The Next Recession: Is MMT Inevitable?
Summary
- Quantitative Easing has boosted asset values, but it has not reignited real economic activity, given that ownership of financial assets is highly concentrated.
- Something will need to be done during the next recession, if not before, to "spread the wealth," especially given continued high debt/income ratios among the bottom 90% of US households.
- We should not be altogether surprised if, given balance sheet constraints, some type of helicopter money fits the bill.
In 2019, virtually every asset class around the globe added value. The S&P 500 returned a stunning 31.5%, the highest return since 2014, despite numerous headwinds that included fears of recession, negative interest rates in Europe, repo market disruption, record levels of debt, an inverted yield curve and the slowdown in global growth. Offsetting these factors, the Fed shifted policy dramatically during the second half of the year and other central banks, namely the Bank of Japan, European Central Bank and the Bank of China, also eased policy, with market valuations largely driven by the massive creation of liquidity during the second half of 2019.
What is clear is that the shift in Fed policy in 2019 was both unexpected and dramatic and it undermined Bernanke’s earlier claim that unwinding the effects of Quantitative Easing would be seamless. Having announced in late-2018 that it expected to raise rates four times in 2019 and continue the process of Quantitative Tightening (QT), the Fed instead abandoned QT, cut interest rates three times and then proceeded to increase its balance sheet (QE4?) in response to the mid-September spike in repo rates. Other factors also helped fuel the upward movement in equity prices, including buybacks of corporate stocks.
There was very little question at the end of the year that stocks were expensive. According to Robert Shiller’s cyclically adjusted price earnings ratio (CAPE), at year-end, stocks were valued at 30.5 times earnings, a level achieved only twice before (the first time in 1929 and then again in 2000). Although it is well known this ratio is not useful as a market timing tool, when it reaches extreme levels it often provides valuable information.
The chart below takes a look at the relationship between CAPE and the following ten years of earnings. When the CAPE is below 10, the average real annualized return over the following years is 11.3%. And when it is more than 30 times (as it was at the end of 2019), the average real annualized return over the following ten years is -1.0%, suggesting that the CAPE provides useful information when it reaches extreme levels.
Source: Robert Shiller, author’s calculation
Other measures that are included in the chart below (from Crescat Capital), likewise indicate that current equity valuations are extremely high. All of these measures support the notion that, as of year-end 2019, US large cap equities were expensive relative to history and the fundamentals.
Other central banks, including the BOJ and ECB, have utilized negative interest rates, a step the Fed has declared it does not intend to take. With 10-year yields having fallen to less than 1%, the lowest in recorded history, the Fed may be forced to consider alternative options to deal with the potential risks of recession, especially given the rising uncertainty associated with the spread of COVID-19 (Coronavirus). In response to the virus, on March 3, 2020, the Fed chose to reduce short-term interest rates on an inter-meeting basis by 50 basis points. This marks the fifth 25 bp cut in the Fed funds rate in this cycle, and according to history, since 1990 the Fed has never cut rates more than three times without a recession occurring within the next twelve months.
The uncertainty associated with COVID-19 has heightened risks of recession. How might the government choose to respond? This is important, especially given that the current economic recovery is nearly eleven years old and events often unfold rapidly. In our view, the remarkable performance of asset classes in 2019 and for much of the previous decade was largely driven by liquidity creation. The balance sheets of global central banks reportedly increased from $5 trillion in 2007 to $21 trillion in 2019. Curiously, over that same time frame, global stock market valuations rose from $65 trillion to $85 trillion, which is consistent with the notion that liquidity, and not fundamentals, have been driving asset class valuations over the past decade.
And yet this liquidity has not triggered rising inflation. Why not? Quantitative Easing involves a swap of central bank reserves for US Treasury (UST) or Mortgage-Backed Securities (MBS). It boosts the prices of financial assets (see the initial chart) but has little impact on real economic activity, since the newly created reserves are walled off within the banking system. Rising asset prices due to liquidity creation are equivalent to both asset price inflation and capital gains. So, who benefits from this process?
The top 10% of US households are the main beneficiaries. In 2016, the top 10% owned nearly 91% of all financial assets (Edward N. Wolff 2017). These households have been the primary beneficiaries of QE and other steps taken by central banks in the increasingly financialized economy over the past four decades. The flip side is the bottom 90% of US households whose incomes have stagnated. Historically, they consume nearly all of their income, providing the engine for the growth in aggregate demand and GDP. However, with stagnant incomes, these households have been compelled to borrow simply to maintain consumption standards, so the weakened state of their balance sheets have undermined their ability to stimulate growth. This also helps explain why real GDP growth has been stuck at 2% over the past decade. What is needed is not to stimulate further asset price appreciation, but to get more income into the hands of the bottom 90%.
Policymakers may choose to construct policies that re-energize consumption within low- and middle-income households (the bottom 90%). To stimulate growth either before or during the next recession, the Fed may be forced to create tools that provide support for these households. One policy that was referenced by Milton Friedman and then later by Ben Bernanke is known as “helicopter money.” A variation that has frequently been mentioned over the past twelve months is known as Modern Monetary Theory (MMT). Utilizing this approach, or some variant thereof, the US Treasury and Fed might work together with the Fed directly creating deposits in bank accounts that target the bottom 90% of US households
These proposals undoubtedly will require legislative changes, given prohibitions on the Fed directly purchasing debt issued by the US Treasury, though there may be ways of circumventing that restriction (a topic that will be addressed in another article). If the Fed were to create deposits in household bank accounts, recipients could spend these funds either to pay down debt or to make new purchases. These funds could be targeted at the bottom 90% (or on a smaller scale, the bottom 50%) of US households. The end-objective is to stimulate spending and boost aggregate demand (and GDP) and/or inflation. Creation of inflation reduces the real value of debt, as well as the risks of outright default, while potentially restoring conditions for future growth.
The helicopter money route sounds frightening, no doubt reminding many of recent experience in Zimbabwe or the Weimar Republic during the 1920s. However, in reality, this may be the “least-worst” option available, given current debt levels and potential obstruction to using normal channels for additional fiscal spending. Unless economic growth magically picks up, this may be the only option. And there is precedent. To finance World War II and the postwar recovery during the 1940s, the Fed fixed the interest rate at 0.375% for short-term and 2.50% for long-term government debt, and then purchased any debt that the public chose not to hold. Rising inflationary pressures after the war (given pent-up demand) reduced the real value of the war-related debt issued by the US government from about 116% at the end of the war to 63% in 1955. There clearly is precedent for this type of action however draconian it may initially appear.
Given the elevated magnitude of private sector debt that still exists ten years after the global financial crisis (see chart below), “helicopter money” may become essential in the next recession. To some extent, it will supplement incomes for low- and middle-income households. Given current debt levels (see chart below), if the next financial crisis and/or recession becomes particularly severe, the Fed may have little choice. It is not an ideal choice, but the time for better choices faded away some time ago. In terms of positioning portfolios to hedge these risks, precious metals, TIPs, and potentially commodities may be candidates. This outcome may not occur for some time, though knowing precise timing is impossible, so it makes sense to begin thinking outside the box.
This article was written by
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DOI: 10.2139/ssrn.1723589Scott Fullwiler
