Fed Chair Janet Yellen was the subject of a flattering profile in The New Yorker magazine recently titled, “The Hand on the Lever.” Policymakers have been monkeying with the levers of prosperity since Roman times. Sometimes the consequences are predictable, immediate and obvious. Other times not.
Since the end of 2007, for example, the U.S. Federal Reserve has created more than $3 trillion out of thin air. At the same time, the U.S. public debt has nearly doubled, from $9.2 trillion to $17.5 trillion.
As financial journalist Jim Grant describes it: “We are embarked on a unique experiment in monetary manipulation. Paper money was almost always a wartime expedient, introduced as a means of extraordinary financing in extraordinary times. No longer. Paper money is what the politicians and central bankers wheel out to address the failures of finance — failures chargeable to prior episodes of inflation and overlending.”
And how is the experiment going so far? The answer depends on how you define previous failures. If you define them as insolvency in the financial system due to an orgy of bad lending, then yes, we’re well on the way to fixing the problem by driving up the prices of houses, 401(k)s, office buildings and other assets. This result is entirely in line with the expectations of central bankers, even if they refuse to admit it publicly. You fix a shortage of equity in the financial system by reflating the asset side of the balance sheet — end of story.
Except it’s not the end of the story, for a couple reasons. First, while reflation may seem like a costless exercise, this is a mirage. One of the side effects of printing $3 trillion in new cash is rock-bottom short term interest rates, which produces negative real returns for savers. Consider the comments from a retiree published recently on the Pittsburgh Post-Gazette website:
“We and [our] financial advisors assumed (silly us) that the economic system wasn’t so totally corrupt as to steal almost all interest from savers and give it to the crooks (none of them in jail, either) whose greed and malfeasance almost crashed the world economy. Who knew that interest rates would be manipulated to fall to just a sliver above zero and stay there for 6 years (and maybe forever now that it has been determined that they can get away with it)...and inequality rises?”
This person gets it. Returns on short-term investments well below the rate of inflation are confiscatory. And as the final comment indicates, the widening gap between people at the top of the economic ladder and those below is a direct result of Fed policy. Central bankers may have fixed the short-term insolvency problem, but the remedy has real long-term costs.
But let’s step back for a moment. What if the failure is more fundamental than bank insolvency? What if the true problem emerging from the recession in 2001 was a longstanding lack of real income growth for the majority of Americans?
In 2013, U.S. median real weekly earnings were little changed from the level 35 years previous. Given this ongoing stagnation in wages, the proper response on the part of policymakers would’ve been a serious examination of the causes of the shortfall (international competition, technology substitution, etc.).
Instead they made the easy choice to crank up the credit engines. This “fast buck” method for raising middle-class incomes didn’t work, yet we appear to be trying it again.
We’re deploying trillions in student loans and other public borrowing in an effort to drive up consumer demand and (eventually) wages. Most of the gains are likely to be absorbed in record corporate profits and taxes, just as occurred in the last cycle.
Why not try inverting the problem instead? Why not let prices fall so that each dollar of earned income buys more? Allowing consumers to reap the benefits of improved productivity and lower production costs via lower prices is the sine qua non of a healthy economy. It also has a catchy name that most people, even noneconomists, can relate to. It’s called progress.
Of course, this sort of progress is anathema to bankers and bureaucrats, the great defenders of the status quo. Bankers hate deflation because it erodes the value of assets securing their loans, and raises the dual specters of insolvency and unemployment (their own!). They further argue that our overlevered economy would collapse if prices were permitted to fall for more than a quarter or two, as they did in late 2008.
Americans are getting sick of an economy run entirely by and for bankers, however, and balance sheets are in far better shape today than they were during the crisis. If it ever came to it, TARP II likely wouldn’t fly. As for politicians and other government types, deflation drains tax revenue like a bullet hole in a bucket, so bureaucrats would likely not come voluntarily to any party celebrating lower prices.
Given that these two powerful groups control the main levers of the economy (the Federal Reserve lies at the nexus of both), any shift toward a more laissez-faire and less Keynesian approach to the problem is unlikely, no matter how much it might benefit the middle class. Instead we chase a fast buck down the reflationary path.
Charlie Smith is chief investment officer for Fort Pitt Capital Group in Green Tree. He can be reached at firstname.lastname@example.org