The Federal Reserve's easing policies have added an excessive amount of dollars to the international financial system. This has been carried out in the following manner: primary buyers, such as large banks, buy a certain amount of treasuries directly from the U.S. Government at auction. The Federal Reserve then purchases the treasuries from the primary institution, and pays for it by simply crediting the account that the institution has with the Federal Reserve (this is the "reserve" segment of the Fed). While the Fed does not physically "print" the money via a traditional printing press, the new cash is now available to the institution for various banking activities.
ZIRP Policy: Speculative Fervor, Low Savings Rates, and Relevering
Low interest rates, however, have so far dampened profitability and thus desire to loan money to businesses and households, and, as always, have induced a speculative fervor in which malinvestments are a natural consequence. More importantly, our low personal savings rates, also a consequence of ZIRP, hovering around 3.5%, display our low capacity to invest in productive assets and organic growth. Furthermore, low personal savings rates foretell of a situation in which most retirees do not have significant "nest-eggs" and will rely heavily on social security (which probably won't be available when the time comes). Finally, we can argue all we want about the jobs market, but it remains weak. When we have underemployment above 17%, and an announced unemployment of 8.6%, statistically significant wage growth is highly unlikely in most sectors. A lack of wage growth has been a rather loud trend since the beginning of the "recovery:"
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So the big question is, with a lack of wage growth, how are we financing our purchases? Naturally, with such low rates of interest, consumers are relevering, and now have the most credit outstanding since October, 2009. So, while the Fed is doing everything it can to stimulate consumption, they are simply neglecting how the spending is being financed. What we're left with is stagnant wages, a historically low savings rate, an expansion in consumer borrowings, and a reinflation of a bubble that was never fully addressed via economic restructuring.
As previously mentioned, the speculation induced from artificially low interest rates occurs within financial markets. Money managers, with their new supply of cash credited to them by the Fed, chase commodities, stocks, and bond prices up. This is a simple equation: more dollars are now chasing the same number of assets. Only a small portion of the new dollar supply has made it into households and businesses, and consumer prices (the CPI) have "only" risen 3.4% during the past 52 weeks. It should be noted that while the Federal Reserve aims to keep inflation between 2 and 4%, the upper range is expected to be seen during times of substantial economic growth, not while about 17% of the workforce is underemployed, and at least 8.6% are unemployed.
It should also be observed that a drop in unemployment, as measured by the government, is historically very common during long periods of recessionary or depressionary economies. While lending has been noticeably weak during the past several years, the Federal Reserve has tirelessly attempted to simply the reinflate the bubble economy that we should be resolving. The key concept here is that the malinvestments made during the artificial boom of the mid 2000s, as a result of unnaturally low interest rates and other versions of loose monetary policy, should be given time to clear via the free market.
Keynesian Arguments and the Harsh Cure for Malinvestment
Now, Keynesians will be awfully quick to step in and mention the fact that the "invisible hand," the central tenet of free market economics, has been frozen by the "sticky wages" phenomenon. While this may (or may not) be true in terms of the overall economy, the clearance of malinvestments (in this case, housing related items in particular) has no barriers except government intervention. What this describes is that the cure to malinvestments is, in the short-term, a painful pill to swallow; banks have to work with debtors who are deeply underwater on their homes, a wave of foreclosures ensue, lenders of all sorts have to accumulate cash and sanitize their balance sheets, and economic growth quite simply plummets. The money supply shrivels up, unemployment naturally grows, and the process begins anew. For Austrian Economic thinkers like myself, this is ideal for long-term health. Of course, the societal strain of huge unemployment, foreclosures, and so forth, puts pressure on politicians to stimulate excessively to get things moving again.
As a result of political pressures and ideology, we have maintained a zero interest rate policy (actually negative after inflation), and increased fiscal stimulus (deficit spending). Housing clearly has not yet bottomed, but the Fed has also attempted to re-inflate that market by purchasing mortgage-backed securities, keeping a ZIRP, and buying long-term treasuries. It's almost incredible how short-sighted our Fed really is. Even if the housing bubble reinflation worked in the short-term (it hasn't), what happens later on? Well, we've seen the effects that a reinflationary policy has. Artificially low interest rates after the popping of the dot-com bubble led to an even bigger housing bubble. What's next?
While malinvestments may clear in Austrian theory, Keynesians argue that wages will not clear to equilibrium levels, and the economy will stall out either indefinitely, or too long to standby and watch citizens suffer. And heck, since "we're all dead in the long-run," we might as well act now.
The sticky wages argument does have a solid basis, and there is a decent amount of evidence to back it up. The reality is that it takes a relatively long time for wages to drop in the U.S. Isn't it amazing though, that even while the government has stepped in to the labor market with wage and employment laws (the most notable, and nonsensical of which being minimum wage), the income growth of the top 1% has far outstripped that of everyone else over the past couple of decades? It shouldn't be that surprising -- these interventionist policies, as usual, have unintended consequences that, in this case, have done the opposite of what they were supposed to achieve. These excessive laws that I speak of have reduced the competitiveness of the American worker in the global labor market, and we've seen an incredible amount of outsourcing as a result.
I know, I know. "But these laws protect the American worker who has always been taken advantage of." In theory, sure. In practice, at least in a globalized world, it simply disincentivizes domestic hiring, increases unemployment, and improves the GDP of every country we outsource our work to. Worst of all, the artificial floor on American wages, and the inflexibility of labor restructuring due to various pieces of "protective" legislation, make it impossible (or at least painstakingly slow) for wages to arrive at equilibrium. Also, sticky wages can also be contributed somewhat to a unionized workforce, but only 7% of the private sector is unionized.
I mention my disagreement with our policy on labor because the issue is a major piece of a much larger, structurally broken United States economic puzzle. Over the next months, we'll see plenty of headlines touting terrific gains in the labor market, signs of a possible housing turnaround, improving GDP growth, and other optimistic, short-sighted stories. In reality, many of these jobs will not come back. Our unemployment rate appeared healthy in the mid 2000s because most of the manufacturing jobs that were outsourced in the years prior were simply filled by a growth in the financial services and real estate sectors. While both sectors were immensely profitable during the bubble, they have been viciously contracting in the aftermath, and unemployment is as a result, persistently high. This could not illustrate structural deficiencies any clearer.
The Keynesian vs. Austrian debate aside, how much more debt can we actually issue before the market begins to get spooked? With our debt to GDP ratio now proudly above 100%, we are firmly entrenched in black-swan territory; any significant event could set a dangerous chain of events in motion. China, our biggest foreign creditor, is beginning to unload of our long-term (30 year) bonds. While China used to frantically buy up our debt to keep their currency, the RMB, artificially low (hence, we have been transferring our inflation to China), China will eventually have to allow their currency to rise to quell inflation, and they must reduce their exposure to an endless supply of U.S. debt. Interest rates will soar in the U.S, and financing the debt will become a legitimate worry. The dollar, meanwhile, will rapidly depreciate relative to the RMB, and we will see a decrease in purchasing power back home. Why? U.S. firms purchase a ton of raw materials from China, and also get cheap labor there. Strength in the RMB would cause a subsequent rise in the costs of production, which would reflect itself in consumer prices paid in America. This is the main inflationary worry.
Some analysts have simply calculated that we only spend about $200 billion to service the debt, while we have an economy that produces $15 trillion every year. This argument is pure nonsense, and cuts out basically every important fundamental detail. We'll spend somewhere near $200 billion servicing the debt in fiscal 2012, but at record low rates. To service most of the debt, we simply borrow even more (as opposed to paying it out of tax revenues). Furthermore, our budget deficit, 8.6% of GDP, does not imply any sort of sustainability. The cuts necessary to significantly reduce the deficit would drastically harm our engineered recovery. During the Great Depression, Roosevelt's worries regarding the deficit caused him to reduce spending, resulting in another mini-depression after a couple years of recovery. It's the same deal this time -- our economy is now wholly dependent on powerful, multiplying stimuli, and we will run out of road when the markets get spooked (thereby running from treasuries). The catalyst? It could be a number of things. A major European default is probably the most likely. Also possible is that we avoid a European default long enough to reach our own end-game, where the markets simply take a look at our fundamental flaws, and treasury holders, noting both the risk of default and/or loss of purchasing power, run for the exits. It absolutely can happen in the U.S; the printing press is simply a less direct way of announcing default.
For those who think more monetization (the purchase of government debt by the Fed) is a legitimate option, let's not forget that our Federal Reserve is already leveraged at 54 to 1 ratio (assets/capital). How much more can they buy? Furthermore, I won't go into detail here, but investors in treasuries are getting slammed after inflation in terms of purchasing power, and inflation can only go up from here (that's what the Fed wants, doesn't it?). A holder of a 30 year bond can expect to lose a huge portion of their purchasing power, and a sale of said bond would result in a capital loss. Catch-22. I doubt an efficient market (one that is less of Fed intervention) would be ok with swallowing our debts at current interest rates.
Unlike the housing bubble, or even the dot-com bubble, the timing of the end-game for our reinflationary, bubble economy policies is impossible to predict.
While we may see signs of modest "growth" for a period of time, I encourage investors to expand their thinking past today's market and look at our problems:
- Inflationary: as a result of Fed policy and Chinese actions, significant inflation is absolutely plausible. If the economy continues to be reinflated, and meaningful consumer lending expands further, even more dollars will be bidding up consumer goods. In this case, economic growth has significant consequences. Meanwhile, large money centers are active speculators in the commodity markets, affecting the prices we pay for groceries, fuel, and plenty of other goods. In
- Debt: the trajectory of our fiscal deficits is critically dangerous. While CBO future estimates assume full employment (4.0%), and as a result, significantly higher tax revenues, there is simply no way our structurally broken economy can achieve that kind of growth. Additionally, deficit spending is completely necessary to keep the whole system growing; we're truly locked in. Lastly, interest rates have to rise at some point, and I believe long-term rates will rise dramatically as nations begin to recognize our risks, and the Federal Reserve runs out of bullets and expansionary leverage capacities.
- Structural: As American workers have lost some of their competitiveness on the global scale (this isn't true in all aspects -- American ingenuity is still alive and, contrary to some popular opinion, Americans do in fact work hard), many middle-class jobs have been outsourced, and the jobs that previously replaced them (financial services, real-estate related) are now also gone.
- Foreign Events: Europe came unbelievably close to setting off a Global catastrophe in 2011, and the intermediate and long-term fundamentals have not changed one bit.
So, as investors, what should we do?
In the short run, markets are driven by financial liquidity, and right now, there's plenty of it. As a result, the U.S. market could in fact run higher in the short-term. It probably will. I believe higher prices offer investors a significant opportunity to scale back on some holdings, and/or initiate short positions. I personally recommend absurdly-valued, poor cash flow stocks like salesforce (NYSE:CRM) and Dunkin Brands (NASDAQ:DNKN), in addition to some investment bank shorts. I believe the risk/reward profile of companies like Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) remain remarkably compelling from the short side; these institutions have significant European exposure, are dealing with poor M&A activity, and are sitting on hundreds of billions of dollars that are at major risk of losing significant value. Looking out further, their massive holdings of U.S. Government debt could choke them when the value of their holdings fall, as is the case with European banks and their holdings of European sovereign debts.
James Kostohyrz had an excellent piece last week, where he recommended accumulating cash and/or shorts for the next several months. I would take that advice. While my outlook on the dollar is tremendously bearish in the long-run, legitimate loss of dollar purchasing power is highly unlikely over the next several months. The reality is that we can't time this, and sitting out the rest of this so-called recovery is more than worth being able to scoop up opportunities later on. I'd also argue that we're already in the later stages of the "boom" part of the cycle. While this phase has been weak relative to our other boom periods, this appears due to diminishing returns from stimuli, and aforementioned unprecedented loose monetary policy.
Disclosure: I am short CRM.