The Most 'Fundamental Of Fundamentals', And How It Can Prevent An Economic Crisis

Summary

• An expanding economy requires money.
• Money comes from two places: government deficits and bank lending.
• Individuals and businesses should not have to pay for the war against CV-19 from their existing supply of money.
• The government must fund this particular war just like they would fund any other war.
• This idea was discussed in more depth with members of my private investing community, Away From The Herd. Get started today »

We expected a pullback, and we expected it to last longer and go deeper because of the virus, but the straight and vertical drop of the last week was breathtakingly unexpected. The fundamental metrics of the economy, however, look sound and not at all like they would ahead of a recession. In this piece, we look at the most "fundamental of fundamentals" of the economy - money - and how it can prevent CV-19 from causing a serious economic slowdown.

An expanding economy requires money, and money creation comes from the Federal Government's deficit spending and from private bank credit.

Recessions are preceded by decreasing deficits (red lines on the chart below), and recovery from recessions, by increasing deficits. The decreasing deficit between 2011 and 2014 would have caused a recession in 2015 if the deficit had not been increased again (green line below). The deficit continues to increase and fund the economy to the present day.

Source: FRED, ANG Traders

The deficit eventually is securitized as the National "debt", which is the record keeping of the funding of the economy (stock of Treasuries) and correlates with the size of the economy. (Note: Since the US is monetarily sovereign, this "debt", unlike household debt, is not "owed" to anyone). The debt correlates positively with the SPX (chart below).

Source: ANG Traders, stockcharts.com

All money is created through the System Open Market Account (SOMA) which is operated by the New York Federal Reserve. As my friend and fellow SA author, Alan Longbon, writes:

SOMA Operations are money creation in action. The basic stages of SOMA money creation are as follows:

1. The Fed detects a future need for more bank reserves in the payments system from bank credit creation and/or Federal government deficit spending.

2. The Fed offers the Primary Dealer banks cheap SOMA funding. This is the new money being made.

3. The Primary Dealer banks use the SOMA loan to buy treasury bonds off the US government. Are indeed legally obligated as Primary Dealers to do this.

4. The Fed then buys the US treasury bonds off the Primary Dealer banks. The banks have cash from the bond sale and buy other assets. So, as the debt grows, assets prices rise with the growth in overall system liquidity.

If the SOMA and the debt are both increasing, then the stock market tends to grow as well. If SOMA stalls - as it has since the start of the year - then the SPX drops until the rising debt allows recovery. The recent crash was expected to be a shallow and temporary pullback since there was still a $1.2T deficit forming which would maintain the expansion. Unfortunately, the fear of CV-19 has overpowered the market, despite the continuing growth in debt (chart below).

Private banks also create money 'out of thin air' whenever they make loans. This debt-money grows the economy - like sovereign money creation, but unlike sovereign-money, it has to be paid back; a feature that limits the size of the bubbles it creates. Like sovereign debt, bank credit continues to grow.

The chart below shows the regular seasonal reduction in bank credit, car loans, and Treasury agency debt held by banks.

A closer look shows that all three measures rose in the latest week (chart below).

Loans and leases accelerated their growth the most in three months (chart below).

Money growth, the fundamental underpinning of the economy, is not responsible for the drop in the SPX, and the economy continues to expand. The stock market is pricing in a severe slowdown in the US (and Global) economy because of CV-19. The virus is not out of hand in the US (yet), but even the fear of it is already causing problems.

It was no surprise that the Chinese PMI for February came in at a record low, but we don't think this represents a permanent decline in the Chinese economy. Remember that the period includes the New Year and the height of the quarantine. This is the price that had to be paid to slow the virus down. It will not be permanent.

Our economy was and still is on the verge of a massive green-tech expansion not dissimilar to the latter half of the 1990s tech bubble. The virus is a short-term setback. However, if the Central Banks do not act this week to distribute money into the various world economies, then we could be in trouble. Dealing with the virus has a cost. If the government leaves it up to individuals and businesses to pay for the war against the virus - to limit the spread, people must stay home from work, but that costs money - from the existing money supply, then a contraction is almost unavoidable. Individuals and businesses would not be expected to pay for any other type of war from their own pockets (existing money supply), so the government better not expect that in this war either.

Adding money to the economy would lessen the fear and increase the resilience of the economy in the face of a temporary slowdown. A financial crisis can be avoided if the US government and the Federal reserve act appropriately and immediately.

The following is what we consider appropriate action:

• An immediate rate cut by the Fed. While a rate cut is necessary, it is not sufficient; fiscal policy (increased spending and decreased taxation) is also required.
• The suspension or elimination of tariffs on Chinese goods. It is the American economy that pays these tariffs, not the Chinese.
• A reduction in income taxes, retroactive to the 2019 tax year. This would mean sending tax rebates to all tax-payers.
• Reduction in, or suspension of payroll taxes (FICA). These taxes do nothing but remove money from the private sector - in reality, they don't fund anything.
• Send money to every resident in the country. Delivering money straight to the base of the economic pyramid (like President Bush did) means it will be spent in the economy. Hong Kong is doing this.

The first point above has already been implemented, and the market let it be known, in-no-uncertain-terms, that monetary policy is not going to be enough. Fiscal policy - outright money creation - must be implemented, and soon, if a recession and bear market are to be avoided. We are not buying the dip until (unless) a sufficient number of the points above are implemented... or at least planned.

Analyst’s 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Alan Longbon]

With you all the way on this one. Wars of any kind are won with fiscal policy not monetary policy.

You can raise and lower and do QE all you want but it will not provide the healthcare and research required to combat this virus. Only targetted fiscal policy can do that.

[ANG Traders]

Yet Matt Gaetz (wearing a gas mask) regrets that the measly 8B for the virus was not off set by spending cuts elsewhere. It is depressing.

[brainleft]

I agree with the author. also fourth quarter earnings was irrationally high and Corona was the cover for inept analysts to print reasonable expectations.

[Sumit Bagri]

Hi ANG, so you believe it's much bigger than previous cases of SARS, MERS or Zika where SPX had 12-14 per drop and then recovered to all time highs

[ANG Traders]

It certainly is heading that way. This virus is very infectious. 100million people not going to work for a month + in China has created ripples that are only now reaching the rest of the economies. China is climbing out because they unleashed massive fiscal policy.

[dougkitchen]

I'd like to see a 20% import tax imposed with the proceeds refunded to all citizens equally. In this way, we are not paying for any import taxes, yet there is a strong incentive to buy goods produced in the U.S, resulting in a lower trade deficit.
For some timely stimulus, cut rates to 0% and suspend payroll taxes as you recommend above.

[ANG Traders]

All tariffs and taxes are deposits into the Treasury general account,and all taxes and tariffs are debits of the private sector (removal of money from the economy). Deficits happen when the Treasury account spends more than it collects. NOT taxing is the same as increased spending. To get through this virus patch without a recession, the government has to deliver more money to the private sector.

[microhoo]

It's not like consumers don't have money and businesses don't want to invest, the virus won't let them. It's a supply shock, only time can heal it.

[jz30]

"We are not buying the dip until (unless) a sufficient number of the points above are implemented... or at least planned."

So are you expecting more like a 20-30% correction/mini bear instead of this nearly 16% drop we experienced? If another one of your bullet points doesn't get taken out that is.

[ANG Traders]

I wasn't expecting a 16% drop because I didn't know what the virus was capable of. I still don't know how much economic damage may result. What I do know, is we are not going back up to new highs until this passes. It won't pass quickly if fiscal policy is not unleashed. We need tax rebates and elimination of tariffs. Having said that, at this point, the primary bull trend is still in place, but without the fiscal support required, we could fall into a recession and then we would lose the trend.

[DSal1973]

"If SOMA stalls - as it has since the start of the year - then the SPX drops until the rising debt allows recovery. The recent crash was expected"

This sounds like an incredible leading indicator for SPX. If this can be shown to be a regular pattern, it looks like the amount of easy money made by trading it to short SPX could be beyond stellar.

[ANG Traders]

You missed the last part of the sentence..."The recent crash was expected to be a shallow and temporary pullback since there was still a $1.2T deficit forming which would maintain the expansion."

The virus overpowered the fiscal support that was in place. That is why we need to increase the fiscal support...big and fast...if we want to limit the damage to the economy. The Treasury cash account has a record $400B+ just sitting there. If they were to spend half of it, they would still have an average amount in there and the economy would be cushioned through this.

I doubt they are smart enough to do that.

[153972]

@ANG Traders, The last time I looked the federal government was THE component keeping the economy afloat given the past 6 months of real PCE per the BEA, the GDP stats for Q4 2019 and full year 2019. In short, the consumer was waning in 2019 vis-a-vis 2018 and continues in 2020.

Since the US has anywhere between 80 - 90 million of its citizens either under or uninsured and a chief executive that can't lead much less manage a foreign or domestic crisis the Covid-19 health palpitation in the US may very well turn into a cardiac arrest for the the consumer demand shock and therefore the world economy.

The capitalists on Wall Street are calling for workers quarantined to be paid by the federal government (sounds like Bernie to me) and paid family leave in the event schools close in a district, etc., (more socialism) to keep markets buoyant.

The Democrats and not going to assist Donald J. Trump a jot of except for testing. There will be no middle income tax cut. There will be no payroll tax cut. There will be no stimulus of any kind.

The FED has finally re-implemented negative interest rates given latest Treasury Yield Curve except for the 30-year bond. Moreover, the IOER is more than the 10-year note. WTF!!!

The FED has lost control once again.

And when they officially meet they will in all likelihood reduce rates another .50%.

FYI: IMHO China is still lying about the Covid-19 breakout and death results based upon what I read from zerohedge.com

Germany, France, Italy and Japan are in a recession or might as well given the stats from Trading Economics.

The US stock market was way overvalued based upon fundamentals. The Covid-19 pandemic and epidemic in the US IMHO was the straw that broke the camel's back.

[ANG Traders]

The Chinese (lying or not) shoveled the money into their economy and their stock market has recovered to pre-virus levels. The West hims-and-haws. If individuals and businesses have to fund this war with resources on hand, then you can't expect growth. The CBs wouldn't expect a military threat to be funded like this.