San Francisco, CA
2019 Update: I originally wrote this essay back in 2013. At that point, the US housing market was definitively off the lows, in large part due to institutional buyers taking an interest in purchasing REO properties. The S&P had roughly doubled from the 2008 bottom. It appeared that the American economy was beginning to rebound, at least if you were looking at the markets.
Yet, the economic indicators that typically correlate with an expansion such as hourly wages and the labor participation rate had not really picked up much, if at all. A year prior, I had driven about halfway across the country on a route that took me through many of the cities that were hit hardest by the Great Recession. It was grim. The outskirts of Phoenix, for instance, were effectively a ghost town. This essay was an attempt to reconcile what I had seen on the ground with what I was seeing in the financial markets.
In the past 6 years, we’ve been through an additional round of quantitative easing. At the end of 2018, it appeared that the Federal Reserve was finally set to raise interest rates, only to walk back those pronouncements as markets soundly rejected the prospect of any interest rate hikes for the foreseeable future. The inflation rate in the US is still at roughly 2%. The yield on the 10 year treasury is at just 2.3%. The labor participation rate is about 1% lower than it was in 2013. Yet, the stock market is basically at all-time highs.
In short, there still seems to be a disconnect between the exuberance of the financial markets and the real velocity of money in the economy. By many historical metrics, such as the CAPE index, markets are historically overvalued, but perhaps this truly is the new normal. As Warren Buffett put it, “stocks are ridiculously cheap if you believe… that 3% on the 30 year bond makes sense.” Could it really be different this time?
I’ve updated the original essay a bit to make it more readable and a bit less hyperbolic, but the gist of it remains intact.
As I updated this essay, I was struck by just how relevant it still is. For the most part, the short term has played out more or less in the way that I predicted. Attempts to raise interest rates just a few fractions of a percent were met with such a strong rebuke that the President is now calling for lowering interest rates again. We are clearly still “plodding along at near 0 interest rates.” On the other hand, the Fed balance sheet actually appears to be normalizing slowly. Many of the graphs I originally included have been trending in the opposite direction since late 2017. America has more or less led the developed world in terms of growth, and growth is what will ultimately put the great Financial Crisis behind us.
A little more than two eight years ago I first traveled to Argentina. To say that Argentina has had an interesting economic history would be an understatement. Since 1980, Argentina has defaulted 3 times (and “Selectively Defaulted” in 2014). 100 years ago Argentina was one of the wealthiest countries in the world. Today, its per-capita wealth is 55th of the 188 member countries of the IMF.
Argentina’s economic stagnation over the past century is nothing short of a tragedy. The effects of the “Liberating Revolution,” the Argentine Revolution, the expansionist monetary policy of the 1960s and the subsequent debt crises of the 1970s and 1980s continue to echo through the streets of Buenos Aires.
When I encountered discussions of politics and economic policy among friends in Buenos Aires, I sought to learn more. Occasionally those discussions would shift to the topic of the United States. In 2011, the opinions I encountered in Buenos Aires were decidedly pessimistic about the future prospects for America. Indeed, many Americans had a similar outlook. America’s credit had just been downgraded in the wake of the first debt ceiling debacle. It was unclear whether quantitative easing (QE) would have the necessary firepower to prevent a double-dip recession. Things were looking pretty grim.
Those conversations and experiences in my first few days in Buenos Aires really bridged the theoretical equations you come across in economic textbooks with the realities on the ground. I had trouble getting money from ATMs, particularly on weekends, because the ATM machine would literally run out of money. Some speculated that this was an attempt by the government to control the money supply and inflation. Though the government claimed the inflation rate was around 9%, it was clear to virtually everyone I met that the real inflation rate was more like 25%.
My landlord insisted that I pay rent in dollars rather than pesos, thereby providing an inflation hedge and circumventing the artificially low government exchange rate. Of course, getting dollars at close to the official exchange rate is not particularly easy in Argentina, even for a foreigner, so I brought my first month’s rent with me in my backpack.
As an aside, in 2015, the Argentinean government removed most exchange restrictions on the peso, causing the USD:ARS exchange rate to increase dramatically. As of 2019, the peso is worth roughly 1/10th its 2011 value against the dollar.
I had trouble using my credit card to buy anything other than groceries at large chain stores. Part of the problem was surely infrastructural, but I deduced that it also had to do with the economics of credit card usage in an inflationary environment. The Argentinean government had recently announced that it would begin to track all credit card transactions and apply a 15% surcharge to transactions made outside the country in order to make it more difficult to convert pesos into a stable currency. In short, Argentina was doing everything that it could to prevent a flight out of the peso.
Since that experience, I’ve become increasingly interested in economic history. I've wondered about the parallels between the US and Argentina. In the 1980’s, faced with large deficits and a lack of foreign creditors, Argentina was forced to monetize its debt. The M2 money supply (currency + deposits) expanded by an average of over 250% per year from 1980-1988 which ultimately resulted in uncontrollable inflation.
In comparison, the US has roughly tripled its monetary base since 2008. Fed quantitative easing has injected roughly 3 trillion dollars into our economy, yet inflation has barely budged. I wondered, as many did in 2009 and 2010, whether we were headed down the path towards high inflation. How was it possible for the Fed print 3 trillion+ dollars and yet the inflation rate remain below 2%? Who in their right mind would continue to purchase our debt for meager 3-4% returns?
The lack of inflation appears to boils down to two factors: banks are not lending sufficiently and people are not spending money. For the last 80 years, banks tended to lend out nearly all of their excess reserves, maintaining reserves roughly equal to their reserve requirement. Since 2008, however, banks have maintained large amounts of excess reserves:
The M1 money multiplier, the ratio of the M1 money supply to the monetary base, fell significantly in 2008 and has not recovered:
Though not surprising in a time of deleveraging, we are also spending less. The velocity of money has declined significantly since the financial crisis:
Despite the Fed's best efforts, we haven't seen much in the way of increased liquidity or inflation. These factors have led a number of economists to declare that the link between the monetary base and inflation (aka “monetarism”) no longer exists.
One possible explanation is that the Fed began paying interest on excess reserves in 2008, which mitigates the opportunity cost for banks to keep excess reserves. In essence, this provides the Fed an additional tool to control interest rates and to influence the incentives for banks to lend. From a perspective of liquidity preference, if cash returns are nearly the same those for securities, there is reduced incentive to hold securities. The result is a flat LM curve in the IS-LM model.
Another possible explanation is that there might just not be enough credible borrowers at a time where most American households are deleveraging. Perhaps banks would like to lend, but can’t do so profitably at current interest rates.
Perhaps it really doesn’t matter why we’re not seeing a deluge of liquidity. Regardless of whether you’re looking at it through the lens of the money supply, interest rates or something else, the conclusions about the future are essentially the same.
It’s clear that we aren’t seeing a whole lot of inflation for now. Banks are hoarding dollars and the dollar is perceived internationally as a safe haven. The U.S. debt appears manageable. QE seems to have functioned as an asset swap rather than as the creation of new money. As long as such conditions hold, the Fed can continue to expand its balance sheet indefinitely. Those who warned of dollar debasement have been forced to slow those claims for the time being.
But what does the future hold? At some point, the Fed will need to sell the 3 trillion in securities it has accumulated over the past 5 years. If the economy does eventually start to pick up, presumably it will be accompanied by rising interest rates. Will the Fed have the ability to sell into such a market and drive rates even higher without putting the brakes on a recovery? In such a scenario, rising interest rates would also mean larger interest payments on our debt. At what point do those interest payments become unmanageable?
Alternatively, the Fed could hold until maturity. It could continue to roll over debt, plodding along at near 0 interest rates. The problem with this scenario is that it implies years of low growth, high unemployment and a stagnant future. Is 30 years of low-growth and an emerging plutocracy worse than a currency crisis?
One lesson from Argentina and countries that have gone down similar paths is the remarkable ability of unsustainable fiscal policies to plod along for years relatively unscathed. However, when the crisis point inevitably does arrive, the shifts can be rapid and dramatic.
During the 2001 Argentinean crisis, there was a run on banks as Argentineans lost faith in the peso. In order to prevent a banking collapse, the government froze the banks accounts of millions of working class people. Many who had trusted the banking system with their savings lost everything overnight. Those who had the means to store cash abroad or were politically connected were able to flee the country. However, the debate over austerity measures, national debt and credit via the IMF had been raging for decades before the crisis point was reached.
In fact, if you consider nearly any recent economic crisis, the warning signs often go back for years. It may be that QE is just a stopgap, another form of unsustainably kicking the can down the road, bumbling along before things reach a crisis point. The current low interest rate environment allows the government to finance its debt more cheaply and to apparently spend without consequence. The empirical result of our recent Fed policy has been inflated equity and real estate prices, ballooning entitlement spending and increased wealth disparities, none of which bode well for the future. At some point, the US will need to focus on things like driving down health care and education costs, building high tech infrastructure, incentivizing investment in growth technologies and reducing unnecessary government bureaucracy. The market forces that would naturally do so have become muddled. To be clear, the US is not Argentina, but there is a lot to be learned from its story.