The Fed: Love Minus Zero/No Limit
In the dime stores and bus stations
People talk of situations
Read books, repeat quotations
Draw conclusions on the wall
Some speak of the future
My love she speaks softly
She knows there’s no success like failure
And that failure’s no success at all
– Bob Dylan 1965
How much does the Fed love us?
To find the answer we invite you peruse the chart nearby. It plots the issued debt of the federal government in red along side (in blue) the total U.S. GDP. The green line measured on the right-hand scale is excess reserves in the banking system.
No one should be surprised at the red line measuring the bi-partisan profligacy of our esteemed public servants now surpassing 136% of GDP. That does not include the nuisance of unfunded and unaccounted liabilities like future Medicare and Social Security obligations. Nor does it include the recent ladling on of an additional $2 – 3 trillion of COVID pandemic panic money now under discussion.
Yet it is that odd green line that is most interesting. These excess reserves represent unused lending capacity in the banking system. As you can see for decades a mere $1 – 3 billion was sufficient to keep the gears of finance lubricated – until the financial crisis of 2008. With interest rates already at zero the Fed began their program of creating money to buy assets in the bond market or Quantitative Easing (“QE”).
Today those excess reserves total a whopping $3 trillion enough to support $25 trillion in additional bank loans. But, of course, the banks are not lending (that is why they are excess). Those excess reserves are on deposit with the Fed.
Thus, the risk aversion in the banking sector has been replaced by new risk-seeking behavior at the Federal Reserve!
Our new multi-product Fed has made commitments to support primary dealers, corporate bonds, “main street” lending, muni debt, Paycheck Protection Program, commercial paper, money market funds and asset-backed securities. According to the Economist, these commitments total some $4 trillion in credit markets with total outstandings of $23.5 trillion.
So what’s next – credit cards and ATM machines?
Normally this sort of massive expansion of money and credit would lead to inflation as economic players bid up prices to use their newfound excess liquidity. So far inflation in goods and services remains low thanks, in part, to the deflationary effects of globalization and a leap forward in communication technology known as the Internet. More recently the lack of demand in our disease-ridden nation has also kept prices subdued. Importantly, some good part of that excess money supply is washing up on foreign shores as the Fed keeps foreign central banks liquid with USD swap lines of credit.
Remember, that excess liquidity is being directed to financial and credit markets. Accordingly, equities are in a happy place setting occasional all time records and interest rates are very low. Not long ago, we had puzzled over the prospect of the ten-year treasury yielding better than three percent. Now we wonder if it can break one percent in the near future.
Incredibly, the S&P high-yield bond index is at the same level as at the beginning of the year. With an estimated 9.5% drop in quarter-over-quarter GDP, one would think that might put some pressure on the cash flow of junk bond issuers and that traders would react. Is it possible the Fed is also buying this stuff?
So it appears the inflation is manifest in equities and credit markets.
Modern Monetary Mischief (with apologies to Milton Friedman) That old adage strange times bring strange ideas is on point today with the development of Modern Monetary Theory. As explained by Biden’s economic advisor, Stephanie Kelton, the U.S. can never run out of dollars because they are cheap and easy to print.
In effect, the federal debt can always be serviced by simply printing more money. Moreover, according to MMT, if people are unemployed the government can print even more dollars and hire them to do something (or nothing). The “or nothing” is the notion of universal minimum income whereby the government prints enough money to pay people so they don’t need to work.
If we follow the true potential of MMT– what economists might call a “corner solution” – we can see a scenario where all the operations of government are financed with The Theory. There will be no need for taxes at all since we can always print as many dollars as we need.
The theory has been tried many times before. The Weimar Republic in Germany is a well-known example but there are many others. Zimbabwe and Venezuela are modern day cases.
What are the chances this MMT will come a cropper?
If the Fed assumes and monetizes debt, faster than the growth rate of the economy, as is the case today, the absolute value of the dollar will decline. Suddenly, with the real value of the dollar in free fall, foreigners will refuse to accept payment in dollars so we will need to sell dollars to buy Euros or Yen or Yuan to purchase goods abroad at ever-higher dollar prices.
Has this happened before in the U.S.? It happened during the Continental Congress (“not worth a Continental”), during the Civil War on both sides and more recently, in the 1970s. When inflation increased and the U.S. dollar continued to lose purchasing power, several oil-producing nations began to question the wisdom of accepting increasingly devalued dollars for their oil exports. At that point it does not matter that as, Kelton puts it, “we will never run out of dollars”, as they become increasingly worthless.
Could it happen again? You may have noticed that gold recently hit an all-time high.