USA Inc’s 36% share of global income in 1969 fell slowly over the next three decades to 31%, then plummeted to 23% in 2010. Half of the loss since 2000 was before the Great Recession. IMF data also shows our cumulative current account balance (exports minus imports) grew massively negative between 1980 and 2008 (see below). How can we reverse that extraordinary decline? This is the first of a set of posts about the indicated monetary, fiscal and Presidential policies.
First, monetary policy. What is it and how does it work? Monetary policy expands or contracts the supply, cost and availability of money. Expansion aims to increase economic growth and lower unemployment, contraction aims to to cut inflation. US monetary policy is set and executed by the Federal Reserve, which is independent of the executive and legislative branches so it will not try to influence election results but keep the economy stable over the longer term. The Fed was created by Congress in 1913 after a series of financial panics with bank runs, credit contraction and financial asset fire-sales to raise desperately needed cash. The goal was to avert bank panics by establishing a lender of last resort and, over the longer term, to maximize employment and keep prices stable. The Fed’s Board of Governors is chosen by the President and confirmed by the Senate but its decisions need not be approved by them. Although the Treasury prints money, only the Fed can issue it (explained below). The Fed also has regulatory authority over commercial banks’ issuance of loans.
The Treasury was established within the Executive branch by Congress in 1789 to manage government revenue. It collects federal taxes, sells federal debt, and prints currency. Note that it prints but does not issue currency. What does that mean and how does it work? When the Treasury finances federal debt by selling bonds, those bonds may be bought by domestic and/or overseas investors using money that already exists or by the Fed using new money created by that act of purchase. That’s what issuing money means. The Fed can also recall money (de-issue it) by exchanging its financial assets for cash, i.e, selling them. Note that the Fed does not buy bonds directly from the government but in the open market just like other investors. This two-step process where the Treasury issues debt to finance federal spending and the Fed purchases it in the open market is called monetizing the debt. It increases “base money”, i.e., currency in circulation plus commercial banks’ reserves at the Fed (explained below).
Money supply is one of the Fed’s three monetary policy levers. The others are cost of money, i.e., interest rate on borrowed money, and availability of money. Availability is the fraction of their total assets commercial banks must hold in reserve with the Fed. There will in normal times be more borrowing and economic growth if money is created, if the interest rate is lowered and/or if banks that were required to place, say, 30% of their total assets in reserve are allowed to reserve only 10%. The Fed can try to increase economic growth and lower unemployment by increasing the monetary base, cutting interest rates and/or cutting reserve requirements. Or it can try to reduce inflation by decreasing the monetary base, increasing interest rates and/or increasing reserve requirements.
The Fed recently quantified its targets for unemployment at 5% to 6% and inflation at 2%. Economic growth is produced by more labor and/or new methods and equipment. The unemployment target is non-zero so labor will be available to increase production just as cash should be available to deploy new equipment. The inflation target is non-zero because mild inflation can stimulate economic growth. It gives debtors an increase in their nominal income. If they have fixed interest debt payments, they may spend the nominal increase on other things. Also, a less valuable dollar may stimulate exports and decrease imports. The target inflation rate is set relatively low so it will not greatly harm owners of fixed income assets (e.g., Treasury bonds). Their spending power is reduced by inflation along with overseas owners of dollars, and government spending on inflation-indexed entitlements increases. Inflation is in essence a redistribution of wealth away from asset-owners (creditors).
Because our economy is weak at this time, our monetary policy is expansive. The cost of money was very low when we entered the Great Recession and reserve requirements were very low. That drove explosive growth in easily satisfied demand for real estate, which led to correspondingly high real estate prices and exceptionally high leverage by both home-owners and banks. Then confidence was shattered by the failure of Lehman Brothers bank, the economy began to contract, unemployed home owners began to default on mortgages, potential buyers waited for prices to reach bottom and banks stopped making easy loans. House prices spiraled down, household and bank assets collapsed. Some say the Fed created the problem by keeping interest rates and reserve requirements so low for so long. In any case, when the bubble burst the Fed could not try to stimulate a rebound by reducing the already close to zero cost of money or increase its availability because reserve requirements were so low. Their only remaining lever was money supply.
In normal times the Fed increases money supply by purchasing more government bonds. This time the Fed wanted an exceptionally big increase in money supply and to direct it where it would have most benefit, commercial banks that lend to businesses and home buyers. It began purchasing mortgage-backed securities (MBS) (explained below) held by those banks hoping this big increase in demand for them would also raise their price. The big change was the Fed was now buying debt securities from the private sector. That was termed Quantitative Easing (QE) although qualitative would be more accurate since the Fed was buying higher risk assets. Treasury bonds theoretically have zero risk because it is assumed the Treasury will return all money it borrows. Private enterprises may not because their assets may lose value or have been over-valued in the first place (e.g., real estate-backed mortgages), or because an unforeseen catastrophe unbalances their revenues and expenses.
Mortgage-backed securities represent a claim on cash flow from a collection of mortgage loans. They’re complicated. They’re so complicated, in fact, that MBS sellers often quote very different prices for the same MBS. What happens is a large set of mortgages is bought from banks by a trust. The banks can then use that money to issue more mortgages. The trust assembles pools of mortgages with diverse levels of default risk, interest rates and duration, then issues securities backed by the pools. Buyers of the securities get a share of the mortgage payments. The risk with a mortgage is it may not be repaid, in which case the lender gets the mortgaged property but with costs to regain possession and sell it, perhaps at a lower price than the unpaid loan balance. That risk is compounded with an MBS because they are bought to get a cash flow but payments may not be made on time and there is the risk of prepayment. If the mortgage is paid off early, the MBS owner does not get the full expected cash flow. Prepayments increase when interest rates fall and mortgage-holders refinance at the new rate. A complicated mix of factors, each with associated risk impacts the value of an MBS and in addition the risk associated with the underlying pool of mortgages is uncertain. Any estimate of the future value of real estate is uncertain. The future value of an MBS is much more so.
QE created an unprecedented increase in the money supply. The Fed held $700B to $800B of Treasury notes before the recession. Starting in late 2008 it bought $600B of MBS then an additional $1.25T in 2010 and subsequently began buying $600B of preexisting Treasury securities in addition to ongoing purchases of new federal debt. Note that QE is not monetizing debt but purchasing existing assets from investors, however increasing base money always carries risk because if too much money is created, inflation grows. QE was an exceptionally large increase. There was also the risk that QE may not help the US economy overall. Banks may not lend the new money to local businesses but invest it for a potentially higher return overseas, e.g., emerging markets. And, because the Fed is the lender of last resort it may turn out to have overpaid for QE assets.
Has QE been effective? The IMF says it reduced the risk of further bank failures like Lehman Brothers and others say that cutting the already low return on bonds induced investors to instead buy stocks, which raised their price and so enabled increased consumption and economic growth. Others say, however, that while QE certainly helped the banks it did less for the US economy overall. They point to the banks lending new money overseas.
What will be the eventual effects of QE? Fed officials and others believe traditional monetary policy can smooth traditional business cycles although some say it tends to aggravate fluctuations. There can be no consensus on the effects of QE because there is too little history. There are centuries of history of lending so we can see what has always happened before when debt levels were very high. We can only theorize, however, about the interaction of QE and high debt. In normal circumstances low interest rates do encourage borrowing to fund investments and consumption but there is a limit beyond which borrowing can no longer increase. Demand in that case should drop, which means prices should, also. But if monetary expansion continues when there are no borrowers, that should lead to inflation. Which are we experiencing now, deflation or inflation?
House prices are still dropping, businesses are not investing, unemployment remains high and wages are therefore not increasing. That’s deflation. However, global supply and demand is driving up the cost of energy and other commodities. People must keep buying food, gas and other staples regardless of price, so their price is increasing. That’s inflation. So we have simultaneous deflation and inflation, which means instead of combating one or the other as usual, the Fed must simultaneously try to fight both. What should it do? Continue to increase the money supply to arrest deflation or cut it to reduce inflation?
This is a new situation. Monetary policy encourages but cannot cause behavior. Encouragement works only on those who can respond. Consumers can no longer respond as in recent years because unusually low interest rate and bank reserve requirements encouraged them to take on excessive household debt. Government is approaching the same constraint. A massive increase in money supply may facilitate recovery but we can not be sure of its effects. They are unlikely to be entirely positive.
In my next post I will examine the acceleration and size of our debt and money supply in more detail, then move on to fiscal policy. What role did tax policy have in our economic decline and to what extent could changes alleviate our excessive debt? This, too, is uncertain because USA Inc delivers its services via a combination of federal, state and local governments each of which raises revenue differently and operates under different borrowing constraints. With monetary and fiscal policy as background, I can shed more light on government debt. A fundamental source of confusion there is that unlike a business, USA Inc does not differentiate in its federal financial statements between debt to pay operating expenses and borrowing to make investments for the future. That is a very big problem.