FWIW # 9 Federal Reserve Actions October 2020

Some analysts criticize Federal Reserve (Fed) actions and policies as highly dangerous to the economy and to capitalism in general. Others laud what the Fed is doing as saving the economy, the country’s political structure, and capitalism in general. Both sides cite strong evidence they are right. The problem is no one knows how an activist Fed economic intervention will ultimately work.

Before we begin this analysis, it’s important to dismiss one of the two major myths the national political leadership has foisted on the American public since at least the 1960s: The Fed is independent of political considerations. Fed officials are appointed by politicians, required to answer to the House and Senate twice a year, and, for decades until recently, its chairman met regularly with the president. The Fed is not independent of the country’s political leadership. Without the Fed’s tacit acquiescence, the massive deficit spending over the last 50 years could not have taken place.

Where to Begin?

The examination of the past starts with the Kennedy-Johnson era in the 1960s. It was the time when, post-WWII, the political class and its appointees at the Fed began destroying the value of the U.S. dollar in earnest. Stop for a minute and get the right mindset. In terms of economic activity, the United States was the richest country on earth in 1960. The United States dollar was backed in the international economy by gold at $35 an ounce. Other countries could swap dollars for gold bullion. Beginning with John Kennedy and accelerating under Lyndon Johnson, political leaders decided they would buy longevity in office by installing social welfare programs. These transfers of wealth by the federal government, deemed the Great Society, could not and would not be paid for by raising taxes, but by borrowing and monetizing that debt. The programs are now at the level where their costs could overwhelm the finances of the federal government even though the Great Society expenditures have been modified to lower the compounding of costs. Initially, cost estimates were deliberately understated and manipulated by “expert” analysis. But while social fiscal irresponsibility was enough, it wasn’t the only waste.

These same political leaders deliberately wasted the country’s wealth and young people on an unwinnable war in Southeast Asia. The long-term effects of both questionable actions could have been minimized through higher taxes on income; however, the politicians who decided to embark on these economic drains lacked the fortitude to address the issues responsibly. What they did do, in essence, was have the Fed turn on the printing presses. The average American did not notice this flood of currency and borrowing, but other countries did. Toward the end of the 1960s, demands were building from other governments to swap their U.S. dollars for gold at the fixed price of $35 an ounce.

The Fed’s response to the political leadership was one of accommodation. Keep in mind that the 1960s was a period when interest rates were still controlled by the Fed. Once the full extent of the Fed’s monetary accommodation of the political fiscal mismanagement became known, voters changed political leadership. It was too late. The problems were severe and led to the hyperinflation of the 1970s. This is a critical lesson for today: Once an economy is infected with inflationary factors, it is difficult to eradicate them and takes long periods of time to reverse course or control the level of inflation. Even back in the 1970s, the country was misled by the authorities, who blamed the hyperinflation on workers. They called it wage-push inflation even though workers were only trying to keep up with it. The economy faltered, growth during the 1970s was slow or nonexistent, and all the time, inflation continued to erode the net worth and purchasing power of the population. Debtors realized they were in the sweet spot if their debt was long-term and at a fixed interest rate. Creditors suffered because they were being paid back with depreciated dollars and low interest rates.

Early in the 1970s, President Nixon took the U.S. off the gold exchange standard to preserve the country’s gold reserves. That put this country on a fiat monetary standard – meaning the value of a dollar was worth nothing other than what someone thought it was worth. This one political act, necessitated by politicians and their enablers at the Fed in the 1960s, changed economics, shifting economic power to unelected, appointed officials at the Federal Reserve. Political leaders could now use their cohorts at the Fed to supply the liquidity needed for their deficit spending.

In the 1970s, the Fed had to relinquish control of interest rates. Rates soared to compensate creditors properly for lending money to borrowers. By the end of the decade, President Carter decided to restore monetary discipline to the economy. Just as the political leadership had turned to the Fed to create the monetary mess experienced in the 1960s and 1970s, in 1979 Carter turned to the Fed to fix the problem. By that time, the Fed chairman understood the disaster created by politicians and his organization over a 20-year period, so he did what was necessary to break the back of the inflationary spiral and, more importantly, the psychology of inflation expectations. From 1979 to 1981, interest rates soared as the money supply contracted. By 1982, the first part of the job was done. Investment valuations had fallen as well as interest rates during the recession. Another investment strategy arose and would eventually add fragility to the financial system and economy. The leveraged buyout (LBO) became the quick and easy way for the Wall Street operators to make money. The economy was introduced to greater borrowing as a way to riches. Rather than regulate the process, the Fed, the political leadership, and the appointed financial regulators allowed it to mushroom during the 1980s and 1990s.

Over the 1980s and 1990s, the Fed let the markets control interest rates while it controlled the supply of money and liquidity, all while telling citizens and the markets they were steadily and consistently wringing inflation out of the economy. By the mid-1990s, Fed leadership changed. However, the policy remained the same, with one major adjustment: In the 1980s, many financial contracts by governments and the private sector were indexed in response to inflation shrinking the dollar’s purchasing power. These contracts called for interest boosts every so often based on changes in the Consumer Price Index. Private retirement plans, social security payments, and military and railroad retirement pay were adjusted for changes in the CPI.

In the late 1990s, the Fed chairman and Congress began discussing modifications to the Consumer Price Index. These changes caused the index to measure smaller amounts of inflation, thus triggering smaller increases in indexed costs. Throughout the 1990s, inflation expectation psychology subsided as globalization continued shrinking higher-paying manufacturing jobs in the United States while flooding the economy with cheaply made goods from overseas. The Fed was freed from serious efforts to maintain a stable currency value and focused on keeping unemployment low. By the end of the decade, the technology revolution added productivity increases, thus putting more downward pressure on reported inflation. By then the Fed found other indices that continued to lower the measured amount of inflation.¹ It was a boon for the Fed that globalization shrank the supply of good paying jobs in this country while the population of workers continued to grow through illegal immigration.

Starting with the 2000 financial crisis and continuing through today, the Fed has complete control of interest rates. It is using all means possible to flood the economy with liquidity, not only digitally running the printing presses wide open, but also purchasing assets to add to its balance sheet.

The serious incursion into unknown monetary manipulation started with the 2008 collapse of the economy and financial system. Guaranteeing money market funds, lending directly to markets that private-sector businesses needed to survive, and buying assets were new policies the Fed implemented to keep the country from going into complete economic collapse. Fed critics do not give enough credence to the potential political and social disruption in the country if the Fed had not taken the steps it did in each of the past crises. Yes, Fed actions aided and abetted the financial system through questionable policies, leading to incompetent businesses and financial institutions staying open and wasting resources that better managers could have used to grow the economy. The financial system is now so fragile that punishing the irresponsible borrowers has a high probability of wiping out the savings of a vast number of middle- and lower-class families. The Fed knew wiping out the savings and net worth of these citizens would directly lead to a change in the political structure of the country. Survival of the smartest, the most cautious, and the strongest is what is best; however, it needs to be done without crumbling the country’s social order. Unfortunately, because of the cumulative past actions of the political leadership and their enablers at the Fed over the last 60 years, the cost of cleansing the economy of incompetent and unworthy borrowers is higher than the political leadership will allow.

What the Fed Is Afraid Of

Very few citizens know that the United States defaulted on its debts during the Great Depression. President Roosevelt banned ownership of gold by U.S. citizens. Much of the debt at the time, including what the federal government had borrowed, was payable, at the request of the creditor, in either U.S. dollars or gold at a price of $20.67 per ounce. When the economy experienced severe deflation, two economic problems arose: First, people began hoarding gold and dollars, waiting to buy goods and services when prices came down. Second, all the debts were payable in either gold at a price of $20.67 or dollars. Because the government arbitrarily revalued the price of gold to $35 an ounce, devaluing the dollar, borrowers, including the federal government under the terms of existing loans, were in trouble. The government mandated all debts had to be repaid in the devalued dollars and not gold, making the debt value 40% less than before the government actions.

Fed officials today believe the potential threat of deflation is the greatest threat to the economy and country. They believe a psychology of falling prices will stop or slow economic activity and at the same time begin a cascade of debt defaults by the borrower class. Through suppressed interest rates, they confiscate legitimate interest income from creditors and give it to borrowers. All the while, they are trying to educate the citizens that inflation is good, not bad.

The Present Situation

The Fed has changed its monetary policies over the last few weeks. First, it dictated that interest rates will not be raised by it until at least the end of 2023, essentially three years from now. Second, it has put the country on notice that it will not consider changing any of its policies about inflation until its measured inflation has boosted the cumulative inflation rate to 2% over time. It has not said for what period it will tolerate inflation “moderately” above 2%. Nor has it defined moderately.

There are two problems with that policy. First, it implies the Fed can calibrate inflation to a fine tuning so it can magically adjust it. This can’t be done. Once inflation is embedded in an economy, it can’t be surgically removed over a short time. It took from 1979 to approximately 1999 for the inflationary expectations and related economic decisions to remove the inflation begun in the 1960s–1970s from the economy. Second, the policies don’t give credence to the imbalance in the economy it causes by suppressing interest rates. The Fed not only takes steps in the markets to regulate interest rates, but also purchases assets to infuse liquidity and increase the money supply. Both of these policies have been a major factor in the stock market hovering near all-time highs during this sharp recession caused by the pandemic. Just two weeks ago, the Fed announced in its Flow of Funds report that U.S. households and nonprofit organizations had the highest net worth in history in the second quarter of 2020.² A major factor in this record net worth was the stock market recovery. Everything is good, right? Maybe, or maybe not.

Unintended Consequences

According to a Gallup poll taken last September and updated in June 2020,³ 45% of Americans do not own any stocks. Think about that for a minute. If a person doesn’t own stocks, what do they do with their savings? They put them in a bank, credit union, or some other institution where they feel the money will be safe and available. For the last 20 years, the Fed has artificially suppressed interest rates on safe securities and deposits, confiscating these individuals’ rightful interest earnings and giving it to those who recklessly borrow too much for their lifestyle, speculation, or business. The Fed says this is for the good of the country, necessary to keep it from economically collapsing. Really? Let’s examine who is hurt by this policy. The numbers in parentheses are the percentage of that demographic group not owning stocks. Women (47%), those under 30 (68%), those over 65 (41%), Blacks (58%), Hispanics (72%), those with no college education (66%), those making under $40,000 annually (77%), and independent voters (49%) are the segments of the population bearing the brunt of the Fed’s policy to suppress interest rates. Who benefits? Large corporations, many sending jobs overseas; stock market speculators; and private equity companies buying businesses, leveraging them, and stripping their assets, in some cases pushing them into bankruptcy. Is there any wonder citizens have lost faith in the fairness of the country’s leadership and institutions? In addition, these same political leaders and their enablers at the Fed are responsible for tilting U.S. taxes and monetary policies toward globalization, sending jobs overseas and leading to stagnant wages and manufacturing industry contraction between 1980 and 2016.

Stagnant wages, confiscated interest earnings, and job opportunities shipped out of the country all contribute to the intense feelings of income and net worth inequality among the middle and lower economic groups. These feeling are correct. This imbalance in policies must be an unintended consequence because it is too dangerous to think it is intentional.

There are further troubling circumstances. At the same time the Fed is artificially suppressing interest rates for depositors in the banking system, it is requiring severe credit-loss stress tests for regulated financial institutions, notifying these institutions they cannot return excess capital to their shareholders through stock buybacks and/or dividend increases. These actions by the Fed essentially tighten the requirements for individuals and small businesses to get loans from traditional banking system entities.

What’s the result? Small borrowers and small businesses are being driven to the fintech companies, financial institutions that do not have the same regulatory oversight. These companies are more than happy to make the loans people need, but not at the same interest rates the banking system would. The rates are higher – in some cases, much higher. These fintech companies are backed by wealthy investors who are able to borrow money in the banking system at the lower, suppressed interest rate and lend at the unregulated higher rate. It’s another example of regulators and the Fed siphoning wealth from needy but unsophisticated citizens and putting it in the pockets of the wealthy risk-takers.

Conclusions

Some economists, examining the history of the last 60 years, pontificate that deficit spending at the governmental level doesn’t matter. In an era of fiat currency, that’s true until it isn’t. Just like the characters in the Roadrunner cartoon who run off the cliff and don’t realize it until it is too late, how long any economy can go without fiscal and monetary discipline is unknown until it is too late. These economists are wrong.

Some economists say we have passed the point of no return and will not be able to extract ourselves from the financial disaster we are living. These economists are also wrong.

No one knows what the future holds because it is unknowable. Can the economy and country collapse? Absolutely. Can it be saved from political, structural, and economic disaster? Absolutely.

What must be done to chart a course for unraveling the economic snake pit we are in? First, the Fed should allow the marketplace to set interest rates. Why it doesn’t is an indication it is tilting the economy toward borrowers and increasing the fragility of the economy and financial system. The Fed says it will artificially suppress interest rates for the next three years because the economy is too fragile not to. Really? If the economy is fragile, that means economic activity is tepid; therefore, the demand for loans will be less than the supply of capital, causing interest rates to stay low based on market supply and demand. So why is the Fed doing what the market would do – if the Fed’s economic assessment is right? If the economy is stronger than the Fed says, keeping interest rates suppressed will reduce the supply of regulated capital, causing the economy to turn to lenders who charge more than is appropriate and hurting future economic growth. Are interest rates suppressed, hurting 45% of citizens, to accommodate global interests? At some point, and no one knows when, creditors will seize control of interest rates just as they did in the 1980s and drive rates higher than appropriate to make up for the years of forced repression.

Second, the current acceptance of over-leverage in almost all aspects of the economy must change. When the economy begins rewarding businesses and consumers for having more equity capital than borrowed money, the demand for borrowed capital will gradually decline. This change in attitude will come when the cost of borrowed capital is greater than the cost of equity capital, rewarding careful borrowers and businesses and punishing the reckless. That is possible with political leadership dedicated to strengthening the country. This change in attitude by speculators has happened in the past, and likely will in the future.

Finally, from 1980 to 2016, the political leadership in Washington engaged this country in a string of senseless and unwinnable wars. Forget the 9/11 disaster – that was a situation that could have been dealt with and over in less than a year – if incompetent political leadership had not used it as an excuse to start another senseless and unwinnable war. Trillions of dollars have been wasted with the Fed’s acquiescence. Stopping this senseless waste of the money and treasure of our youth would significantly reduce the need for Fed accommodation and result in a slow improvement in fiscal and monetary discipline.

It’s not too late to fix the monetary and economic challenges facing the country. The Fed was the enabler in the 1960s, and in 1979 it led the efforts to reestablish sanity in monetary policy. The Fed has been the enabler in this irresponsible spree of debt over the last 40 years, and it can be the leader that rights the economy in the future.

¹ James Mackintosh, “Inflation Is Already Here – For The Stuff You Actually Want To Buy,” Wall Street Journal, September 26, 2020, https://www.wsj.com/articles/inflation-is-already-herefor-the-stuff-you-actually-want-to-buy-11601112630.

² See Paul Kiernan, “U. S. Household Net Worth Hits Highest Level Ever,” Wall Street Journal, September 21, 2020, https://www.wsj.com/articles/u-s-household-net-worth-hits-highest-level-ever-11600705010.

3 Lydia Saad, “What Percentage of Americans Owns Stock?” Gallup, September 13, 2019, https://news.gallup.com/poll/266807/percentage-americans-owns-stock.aspx

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