Free Money from the Federal Reserve

Right From the Start

Right From the Start

The path to good intentions is littered by governmental corruption, incompetence and unintended consequences.

Anonymous The stock market reacted positively to speculation that, based on the minutes from the last Federal Reserve System, the next rate increase would not occur in April. That’s good in the short term for investors, but it reveals a nagging problem that the federal government has failed to address now for at least five years – the artifice of growth based on virtually free money. It also stands in stark contrast to the near collapse of the stock market following the December, 2015, one-quarter percent increase – the three major indices shed nearly six percent of their value.

There were two major factors causing what would have been a normal and temporary recession in 2008 to evolve into a massive economic collapse. First, Congress was in a twit that segments of the population were being left out of the rapidly expanding home ownership market. Congress insisted that banks loan money to people who could not or would not repay them. Do to this the banks began implementing “sub-prime mortgages.” The result was that banks began issuing mortgage loans without equity positions by the purchasers or even verification of their financial statements. The banks were willing to do this because the federally created Federal National Mortgage Association (FannieMae) and the Federal Home Loan Mortgage Corporation (FreddieMac) would either purchase or guarantee the loans.

Second, the problem was compounded when the banks began to bundle these loans (good with bad) and sell them to investment houses which in turn repackaged them, leveraged them and basically hid the underlying risk of these questionable loans – think The Big Short. (Goldman Sachs just coughed up $5 Billion to settle allegations of fraud relating to its failure to disclose the risk of its packaged mortgage securities.) The influx of newly “qualified” purchasers artificially stimulated the housing market resulting in a rapid and unsustainable increase in prices, upon which new and additional “subprime loans” were made and the vicious cycle repeated itself many times.

None of this would have been possible without the active participation by FreddieMac and FannieMae, the blind eye turned by Congress on their activities (primarily at the behest of Rep. Barney Frank (D-MA) and Sen. Christopher Dodd (D-CN)), or the blind eye turned by the Bush Administration on the activities of the banks and financial institutions involved in bundling and leveraging the unqualified loans. At every turn of the screw, the federal government was primarily responsible for making a bad situation not just worse, but catastrophic.

When the inevitable collapse came – and it always does – the federal government was forced to act to mitigate the damage it had caused. It came in four major areas.

First there was the Troubled Asset Relief Program which allowed the government to prop up large businesses that were on the verge of failure. Economists and historians will argue endlessly as to whether this was necessary to save major institutions and the jobs that went with them or simply rewarded overpaid executives in those major institutions who made poor (maybe even fraudulent) decisions with other people’s money (OPM) – their shareholders. Frankly, I lean toward the latter. I also lean in that direction because the bailout was quickly undertaken by another institution – the federal government – that routinely makes poor decisions with OPM. In many instances, think General Motors, the shareholders lost their investment and the taxpayers lost their “stimulus.” In other instances, the stimulus was paid back with interest. It was a mixed bag. Fortunately the practice ended with the one-time infusion of taxpayer dollars although the remnants of “too big to fail” still exist.

Second came the massive Trillion dollar spending program by President Barack Obama and the Democrat Congress and justified as an economic stimulus. That might have had some salutary effect had the money been used for one-time expenditures utilizing the private sector – capital improvements for instance. But in this instance the overwhelming majority of the money was expended to reward loyal Democrat constituencies and allow federal, state and local governments to raise wages and benefits (recurring expenses) for public employees thus compounding a problem by raising the base from which future demands for increases would be had. Meanwhile main street businesses failed in record numbers and many have never recovered. Again, this give-away was a “one and done” phenomena despite the earnest efforts of Mr. Obama to create second and third rounds of wasted stimulus money. (When government programs fail, Democrat leaders like Mr. Obama never look at the underlying cause of failure but simply conclude that the government didn’t spend enough.)

Third came the Federal Reserve System which steadily reduced the discount (interest) rates until they reached nearly zero. This was done to provide cheap money to stimulate growth in investment. And it had the ancillary effect of driving money in the private sector out of bonds and into the equities market thus creating an artificial demand for stock. (For those forced to endure a teachers union directed education in the Portland public schools, that means that because interest rates were so low people were forced to accept the greater risk in the equities market in order to achieve any return on investment.) It is one of the principle reasons that the stock market has fully recovered from the Bush/Obama recession while the general economy has not. (Despite Mr. Obama’s insistence on the strength of job growth, we have never recovered either the quality or quantity of jobs – adjusted for population growth – that the country experienced prior to the collapse.)

And finally, the Federal Reserve System, in coordination with the Treasury Department, increased the nation’s money supply through a program known as “quantitative easing.” That can be a dangerous game because rapidly increasing the money supply can lead to inflation. However, the economy was in such bad shape, and the additional regulatory burdens imposed by the Obama administration so inhibited recovery that the inflationary aspects of “quantitative easing” were mitigated. The quantitative easing program passed through three iterations (QE1, QE2 and QE3). Eventually, the federal government ended the programs in October 2014 and history is left to determine whether the timing of its termination was too soon or too late. I would have opted for ending the program in June of 2011 at the end of QE2 given that the economy had already stabilized as evidenced by what little positive effect that QE3 had despite its nearly $1.6 Trillion cost.

So, the only remnant of federal action is the suppressed discount (interest) rate from the Federal Reserve System. And it has remained this long primarily for political reasons rather than economic reasons. The original intention was to stimulate capital investment and thus market expansion. Initially it probably did that to a certain extent but in reality three things – all unintended but probably readily foreseeable by anyone other than a government bureaucrat – have occurred:

  • Major companies began hoarding profits, choosing to utilize “cheap money” to undertake what minimal capital investment they undertook. This should have been foreseeable because interest rates made borrowing less risky than expending reserves. That coupled with the uncertainty of regulatory policy under Mr. Obama and the fact that while the stock market was recovering, neither the economy nor jobs were recovering at acceptable rates.
  • Businesses began to use cost controls to maintain or increase profitability rather than expanding their markets. Again, while the stock market recovered rapidly as a result of profit stabilization and/or increases, the underlying economy remained relatively moribund from lack of expansion.
  • As opportunities for additional efficiencies began to decline, the mergers and acquisitions activity began to increase. A Wall Street Journal article updated for December 21, 2015, began:

 

“Subdued for years after the financial crisis, mergers and acquisitions came roaring back as companies seek to boost revenue at a time when sluggish economic growth and low inflation make that difficult.”

The effect of the rise in mergers and acquisitions is to grow by absorption rather than expansion. The fact that two drug companies merge does not increase the availability of drugs but rather can decrease the joint and common costs of producing the drugs. That may be a windfall for consumers but usually it just turns out to be a means of boosting or maintaining profitability thus satisfying the stock market without improving the economy.

Add to these three phenomena that massive impact increasing the interest rate will have on the national debt – currently at over $19.2 Trillion. A mere increase of one-quarter percent will increase the amount of the current budget by $48 Billion dollars at a time when we are continuing to engage in deficit spending.

And finally, because rates remain at near zero, short of negative interest, the Federal Reserve has virtually no weapons with which to combat a new recession – which based on the anemic performance of the economy during Mr. Obama’s tenure is, more likely than not, just around the corner.

In the end, the focus of the Federal Reserve System and the other governmental agencies charged with attending to the country’s economic well-being, needs to be on expansion even at the expense of their friends on Wall Street and in the nation’s investment houses. Given the close financial ties by Democrat Hillary Clinton and Republican Ted Cruz with those entities, that is unlikely. More likely is that Congress and Wall Street – and those they own – will continue to pressure the Federal Reserve to go slow and hope like hell nothing goes amiss until after their next election. And like the past seven years, the result will be that Wall Street and the stock market will improve while jobs and small businesses suffer.

Business as usual.

 

 

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Posted by at 05:00 | Posted in Bush/Obama Recession, Economy, Federal Government, Federal Reserve System, President Obama | 6 Comments |Email This Post Email This Post |Print This Post Print This Post

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