Parts I and II (see here and here) have provided a detailed description of the financialization process and how it impacted the US economy, even before the arrival of COVID-19. The key event was the turn toward the “market knows best” (financialization) ideology that unfolded during the 1980s and 1990s, with the decisions to deregulate and liberalize financial markets.
The Fed facilitated this process based on its failure to properly understand the implications of unconstrained financial markets based on a rather simplistic belief that markets were “efficient” and capable of self-regulation (“invisible hand” applied to finance). Under Alan Greenspan, the Fed emerged during the late 1990s and thereafter as a cheerleader for deregulation and liberalization of financial markets and capital flows.
To his credit, Greenspan did try to constrain asset price bubbles during the early 1990s, raising rates in February 1994 to address an equity bubble (and causing a bond market bubble to collapse). However, he ultimately threw in the towel and shifted toward a highly asymmetric monetary policy, known to financial market participants as the “Greenspan Put” (now the “Fed Put,” since it has been in place ever since). Investors quickly understood that risk-free investing was available and, needless to say, took full advantage of it, as debt ratios and real estate prices exploded relative to incomes during the 2000s.
In its third miscue (or perhaps revelation of its biases toward the industry it is expected to regulate), the Fed chose to bail out many of the financial institutions that had irresponsibly granted credit to subprime borrowers. However, it chose to ignore those households with underwater exposure to real estate, despite clear authority to do so under Section 13(3) of the Federal Reserve Act. These households, on average, lost more than 40% of their net worth from 2007 to 2010. The Fed’s decision not to provide support to underwater homeowners was exacerbated by the decision of the US government to move to austerity. The end result of these decisions was a fragile recovery from 2009 to 2020, given that many middle-class households were incapacitated and unable to drive growth in aggregate demand. Is it any wonder that populist sentiment peaked in the election of 2016?
The Fed once again provided extensive support to asset prices throughout the recent recovery. Its use of Quantitative Easing (QE) policies boosted asset prices during the liquidity bubble (see here for more information). The Fed believed that lower interest rates would boost confidence, aggregate demand and GDP growth. However, the reality was quite different, given the ongoing presence of financialization.
In the financialized world, declining interest rates fuel speculation. For example, US corporations borrowed at record low interest rates to buy back their own stock. This financial engineering boosts stock prices and earnings per share, enriching CEOs and other senior corporate executives. However, these actions came with a cost. In addition to inflating asset prices and increasing fragility within the corporate sector, they imperiled growth in the real economy. Investment fell sharply in the real economy, as did R&D and wages (as documented here by William Lazonick).
The Fed failed to properly understand the impact of lower interest rates in a financialized economy. It assumed that lower interest rates would increase productive investments – an outcome that failed to materialize. What did materialize was ever-greater speculation by banks (also privy to record-low interest rates) and corporations. Both borrowed to finance speculative (or non-productive) investments that propelled asset prices higher. And those higher asset prices, in turn, fueled further growth in credit. Unlike productive investments, speculative investments are a zero-sum process, given that nothing new has been created. Instead, money is used to create more money with nothing produced!
The turn toward financialization has been ongoing for four decades and has had two clearly negative impacts on economic growth. First, it has generated enormous increases in income and wealth inequality. The top 10% of US households now own 88% of all US stocks. This means that the average household in the top 10% owns 66 times the amount of US stocks held by the average household in the bottom 90%. And the numbers are even more extreme for the top 1% (roughly 112 times the amount of stocks owned by the average household in the bottom 99%). What purpose does this level of inequality serve? Especially given that it is attributable not to production but to speculation? The second consequence is the rise in financial instability that has become an increasing part of the economic landscape since deregulation began during the 1980s. This has left the Federal Reserve with few options except to provide continued support to this despotic process.
For forty years, financialization has elevated short-term profits and share prices at the expense of wages and salaries. Wages have been stagnant since the late 1970s, and the defeat of organized labor has left wage earners with minimal countervailing power. Households have supplemented stagnant wages by borrowing from financial institutions. This worked for a while, as real estate prices boomed from 2001 to 2007, before collapsing from 2007 to 2010.
Reality check – in a financialized economy, lower interest rates do not spur productive investment. The debt overhang and liquidity bubble cast an immense shadow over aggregate demand well before the pandemic arrived. The Fed is caught in a web of its own design (“between a rock and a hard place”). If it chooses to stop providing support (via QE, SPVs, et al), asset prices will plummet, as occurred in December 2018. In response to the loss of nearly 20% for the S&P 500, the Fed reversed policy and abandoned QT (Quantitative Tightening) as well as the additional rate hikes that were priced in for 2019. The Fed today increasingly has no choice but to act as a “market-maker of last resort,” and its actions only tend to exacerbate rising income and wealth inequality. Is this what the central bank should be doing?
Short-Term Policy Implications
Magnifying an already difficult situation, the COVID-19 pandemic arrived earlier in 2020. More than 30 million people are currently unemployed, and GDP fell by 9.5% (-32.9% annualized) in the second quarter. For 21 of the past 22 weeks (including this past week), the number of people filing initial claims for unemployment has risen by at least one million per week. And according to the Census Bureau, 60% of US households do not have sufficient resources to weather three months of expenses without outside support. And yet, Congress and the White House continue to dither about whether to extend the $600 in additional weekly funding that was approved under the CARES Act (that expired on July 25th) for the unemployed.
It is vitally important to distinguish time frames in any discussion of policy responses. It is clear that QE is not at all useful in stabilizing growth in aggregate demand. When the Fed purchases assets from private financial institutions, the reserves it creates then remain in the financial sector. These institutions can use the reserves to purchase financial assets from other financial institutions, but they cannot be lent to you and me. This is often misunderstood. What it needed is to get money directly to the households that need it.
My guess is that some type of helicopter money (central bank digital currencies?) eventually will be deployed to get money directly into the hands of unemployed people, though this will likely require legal changes to the relationship between the Fed and US Treasury. Working through any legislative issues that may be entailed is far from guaranteed, as noted with the ongoing discussions about whether to make the $600 available to households (keep in mind that this is a direct budget outlay).
If the situation deteriorates, as it may very well in Fall 2020, as more and more businesses are forced to declare bankruptcy (and liquidity risk evolves into insolvency risk), something will need to be done to sustain aggregate demand. According to the Census Bureau, which tracks weekly data now, households that face eviction, or that have insufficient food resources, or that have lost jobs are on the rise (for more information, see here). The human costs of this pandemic are simply staggering.
Helicopter money proposals may sound insane to those who have sufficient resources, but the costs of allowing aggregate demand to collapse could dwarf the costs of the $600 per week of helicopter money in a worst-case scenario leading to a second Great Depression. And unfortunately, the situation within the bottom 50% of US households is quite dire. In fact, some way of getting funds to households in need may be a least-worst case outcome, especially if the health crisis intensifies and the alternative is a second Great Depression.
Long-Term Policies To Reverse Financialization
I have three proposals in mind that will help reverse the tragic financialization process that has been corroding the US economy for three decades:
- First, reverse the financialization process and restructure the US financial system. This should have been done during the Global Financial Crisis. Restoration of a full Glass-Steagall (separation of commercial banking from investment banking) as well as other constraints imposed during the Great Depression are essential. Banks should no longer be permitted to engage in speculative activities that they can fund using low-cost, insured deposits. Banks should be treated as public utilities, much as was the case during the Great Depression. And consideration should be given toward creating Fed Accounts, under which the Federal Reserve System (acting, perhaps through the maligned postal system) could directly provide services to depositors. This could eliminate many of the costs charged by banks, provide interest on deposits and eliminate the need for deposit insurance. And eliminate the disastrous maximization of shareholder value as an objective for corporations.
- Second, the Federal Reserve System should be restructured and democratized. It has become captive to the industry it is expected to regulate. It will need to work collaboratively with the US Treasury Department to finance the recovery, much as it did during the Great Depression. Its focus on financialization must be reversed in favor of symmetrical policies.
- Third, we need a 21st century Reconstruction Finance Corporation (RFC, for more see here) that can invest on behalf of the public in job creation, infrastructure, restructuring of the financial system, green technology, etc. The RFC that was created during the 1930s was instrumental in shaping the post-war economy. It was one of the most successful ventures ever launched by the US government. There is very little incentive for private corporations to invest in core operations given the current economic environment. A public institution must, therefore, take the lead.
The likelihood of the federal government in the 21st century operating on behalf of the public may sound like wishful thinking (it may well be!). However, when FDR took office in March 1933, he had one firmly affixed belief, namely that governments should balance their budgets. He was surrounded by wise, real-world advisors, including Marriner Eccles, Jesse Jones, Harry Hopkins, Frances Perkins, etc., all of whom had a positive vision of what industry and government could achieve together. They created the foundation for an economy that generated several decades of positive economic performance, during which growth was remarkably robust (see table below) and inequality declined. Of course, there were issues (nothing new there), but the economic course correction that was initiated provides at least modest reason for optimism today.
Source: FRED, Author’s Calculation
The Fed is authorized to create money “out of thin air.” Ben Bernanke, in an interview with Scott Pelley of 60 Minutes, was asked whether the $85 billion the Fed provided to AIG resulted from taxpayer funds. In response, Bernanke stated: “To lend to a bank, we simply use the computer to markup the account they have with the Fed.” This is effectively the argument that has been marshaled by proponents of Modern Monetary Theory. The point is that in a country with a sovereign currency, there is no financial constraint on how much money can be created. Although the Fed is permitted great latitude to create money for any purpose it might deem reasonable (given Section 13(3) authority), it is not an elected branch of government. Some type of collaboration will be needed between the Fed and US Treasury, with the latter (representing elected government) providing direction.
Needless to say, laws may need to be altered to permit the Fed and US Treasury to work collaboratively, as they did during World War II. In my view, this arrangement will become inevitable, should the crisis deepen. And the focus must be placed on restoring the welfare of the bottom 90% of US households, who must work to earn wages or salaries that they need in order to survive. Laws can be altered so that the Fed can directly purchase debt issued by the Treasury (without the funds first being filtered by the primary dealers).
There is little question that the financialized system that has been in place for decades is quickly approaching exhaustion. In fact, that was the case in the global crisis more than a decade ago. It simply is not sustainable. It enriches the few at the expense of the many, and when it encounters obstacles, bailouts are offered to already wealthy financial institutions (akin to “socialism for the rich, capitalism for everyone else”).
The Fed cannot facilitate rising asset prices forever – trees do not grow to the sky – though many who have forecast mean-reversion (myself included) have been proven wrong time and time again. The Fed has contributed to the financialization process in four distinct ways: first, by supporting the deregulation and liberalization of finance; second, with the Fed Put, which extended boom-bust cycles; third, by bailing out financial institutions (and not providing support to underwater households); and fourth, via its embrace of QE. All of these policies have given rise to the financialization of US economic activity that has spurred the rapid rise in income and wealth inequality. The rise in populist sentiment can be traced directly to these actions.
Current Investment Implications
As noted previously, gold and gold miners appear to be attractive investments, despite elevated valuations. The lack of yield paid to holders of gold is less of an obstacle now, given the near-zero nominal rates (and negative real returns) paid on bonds. Gold prices tend to do well in extreme market conditions. In almost any conceivable situation today, the Fed will need to persist with its reflationary policies.
So, what happens if there is a vaccine and the economy suddenly recovers? Long-term interest rates will spike higher, potentially significantly, undermining the valuations of stocks and bonds. How will the Fed respond? In my view, it has no choice. It will be forced to intervene, buying long-term bonds to constrain the rise in interest rates, while tolerating any inflationary spike that might result (and the knock-on consequences for the US dollar). In any case, gold will continue to provide a useful hedge against equity exposure, given that it mostly underperforms when the economy and financial markets are relatively stable, which is not likely to be the case anytime soon.
Other appealing assets over the next 3-5 years include Asian equities, given that Asia appears to have handled COVID-19 well relative to the rest of the world. And perhaps in time, European equities will be worthy of consideration, especially given the recent stimulus package approved by the EU and the strength of the euro. And specific emerging markets may eventually appear attractive, though not yet.
This three-part series has covered how the financialization of US economic activity has distorted the economy, elevating private sector debts and asset prices, which have largely displaced earlier reliance on productive activity. Shamefully, even despite the global crisis in 2008, mainstream neoclassical economists have failed to address the shortcomings in their models, and it is difficult to discern what will make them do so now. Fortunately, there are economists and sociologists operating outside the mainstream economic model who are making sense of where the world is going. As the great scientist Max Planck so aptly put it, “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.” One can hope, for the sake of the bottom 90%.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.