In 2013 I wrote an Overview of the U. S. Monetary System describing what money is and how it is created; interactions of the Treasury, the Federal Reserve, and commercial banks; and government and trade deficits. Much of this also applies to Europe, Japan, and other countries or regions with central banks. At that time, the world was in the midst of a painfully slow recovery from the traumatic 2008-2009 Great Recession, and central banks were taking unprecedented measures to try to stabilize finances and help economies regain growth. It is interesting to look back to all the macroeconomic uncertainties seven years ago, and see how things have actually played out.
Europe was still in the throes of a sovereign debt crisis. As of 2013, Greek public finances were still shaky, with fears of default driving 10-year government bonds yields over 10% and Greek populist political parties fighting the austerity measures demanded by the EU as the price for a bailout. At that point, the fiscally-responsible Germans were preventing the European Central Bank (ECB) from simply underwriting the bonds issued by European countries like Greece. However, since then the ECB has devised ways to do stealth quantitative easing – – it provides money at very low interest rates to national banks to enable those banks to purchase government bonds. The ECB balance sheet now stands at over 4.5 trillion euros. This has driven government bond interest rates down and down, to zero and sometimes even negative. Because of the implicit ECB backstop, Greek bonds were recently issued with an interest rate of under 1%, which is lower than the rates for current US Government debt. No one could have imagined such a thing in 2013. Such is the power of central banks.
In Japan, the central bank has gone wild, buying anything and everything including stocks as well as bonds. The Japanese central bank routinely vacuums up a large fraction of the debt issued by the Japanese government. This has kept a Japanese interest rates near zero for decades. For some years, various finance commentators have warned that private bond buyers would rebel against the huge government debt and deficit spending, and would force Japanese rates back up. But all the experience of the last 10 years illustrates the truth that you cannot fight the central banks. They have for all practical purposes, infinite resources to execute their objectives, since they can create as much money as they want with the tap of a keyboard.
The Swiss national bank (SNB) currently engages in raw currency manipulation by creating billions of Swiss francs out of thin air, and using them to buy things like Euros and U.S. stocks. Dumping all these francs into foreign markets serves to reduce the foreign exchange value of the franc. This is done in order to make Swiss exports more competitive. A side effect of this currency war operation is that the SNB has come to own huge stakes in U.S. corporations, e.g. it owns more publically-traded shares of Facebook than Mark Zuckerberg.
In the U.S., the Fed intervened massively to stabilize the financial markets in the wake of the 2008-2009 meltdown, but those interventions were seen as extraordinary. But the extraordinary has since become the ordinary. The Fed balance sheet remains bloated at over $4 trillion, and there is no realistic prospect that it will ever shrink down low enough that the Fed can resume setting short term rates by open market operations, like it did before 2008.
In the U.S., the Fed under Chairman Powell tried to reduce its holdings and to increase (“normalize”) short term rates back up to 3-3.5% or so in 2018. That ended disastrously, with a stock market meltdown at the end of the year, and with the Fed quickly back-pedaling and ratcheting rates back down in 2019. In autumn of 2019, the commercial banks got overwhelmed with the flood of bills issued by the U.S. Treasury due to the ballooning federal deficit, and the “repo” market (which I will not try to explain here) froze up, so the Fed intervened by buying lots of Treasuries, in the process re-inflating its balance sheet.
The bottom line is that central banks have succeeded in enforcing extremely low interest rates over the past decade, and at this point it looks like low rates are here to stay. Private and public debt has ballooned to such enormous amounts, that any large increase in rates would probably crash the whole system, since so many parties simply could not keep going if they had to pay higher rates on their debt.
Here is a graph of nominal bond rates over the last 700 years:
The long term trend has been toward 0-2% nominal interest rates, or essentially 0% or negative real rates (i.e. after inflation). Billions of dollars’ worth of sovereign bonds now trade at negative nominal rates; you would do better stashing your money under your mattress. Corporate and other bonds of course trade at somewhat higher rates than this government debt. This is a novel global macroeconomic experiment, being run in real time. One wonders how economists a hundred years from now will assess it.
So, what are some of the effects of more or less permanent near-zero interest rates? One effect is to enable massive government deficit spending, in Japan and now in the US. It seems like neither major American political party cares about federal deficits any longer. One party used to at least posture about being concerned about it, but their reward was to be bashed as “heartless” by the other party for reining in domestic spending, so they seem to have given up that fight. Politicians now seem to assume that the Fed will step and buy government bonds (“monetize the debt”) as needed to keep interest rates down. It seems that in practice this plank of “Modern Monetary Theory” has become the new orthodoxy.
It used to be the case that the Fed was so independent that it would enforce financial discipline on federal government. If the federal deficit spending started getting high, with attendant inflation, the Fed would crank up interest rates to cool down the economy. This would (in theory, at least) punish the profligate president and Congress by essentially causing a recession on their watch, with all the human pain of job losses. If this punishment caused the stock market to crash, so be it. But now the Fed seems to be more or less hostage to the stock market. If the market swoons, the Fed has shown that it will quickly lower interest rates.
If Europe, the ECB sits above any one country, and is heavily influenced by the Germans, with their tradition of strict financial discipline. Although the ECB has provided cheap money to keep interest rates low in European countries, it demands in return from those countries that they meet certain austerity targets. This has to some extent forced those nations to keep their deficit spending under control. On the one hand, that may seem admirable, but in practice, European economic growth has lagged far behind that of the US in the past decade, perhaps because of all the austerity.
In the U.S., the more productive coastal states subsidize the poorer interior/southern regions via federal transfer payments such as Medicare and food stamps. This money recycling helps allow the folks in the poorer regions to keep purchasing goods and services produced by the wealthier regions, so it is a win-win. However, in Europe, the more-productive Germans and Dutch are reluctant to simply ship their hard-earned euros to Greece and Spain to subsidize the lifestyles there.
In the U.S., companies have taken advantage of low interest rates to issue staggering amounts of corporate debt. Rather than using this money to invest in new factories and hire more workers, a large fraction of it has gone into simply re-purchasing corporate shares. This in turn has driven U.S. stock prices higher and higher and higher. For a given company, the underlying business may not change, i.e. the total revenues and earnings may not grow much, but because fewer shares are in circulation, the earnings per-share continue to creep up. For such brilliant financial engineering, management rewards itself with fat compensation packages.
Looking at things from a more macroeconomic perspective, it seems that permanently low interest rates have a paradoxical “zombification” effect. Japan is a pioneering example of this, since low interest rates and slow economic growth have been a feature there for several decades now. Apparently, the low interest rates enable poorly-executing, walking-dead “zombie” companies to stay in business, whereas previously they would have gone bankrupt and disappeared. On the bright side, this tends to keep employment relatively high, which has been a general feature of many developed economies over the past decade. But on the other hand, this inhibits the “creative destruction” process whereby more productive companies replace less productive enterprises. So the real per capita economic growth remains subdued. Also, large companies seem able to better take advantage of low rates, so we see big companies getting bigger and more monopolistic, to the detriment of smaller firms which might otherwise be introducing new ways of doing things.
A zombified economy where nearly anyone who wants to work can get a job, even at low and stagnant real wages, seems like a fairly benign outcome. However, if young people see only a terminally dull future ahead for themselves, this may lead to dissatisfaction which could have political consequences. Moreover, if the real interest rate of investment grade bonds remains zero or even negative, that will challenge pension funds in meeting their commitments to pay pensioners in coming decades (many pension funds still assume they can obtain secure long-term returns of around 7% on their portfolios). It also calls into question the traditional 60/40 stock/bond portfolio for individual investors, if the 40% bond portion is earning practically nothing. This impelled me to look for, and actually find, some ways to earn reasonably high (6-8%) yields in the present environment (see High Yield Investments).
Every age has its reasons for uncertainties. As I post this, the Wuhan corona virus from China is spreading throughout the world. Hundreds of thousands are sick, and thousands have died. Whole cities have been put under quarantine. Here in the U.S., surgical masks (which are all made in China these days) are all sold out, and organizations are making contingency plans for scenarios where employees, teachers, and students are all confined to their homes for indefinite periods. Tourism and other travel will likely decline, all of which could take a real bite out of GDP. The upcoming election may pit an erratic incumbent against a socialist. Interesting times – – we will see if the Fed can keep working its magic.
UPDATE April 6, 2020
What a difference a month can make – – when I wrote this post in late February, the S&P 500 stock index was hovering near all-time highs, after a steady rise over the previous twelve months. Unemployment was at historic lows, and robust economic growth was forecast.
The “social distancing” implemented to slow the spread of the COVID-19 virus has blown this rosy economic picture to bits. A huge fraction of money-generating activities, mainly in the service economy (dining out, cruises, travel, tourism, getting haircuts, working out at the gym, dentist visits, routine shopping) have been stopped cold, and will likely remain stopped for a number of months. The S&P lost about a third of its value in three weeks, though there has since been some recovery:
The main reason stocks have levitated over the past several years has been corporations taking advantage of low interest rates to issue debt and to use that money to buy up shares. Management usually has impeccable timing of buying shares when prices are high, and stopping when economic conditions drive prices low. Absent corporate buy-backs over the rest of the year, it may be some time before stocks regain their highs.
The unemployment numbers in the next few months will be staggering. While hospitals near New York City are on overload, in the community where I live in the Northeast U.S., hundreds of medical personnel are on furlough because all elective procedures have been cancelled while we wait for the wave of virus cases to come our way. The actual death toll so far is well below what the regular flu season can produce (which is ignored most years), but each case represents its own personal and family tragedy, and it remains to be seen what the ultimate body count will be.
Focusing just on the economic maneuverings – – I noted in the original article some of the powers of the U.S. central bank, the Federal Reserve. As the crisis unfolded in March, the Fed unleashed a barrage of programs aimed at keeping the financial system from imploding. Besides buying U.S. government bonds and government agency-backed mortgages (i.e. traditional “quantitative easing”), the Fed will buy (directly or indirectly) existing (already-issued) student loans, car loans, credit card loans, small business loans, etc., as well as municipal bonds and even (investment-grade) corporate bonds. I suspect the legality of some of this is questionable, but nobody is questioning at this point. The Fed creates “money” out of thin air to buy all this stuff, which in turn (a) provides “money” to desperate, cash-poor entities, and which (b) keeps the prices of these securities from plummeting, which in turn would drive interest rates to the moon.
A reason that organizations are desperate for cash is that many investing entities have borrowed money from banks to buy securities that they thought would rise in value, but now that everything has fallen in value, the banks are demanding that the investors sell off the securities for cash to partially repay their loans, in order to keep a stated margin of safety for the collateral for the loans. These “margin calls” create a vicious downward spiral, where the more forced selling there is, the more securities prices fall, which leads to more demands by banks for more selling. Forcing investment funds to sell their assets for a fraction of what they bought them for is ruinous for investors. (Don’t ask me how I know this.)
Complementing the Fed’s efforts, the U.S. government will be throwing trillions of dollars at citizens in the next several months, to mitigate the impact of mass unemployment. We shall see how this unfolds. Best wishes to all…