In the long run, equilibrium prevails, supply matches demand and something close to pure efficiency in market pricing reigns. In the short run, on the other hand, stuff happens.
The idea that Mr. Market wins eventually crosses our mind as we consider the massive government intervention of late. There are some who are expecting something for nothing as the Federal Reserve, the Treasury and other state entities step into the vortex of market turmoil. In fact, there’s a cost to everything, and that includes the intervention du jour.
The rationale for intervening is compelling at the moment, but no one should think it won’t come at a price. The question is: What price?
To put this question into its proper context, we need to think about what’s going on in a broad macroeconomic sense. To put this succinctly, the government is borrowing from future consumption to fund stimulus today.
It’s clear that the government is borrowing money, lots of it, and far more than it’s borrowed in the past. One direct measure of this borrowing comes from the Fed’s balance sheet. Reserves at the Fed were nearly $780 billion, as of March 18--a colossal surge from a year earlier, when reserves totaled less than $16 billion.
There’s a strong case for flooding the system with money in the short term. Any student of financial history knows that banking crises are an especially potent virus that, left unchecked, can wreak havoc on the wider economy. All the more so when the troubles are global, as they are now.
The cure, if we can call it that, is clear: government intervention in the form of playing the lender-of-last-resort role and extending guarantees to depositors and other holders of debt. Executed well, such a policy can be beneficial, mainly in the form of sidestepping a deeper crisis that keeps the economy humbled for years.
Recent experience supports this view. Perhaps the gold standard in the modern era is Sweden in the early 1990s. The country’s banking system was nearly broke at the time, and the debt threatened to throw the economy into the abyss. Through a deft policy of bailing out the financial institutions at the heart of the crisis, the government of Sweden managed to avert a prolonged slump. The total cost of the bailout has been estimated at 4% of Sweden’s GDP at the time, although some economists say that the true cost was much lower after factoring in revenue paid back to the government in the years after the intervention.
So, how much is the U.S. spending to solve the current ills? Using the latest GDP numbers, and assuming a total cost of around $3 trillion (based on estimates by various economists) works out to a price tag of about 20% of GDP. Keep in mind that some analysts would call the $3 trillion estimate of total cost as overly optimistic, in which case the true cost will be much higher.
In short, the price tag for intervening will be substantial. But there’s likely to be additional costs that aren’t yet obvious, namely: inflation. Once it’s clear that the apocalypse has been averted, the big challenge will be unwinding all the stimulus. That implies that interest rates will rise. Indeed, investors will one day decide that the current bias for holding excessive amounts of short-term government bonds is no longer acceptable. At that point, selling will increase and yields will rise.
In the long run, there’s no benefit to intervening in the economy. Prices will settle based on supply and demand and there’s nothing the government can do to change that. In the short term, of course, manipulating prices is possible and even desirable, depending on the context. The recent crisis certainly calls out for intervention, even though the price tag may be steep in the long run.
The best we can hope for now is that the price tag is lower than the market expects. That’s a possibility, but it’s also true that negative surprises are possible too. There are no free lunches in the long run. What happens next Thursday, on the other hand, is wide open to almost anything.