The Death of Money

by James Rickards

  The wealth effect is one pillar supporting the Fed’s zero-interest-rate policy and profligate money printing since 2008. The transmission channels are easy to follow. If rates are low, more Americans can afford mortgages, which increases home buying, resulting in higher prices for homes. Similarly, with low rates, brokers offer cheap margin loans to clients, which result in more stock buying and higher stock prices.

  There are also important substitution effects. All investors like to receive a healthy return on their savings and investments. If bank accounts are paying close to zero, Americans will redirect those funds to stocks and housing in search of higher returns, which feeds on itself, resulting in higher prices for stocks and housing. At a superficial level, the zero-interest-rate and easy-money policies have produced the intended outcomes. Stock prices more than doubled from 2009 to 2014, and housing prices began rebounding sharply in mid-2012. After four years of trying to manipulate asset prices, the Fed appeared to have succeeded by 2014. The wealth was being created, at least on paper, but to what effect?

  The wealth effect’s power has been debated for decades, but recent research has cast considerable doubt on its impact. Few economists doubt that the wealth effect exists to an extent. The issues are, how strong is it, how long does it last, and is it worth the negative impacts and distortions needed to achieve it?

  The wealth effect is typically expressed as a percentage increase in consumer spending for each dollar increase in wealth. For example, a $100 billion increase in stock market and housing prices that had a 2 percent wealth effect would produce a $2 billion increase in consumer spending. The Congressional Budget Office shows that various studies put the wealth effect from housing prices in a range from 1.7 percent to 21 percent. Such a wide range of estimated effects is risible, casts doubt on similar studies, and highlights the methodological difficulties in this field.

  A leading study of the wealth effect from stock prices, published by the Federal Reserve Bank of New York, contained findings that substantially undermine the Fed’s own belief in the wealth effect. The study says:

  We find . . . a positive connection between aggregate wealth changes and aggregate spending . . . but the effect is found to be rather unstable and hard to pin down. The . . . response of consumption growth to an unexpected change in wealth is uncertain and the response appears very short-lived. . . . We find that . . . the wealth effect . . . was rather small in recent years. . . . When we force consumption to respond with a one-period lag, a . . . shock to the growth of wealth has virtually no impact on consumption growth.

  Another study shows that the wealth effect, to the extent it exists, is heavily concentrated among the rich and has no impact on the spending of everyday Americans. David K. Backus, chairman of the economics department at New York University, echoed this view:

  The idea of a wealth effect doesn’t stand up to economic data. The stock market boom in the late 1990s helped increase the wealth of Americans, but it didn’t produce a significant change in consumption, according to David Backus. . . . Before the stock market reversed itself, “you didn’t see a big increase in consumption,” says Backus. “And when it did reverse itself, you didn’t see a big decrease.”

  Even more disturbing than doubts about the wealth effect’s size and timing is the fact that economists are not even sure about the direction of the effect. While conventional wisdom holds that rising stock prices increase consumption, economists have suggested that it may be the other way around; that rising consumption may increase stock prices. The prominent monetary economist Lacy H. Hunt summarizes the state of research on the wealth effect as follows:

  The issue here is not whether the Fed’s policies cause aggregate wealth to rise or fall. The question is whether changes in wealth alter consumer spending to any significant degree. The best evidence says that wealth fluctuations have little or no effect on consumer spending. Thus, when the stock market rises in response to massive Fed liquidity, the broader economy is unaffected.

  Now consider that several of the leading studies on the wealth effect were published either in 1999 or in 2007, at the height of the two most recent stock bubbles. It’s hardly surprising that academic research on the wealth effect might be of particular interest during stock bubbles when the wealth effect was supposed to be at its strongest, but this research indicates that the wealth effect is actually weak and uncertain.

  Taken together, all this suggests that while the Federal Reserve is printing trillions of dollars in pursuit of the wealth effect, it may actually be in service to a mere mirage.

  ■ Asset Bubbles

  America is today witnessing its third stock bubble, and its second housing bubble, in the past fifteen years. These bubbles do not help the real economy but merely enrich brokers and bankers. When these bubbles burst, the economy will confront a worse panic than occurred in 2008, and the bankers’ cries for bailouts will not be far behind. The hubris of central bankers who do not trust markets, but seek to manipulate them, will be partly to blame.

  Asset bubble creation is one of the most visible malignancies caused by Federal Reserve money printing, but there are many others. One obvious effect is the export of inflation from the United States to its trading partners through the exchange-rate mechanism. A persistent conundrum of Fed monetary policy since 2008 has been the absence of inflation in U.S. consumer prices. From 2008 through 2012, the year-over-year increase in the consumer price index averaged just 1.8 percent per year, the lowest for any five-year period since 1965. Fed critics have expected for years that inflation would rise sharply in the United States in response to money printing, albeit with a lag, but the inflation has not yet appeared; indeed persistent deflationary signs began emerging in 2013.

  A principal reason for the absence of inflation in the United States is that inflation was exported abroad through the exchange-rate mechanism. Trading partners of the United States, such as China and Brazil, wanted to promote their exports by preventing their currencies from appreciating relative to the U.S. dollar. As the Fed prints dollars, these trading partners must expand their own money supplies to soak up the dollar flood coming into their economies in the form of trade surpluses or investment. These local money-printing policies cause inflation in the trading partner economies. U.S. inflation is muted because Americans import cheap goods from our trading partners.

  From the start of the new millennium, the world in general and the United States in particular have had a natural deflationary bias. Initially the United States imported this deflation from China in the form of cheap goods produced by abundant labor there, aided by an undervalued currency that caused U.S. dollar prices for Chinese goods to be lower than economic fundamentals dictated. This deflationary bias became pronounced in 2001, when annual U.S. inflation dipped to 1.6 percent, perilously close to outright deflation.

  It was this deflation scare that prompted then Fed chairman Alan Greenspan to sharply lower interest rates. In 2002 the average Federal Funds effective rate was 1.67 percent, then the lowest in forty-four years. In 2003 the average Federal Funds rate was even lower, 1.13 percent, and it remained low through 2004, averaging 1.35 percent for the year. The extraordinarily low interest-rate policy during this three-year period was designed to fend off deflation, and it worked. After the usual lag, the consumer price index rose 2.7 percent in 2004 and 3.4 percent in 2005. Greenspan was like the pilot of a crashing plane who pulls the aircraft out of a nosedive just before it hits the ground, stabilizes the aerodynamics, then regains altitude. By 2007, inflation was back over 4 percent, and the Fed Funds rate was over 5 percent.

  Greenspan had fended off the deflation dragon, but in so doing he had created a worse conundrum. His low-rate policy led directly to an asset bubble in housing, which crashed with devastating impact in late 2007, marking the start of a new depression. Within a year, declining asset values, evaporating liquidity, and lost confidence produced the
Panic of 2008, in which tens of trillions of dollars in paper wealth disappeared seemingly overnight.

  The Federal Reserve chairmanship passed from Alan Greenspan to Ben Bernanke in February 2006, just as the housing calamity was starting to unfold. Bernanke inherited Greenspan’s deflation problem, which had never really gone away but had been masked by the 2002–4 easy-money policies. The consumer price index reached an interim peak in July 2008, then fell sharply for the remainder of that year. Annual inflation year over year from 2008 to 2009 actually dropped for the first time since 1955; inflation was turning to deflation again.

  This time the cause was not the Chinese but deleveraging. The housing market collapse in 2007 destroyed the collateral value behind $1 trillion in subprime and other low-quality mortgages, and trillions of dollars more in derivatives based on those mortgages also collapsed in value. The Panic of 2008 forced financial firms and leveraged investors to sell assets in a disorderly fire sale to pay down debt. Other assets came on the market due to insolvencies such as Bear Stearns, Lehman Brothers, and AIG. The financial panic spread to the real economy as housing starts ground to a halt and construction jobs disappeared. Unemployment spiked, which was another boost to deflation. Inflation dropped to 1.6 percent in 2010, identical to the 1.6 percent rate that had spooked Greenspan in 2001. Bernanke’s response to the looming threat from deflation was even more aggressive than Greenspan’s response to the same threat almost a decade earlier. Bernanke lowered the effective Fed Funds rate to close to zero in 2008, where it has remained ever since.

  The world is witnessing a climactic battle between deflation and inflation. The deflation is endogenous, derived from emerging markets’ productivity, demographic shifts, and balance sheet deleveraging. The inflation is exogenous, coming from central bank interest-rate policy and money printing. Price index time series are not mere data points; they are more like a seismograph that measures tectonic plates pushing against each other on a fault line. Often the fault line is quiet, almost still. At other times it is active, as pressure builds and one plate pushes under another. Inflation was relatively active in 2011 as the year-over-year increase reached 3.2 percent. Deflation got the upper hand in late 2012; a four-month stretch from September to December 2012 produced a steady decline in the consumer price index. The economy is neither in an inflationary nor a deflationary mode; it is experiencing both at the same time from different causes; price indexes reveal how these offsetting forces are playing out.

  This dynamic has profound implications for policy. It means the Fed cannot stop its easing policy so long as the fundamental deflationary forces are in place. If the Fed relented in its money printing, deflation would quickly dominate the economy, with disastrous consequences for the national debt, government revenue, and the banking system. But deflation’s root causes are not going away either. At least a billion more workers will enter the labor force in Asia, Africa, and Latin America in coming decades, which will keep downward pressure on costs and prices. Meanwhile a demographic debacle in developed countries will put downward pressure on aggregate demand in these advanced economies. Finally, technological breakthroughs are accelerating and promise higher productivity with cheaper goods and services. The energy revolution in natural gas, shale oil, and fracking is another deflationary force.

  In short, the world wants to deflate while governments want to inflate. Neither force will relent, so the pressure between them will continue to build. It is just a matter of time before the economy experiences more than just bubbles, but an earthquake in the form of either a deeper depression or higher inflation, as one force rapidly and unexpectedly overwhelms the other.

  ■ Tremors

  Expected earthquakes of great magnitude near large population centers are colloquially referred to as “the big one.” But before those big quakes appear, they may be preceded by small tremors that wreak havoc in localities along the fault line far from the big cities. The same can be said for the Fed’s market interventions. In its desperate effort to fight deflation, the Fed is causing minor meltdowns in markets far removed from the main arena of U.S. government bond interest rates. The unintended and unforeseen consequences of the Fed’s easy-money policies are becoming more visible, costly, and problematic in many ways. An overview of these malignancies reveals how the Fed’s quixotic pursuit of the deflation dragon is doomed to fail.

  While inflation was quite low from 2008 to 2013, it was not zero, yet growth in personal income and household income was close to zero. This meant that real incomes declined even in a low-inflation environment. If the Fed had instead allowed deflation, real incomes would have risen even without nominal gains, because consumer goods prices would have been lower. In this way, deflation is the workingman’s bonus because it allows an increase in the living standard even when wages are stagnant. Instead, real incomes declined. Economist Lacy Hunt captured this effect succinctly when he wrote,

  Since wages remained soft, real income of the vast majority of American households fell. If the Fed had not taken such extraordinary steps, interest rates and inflation would be lower currently than they are, and we could have avoided the unknowable risks embodied in the Fed’s swelling balance sheet. In essence, the Fed has impeded the healing process, delayed a return to normal economic growth, and worsened the income/wealth divide while creating a new problem—how to “exit” its failed policies.

  Another unintended consequence of Fed policy involves the impact on savers. The Federal Reserve’s zero-interest-rate policy causes a $400 billion-per-year wealth transfer from everyday Americans to large banks. This is because a normalized interest-rate environment of 2 percent would pay $400 billion to savers who leave money in the bank. Instead, those savers get nothing, and the benefit goes to banks that can relend the free money on a leveraged basis and make significant profits. Part of the Fed’s design is to penalize savers and discourage them from leaving money in the bank, and to encourage them to invest in risky assets, such as stocks and real estate, to prop up collateral values in those markets.

  But many savers are inherently conservative and with good reason. An eighty-two-year-old retiree does not want to invest in stocks because she could easily lose 30 percent of her retirement savings when the next bubble bursts. A twenty-two-year-old professional saving for a down payment on his first condo may avoid stocks for the same reason. Both savers hope to get a reasonable return on their bank accounts, but the Fed uses rate policy to ensure that they receive nothing. As a result, many citizens are saving even more from retirement checks and paychecks to make up for the lack of a market interest rate. So a Fed manipulation designed to discourage savings actually increases savings, on a precautionary basis, to make up for lost interest. This is a behavioral response not taught in textbooks or included in models used by the Fed.

  Federal Reserve policy has also damaged lending to small and medium-size enterprises (SMEs). This does not trouble the Fed, because it favors the interests of large banks. Johns Hopkins professor Steve Hanke has recently pointed out the reason for this damage to SME lending. SME loans, he argues, are funded by banks through interbank lending. In effect, Bank A lends money to Bank B in the interbank market, so that Bank B can fund a loan to a small business. But such lending is unattractive to banks today because the interbank lending rate is zero due to Fed intervention. Since banks cannot earn a market return on such interbank lending, they don’t participate in that market. As a result, liquidity in the interbank lending market is low, and banks can no longer be confident that they can obtain funds when needed. Banks are therefore reluctant to expand their SME loan portfolios because of uncertain funding.

  The resulting credit crunch for SMEs is one reason unemployment remains stubbornly high. Big businesses such as Apple and IBM do not need banks to fund growth; they have no problem funding activities from internal cash resources or the bond markets. But big business does not create new jobs; the job creation comes largely from
small business. So when the Fed distorts the interbank lending market by keeping rates too low, it deprives small business of working capital loans and hurts their ability to fund job creation.

  Other unintended consequences of Fed policy are more opaque and insidious. One such consequence is perilous behavior by banks in search of yield. With interest rates near zero, financial institutions have a difficult time making sufficient returns on equity, and they resort to leverage, the use of debt or derivatives, to increase their returns. Leverage from debt expands a bank’s balance sheet and simultaneously increases its capital requirements. Therefore financial institutions prefer derivatives strategies using swaps and options to achieve the targeted returns, since derivatives are recorded off balance sheet and do not require as much capital as borrowings.

  Counterparties to derivatives trades require high-quality collateral such as Treasury notes to guarantee contractual performance. Often the quality of assets available for these bank collateral pledges is poor. In these circumstances, the bank that wants to do the off-balance-sheet transaction will engage in an “asset swap” with an institutional investor, whereby the bank gives the investor low-rated securities in exchange for highly rated securities such as Treasury notes. The bank promises to reverse the transaction at a later date so the institutional investor can get its Treasury notes back. Once the bank has the Treasury notes, it can pledge them to the derivatives counterparty as “good collateral” and enter into the trade, thus earning high returns off balance sheet with scant capital required. As a result of the asset swap, a two-party trade turns into a three-party trade, with more promises involved, and a more complex web of reciprocal obligations involving banks and nonbank investors.