Since the near-collapse of the economy in 2008, the Fed has engaged in a continuing effort to stimulate the economy. These efforts have included purchases of enormous amounts of U.S. Treasury notes and mortgage-secured debt issued by government agencies such as the Government National Mortgage Association, Fannie Mae and Freddie Mac.
Most observers, me included, assumed that, as the Fed ramped up its asset purchase program, these actions would inevitably lead to rampant inflation. That hasn’t happened.
In its most recent quarterly newsletter, Hoisington Investment Management Co., an Austin, Tex., investment firm specializing in fixed-income portfolios, has done a great job of explaining what’s going on and what it portends for us as investors. You can find the article by Van Hoisington and Lacy Hunt here.
Despite the unprecedented expansion of the Fed’s holdings of Treasury and agency securities, and despite keeping short-term interest at near zero for going on five years, Hoisington describes the Fed’s actions as “feeble.” Why?
First, the Fed has less influence over monetary policy than most people believe. To understand why, we need to understand the difference between the “monetary base” and the “money supply.” The Fed-dominated monetary base consists of cash and reserves held by the Fed and its member banks. The money supply, also known as “M2,” is the product of the monetary base times a factor called the “money multiplier,” which is the result of bank lending based on those reserves. At the start of 2008, the monetary base stood at about $820 billion and the multiplier was 9, putting M2 at $7.4 trillion. Despite the Fed’s expansion of the monetary base by more than three-and-a-half times to $2.9 trillion in 2013, the money multiplier has collapsed to 3.6. M2 now stands at $10.4 trillion. Although that’s about 40 percent larger than in 2008, the Fed has had to increase the monetary base by more than 250 percent to achieve that muted gain.
But wait, there’s more—M2 is only part of the equation. More than eight decades ago, Yale economist Irving Fisher first postulated that gross domestic product (GDP) is the product of the money supply times a factor he called the “velocity” of money. If the velocity factor had remained constant, a 40 percent increase in M2 since 2008 would have resulted in a like increase in GDP. Instead, monetary velocity has also dropped significantly and now stands at its lowest point since the 1950s. This has translated into an increase in real GDP over the past four years of just 8 percent. For monetary velocity to increase, the borrowings reflected in M2 must be put to productive use.
There’s the rub. Most of the increase since 2008 in borrowing by the federal government and in the private sphere has been to finance current consumption. Hoisington emphatically states that borrowing to finance current consumption creates neither a productive income stream nor the resources to repay the borrowed funds. As I see it, the fundamental flaw in the Keynesian model now being vigorously pursued by the current administration and the Fed is that it matters what the government borrows money for—and it matters a lot. Spending borrowed money on what amounts to rampant vote buying has not and never will generate a productive income stream and thus has not and cannot “stimulate” the economy.
It’s easy to understand this concept in personal finance. If one borrows to finance a great business idea, then one either succeeds, repays the loan and adds productive capacity to the general economy, or fails and tries again. No matter how much one borrows to finance a lavish lifestyle, the best that can be achieved is feeling a little better today in exchange for serious pain in the future.
The federal government’s current borrowing spree, because it’s mostly financing current consumption, won’t lead to a growing economy. Worse, Hoisington points out that recent credible and non-political economic studies document the negative effect government borrowing has on GDP. Even the Swedes, often considered the model of the modern welfare state, now acknowledge that there’s a negative correlation between the size of government and economic growth. A 2010 study by the European Central Bank concluded that government debt exceeding 90 to 100 percent of GDP has a “deleterious” impact on growth, and that as the debt level increases above that, adverse consequences accelerate.
We’ve all heard the old saw, “When you find yourself in a hole, first stop digging.” That’s where the Fed finds itself today. And the results aren’t just academic. An important by-product of the Fed’s policies has been to eliminate any return on safe investments like certificates of deposit. We have plenty of older clients who’ve depended on interest from federally insured savings for a significant portion of their retirement income. Given the Fed’s stated inflation target of 2 percent annually, risk-averse retirees earning 1 percent on CDs are losing money in real terms they can’t afford to make up.
In December 1799, George Washington rode out to inspect his plantation in foul winter weather. The following morning, he awoke with a nasty sore throat. His doctors bled him, believing (as was accepted medical wisdom at the time) that the problem lay in bad “humors” in the bloodstream. Over the ensuing day and a half, he was bled four times, but died of pneumonia the second evening after becoming ill. In the latter part of the nineteenth century, medicine finally accepted the theory that diseases are caused by bacteria and viruses, and that bleeding a patient can only weaken his ability to combat what ails him. Unfortunately, our present day economic doctors at the Fed cling to precepts of Keynesianism that should have been relegated to the realm of historic curiosity, just as medical science has discarded bleeding the patient.
