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IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
OCTOBER 12, 2016
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In several issues of IntelDigest, we have been critical of The Federal Reserve and its monetary policies over the last fifteen years, during both the Bush and Obama administrations. Fed policies and manipulations of short-term interest rates have perverted the normal business cycle. Here’s another perspective.
Over the two-term presidency of George W. Bush, the cumulative (federal government) National Debt level doubled; the National Debt has doubled again over the two-term presidency of Barack Obama. The Great Recession of 2008 straddled the two administrations. Things started going badly under Bush in 2007 and the stock markets hit bottom under Obama in 2009.
As the Obama Administration now draws to a close, the official cumulative National Debt approaches Twenty Trillion Dollars ($20,000,000,000,000).
The debt of corporations also stands at record levels. In the U.S., the amount of corporate bond obligations is at an all-time high relative to Gross Domestic Product (GDP) … just over 45%. The situation is worse in other parts of the world. Corporate obligations in China have soared from practically nothing eight years ago to more than 120% of GDP today. The International Monetary Fund has reported that global debt is now equal to 225% of global GDP.
Given the steady increases in government debt and debt securities over those few years, one would have expected bond prices to fall, rising interest rates, and lots of inflation.
In actuality, bond prices continued upward, and interest rates have been driven down so low that they are now negative in several countries.
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The expectations of most economists would have been that massive increases to credit and money supply would have caused a great expansion of consumption, resulting in high inflation and high interest rates.
But, this did not happen.
Multiplier Effect
Most economists (especially Keynesians) over the last four or five generations have posited that government borrowing and spending would produce a positive multiplier for an economy. They have thought of government spending as “priming the pump.” The theory goes that if, for example, the government borrows money to build new roads, then private industry would be spurred to build new houses along the roads and build new businesses to serve those houses, etc.
However, some recent research turns that theory on its head. There is a new postulation that the multiplier effect for government spending is actually negative, and reduces economic growth.
The research finds that too much of the capital borrowed by governments and invested in public projects goes to waste. As debt-to-GDP levels surpass 80% of GDP, economic growth suffers, and gets increasingly worse as debt and spending increase.
The data show that our economy is likely to experience big declines in GDP growth as the federal government continues to borrow more and more and spend more and more in an effort to reverse the declining economy.
If this is accurate, it will hurt overall productivity, corporate profits, industrial production, employment, consumer spending, and wealth creation.
Imagining “Free” Markets
Since the Great Recession, the U.S. government has created approximately Ten Trillion Dollars of new debt. Central banks around the world have driven interest rates down to nothing, so the interest on that Ten Trillion Dollars is very low.
Imagine what interest could have been earned on that new debt without central bank intervention. What economic activity could have been produced?
Long-established data-supported economic theory indicates that interest rates should be roughly equal to annual GDP growth, plus a nominal return above the inflation rate. If growth is 2.5% and inflation is 2%, we should see short-term government bonds trading around 4.5%, with longer-dated bonds trading closer to 6%.
Ten Trillion Dollars earning 6% would have put an extra $600 billion per year into the hands of investors. The full National Debt ($20 Trillion) earning 6% would provide $1.2 trillion per year of capital to private investors and savers.
One point of view is that the Federal Reserve manipulations took so much money out of the hands of private citizens, where it could have been used for
consumption and investment, and put it into government programs bedeviled by waste and malinvestment and disincentive.
This is the essence of a negative multiplier.
As we set out in the August 24 issue of IntelDigest:
“Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).”
So, after massive increases to credit and money supply (and printing Trillions of Dollars out of thin air), the central bankers counteracted their own strategy by forcing interest rates to Zero. Consumption has fallen markedly, and the expected consumer price inflation has not developed (except in specific areas).
The primary result of central bank manipulation has been asset price inflation, including the artificial inflating of stock prices. Instead of chasing goods, investors have been chasing yield.
Persistent low interest rates have caused asset bubbles which could pop and unleash a fresh financial panic at any time.
A Better Way?
Perhaps there could be a better mechanism for setting short-term interest rates. As we explained in the August 24 issue, the Federal Open Market Committee (FOMC) of The Federal Reserve has the power to set interest rates and monetary policy. The FOMC has a standing membership of twelve voting members, comprised of seven members of the Fed Board of Governors in Washington and five presidents of regional reserve banks.
Unfortunately, this “elite” group of twelve men and women has, in recent years, prioritized the interests of the stock market above the interests of savers and retirees and pension funds. They have clung to a notion for several years that the stock market is the indicator of the health of our economy, and declined any move to normalize rates for fear of a stock market downturn.
Could there be a pure market mechanism for setting rates? Or, at least, a committee or congress of people from around the country and from a variety of industries (not just banking) who would represent a broader macrocosm of our citizenry? People who could bring different perspectives … rather than the current insular viewpoint of “the 12″ … to a matter of utmost importance to us all?
How much better would our economy be today if the FOMC had begun to normalize rates on a timely basis? If it had starting raising rates by 2012, our economy and stock markets would likely be in good shape today; savers and retirees could be getting decent returns on bank deposits; banks, insurance companies, and pension funds would be able to rely on a stable basic return of 4% or more.
And, with higher interest rates on government debt, governments would be forced to maintain better control of their budgets and deficits.