the scales, influencing price for years. Now, when it dumps tons of bonds on the market, willing buyers may insist on lower bond prices since there will be so many, which means interest rates will go up as bond prices go down. How will this pressure to raise rates interact with the Fed’s usual method of simply raising the federal funds rate.
On the other hand, businesses that want to raise money have been able to sell their bonds to willing buyers, flush with cash. Because interest rates on high-quality bonds were so low, investors snatched up low-quality (junk) bonds because they paid slightly more interest. So, companies with less-than-ideal credit ratings were able to sell bonds without having to pay a high premium for being a new or less stable business. If credit becomes tighter and the economy slows down (due to the Fed fighting inflation) will these questionable companies be able to continue to pay off the bonds? Even for solid companies, people holding their bonds may have to sell them at a discount because interest rates have gone up. However, many of these companies have loaded up on low-interest loans in the last few years, which means they will not have to refinance at higher rates for several years.
Historical Interest Rates
Besides the Fed, another reason interest rates have been low could be the increasing wealth of the extremely wealthy. They have enormous savings, more money than they can ever spend. In a more balanced economy where normal people share more of the wealth, they spend for everyday expenses and don’t have so much excess savings to invest. Thus, there is an upper-class savings glut chasing the same old (or even fewer) things to invest in.
The following graphs show how low interest rates have been in the last few years by historical standards. Low interest rates change the way the economy works. For example, it works against conservative investment strategies. Bonds and savings accounts pay almost nothing. So, people invest in riskier assets. The fact that they are riskier may come back to haunt the economy. In any case, the economy looks different than it did fifty years ago. The old-style financial system brought us the Great Depression during the 1930s. Will the new economy be more successful in avoiding a disaster?
50 Year Chart
20 Year Chart
When money is chaap, it is an invitation to use leverage to invest more in the markets. The amount of borrowed money is leverage. Most ordinary margin accounts for buying stock have a limit of 50%, but wealthy individuals or groups can leverage much more, perhaps only invsting 10% or 20% of their own money and borrowing the rest. But this means that if the investment goes bad, they may owe much more than they have invested. The crash of Bill Hwang’s Archegos Capital Management hedge fund in 2021 cost five big banks about $10 billion in losses. Hwang had leverage of about five times his investment; he had about $10 billion of his own money but bought $50 billion of investments. The banks all survived their losses.
Financialization of the economy
People are using a new term to describe the economy, financialization. Investopedia defines it as “the increase in size and importance of a country’s financial sector relative to its overall economy.” In the US the financial sector grew from 2.8% of GDP in 1950 to 21% in 2019. Critics of financialization say that it emphasizes short-term profits over production of goods. It has also created many new and different financial instruments, such as the packaging of mortgages which led to the 2008 financial crisis and the “great recession.” Today, the financial status of housing and mortgages seems safer, but the Fed has been a heavy investor in mortgage-backed securities. With its bond buying program (Quantitative Easing – QE), the Fed has been deeply involved in many aspects of the US economy, more than in any previous generation, so that it remains to be seen whether there any unanticipated results of that involvement.
Private Equity/Venture Capital
The liquidity slush fund for rich investors has brought us private equity funds, which do huge transactions buying private companies (unlisted on a stock exchange), or they may take public companies private and into their holdings. Because these private companies are not publicly listed, they do not have the same disclosure requirements that public companies have, which means that not as much is known about their financial situation. There could be some risky clunkers hidden in with profitable jewels.
The huge amounts of wealth held by the wealthiest investors has also led to the creation of veture capital firms, which invest in new companies before they go public or make any profits. These firms try to identify a new Apple or Google and get in on the ground floor. Many of these investments will not pan out, but the ones that do should more than pay for the ones that don’t. If the economy goes south, there may be less venture capital money, and it may be harder for new ideas to get funded, or for new start-ups to make it to profitability. Like the companies financed by junk bonds, the venture capital companies have loaded up on cheap loans so that they will not have to refinance for some time., according to the Economist magazine.
SPACs, or special purpose acquisition companies, are a relatively new financial tool, again one developed because of all the liquidity, or money laying around the accounts of extremely rich individuals. They pour money into a empty company listed on a stock market, and then use it to buy a new, small company and make it a public company under the umbrella of the SPAC registration. Because this is a new tool in addition to the old method of using initial public offerings (IPOs) to take companies public, we do not know whether these companies are as sound as those that met the IPO requirements.
Finally, as a result of all of this “liquidity” cash bounty handed out by the Fed, the Congress, and the administration, particularly during the COOVID pandemic, the national debt has increased greatly. Today the national debt held by the public stands at about 77% of the country’s gross domestic product (GDP), or about $20.5 trillion, according to Wikipedia. The Congressional Budget Office expects both the dollar amount and the percentage of GDP to rise in coming years. The United States has the largest external debt in the world; as of 2017, its debt-to-GDP ratio was ranked 43rd out of 207 countries and territories
See the graph below:
Inflation decreases national debt
While inflation has the disadvantage of making goods and services more expensive, it has the advantage of making the national debt less expensive. If inflation is running at 10%, each year debt is worth 10% less. The dollars paying it off are worth 10% less. Although the dollar amount of the debt stays the same, it is much less in 2022 dollars, and probably also as a proportion of GDP, which would grow because of inflation, even if the amount of goods and services stayed the same. Of course, the downside is that if inflation continues, interest rates rates will go up, so that the interest rates on bonds sold in 2023 will be much higher than they were in 2020. But debts incurred in the past basically become cheaper.
Two of the many commentators on economic and financial issues have been particularly insightful, and I believe they are right about where the economy is heading: Larry Summers and Mohammed el-Erian. They both believe that the Fed has failed to react quickly enough to rising inflation. Because of its initial hesitation, it may be more difficult for the Fed to get inflation under control, probably requiring the US to go through a deep or shallow recession before returning to an even keel. I worry that in the process the US may encounter more serious problems like it did during the great depression and the great recession. The pandemic should have imposed financial damage to the US economy, but the extreme actions taken by the government prevented that damage, for the time being, but may have just delayed it.
Offshoring of Production
One reason for the extraordinarily good economy of the last two decades has been te transfer of production from high-wage countries like the US and Europe to low-wage countries like China and other Asian nations. This has meant that goods have been produced much more cheaply but sold in more prosperous countries. As Asian wages rise, the benefit will be reduced; goods will become more expensive. In addition, the pandemic interruption of the overseas supply chains has made goods in America less available and more expensive. America talks about returning manufacturing to the US, but the US is far behind in production facilities and skilled workers. Onshoring production may turn out to be harder than expected.
Too Much Reliance on Fed
There has been too much reliance on the Fed to keep the US economy running well. The main contribution of Congress and the administration has been to hand out cash several times during the pandemic. While it eased hardship in the short term, it has contributed to inflation now. It probably would have been better to physically hand out food and arrange shelter, rather than hand out cash. Also, there should have been more controls on the cash, since many horror stories are coming out about fraud in claiming the government handouts. The Fed needed more thoughtful help from Congress and administration. Building infrastructure was a good idea, but right now we don’t have workers to fill existing jobs, much less big infrastructure projects. The government needed to figure out how to incorporate the work-from-home movement in its redevelopment plans. Infrastructure cannot be built by people who work from home.