This is a guest post by David Stockman who originally wrote this piece for Minyanville. Mr. Stockman was OMB Director during the Reagan Administration, was a founding partner of The Blackstone Group, and left Blackstone to form his own private equity fund, Heartland Industrial Partners, L.P. Mr. Stockman is a regular reader of The Daily Capitalist. — JH
Part 1 of 3 parts
The zero interest rate policy has disguised the ugly truth our economy faces
We are now well into the second year of green shoots, but in word and deed the Fed remains entombed in the zero interest rate policy (ZIRP). Ultra-low money market rates were allegedly needed 18 months ago to insure that the American people wouldn’t be deprived of the munificent services of Goldie and the Fab Five. Since then, these pillars of prosperity – Goldman Sachs (GS), JPMorgan (JPM), Bank of America (BAC), Wells Fargo (WFC), Morgan Stanley (MS), and Citigroup (C) — have together posted $62 billion in after-tax profits.
So why are Fed Chairman Ben Bernanke and his red-helmeted lieutenants still scrambling about with water hoses and fire axes? There’s only one answer that satisfies normal standards: The Fed is terrified that the boys and girls on Wall Street will stage a hissy fit if it doesn’t continue to read them the “extended period” fairy tale at the end of each meeting.
By contrast, there’s certainly no sane macroeconomic reason for a zero-cost federal funds rate. Indeed, given its dangerously over-leveraged condition, no element of the American economy should be incentivized to borrow more money (at 370%, the total debt-to-GDP ratio is already off the historic charts).
The deeply indebted household sector, for example, needs to be squirreling away funds for the day (which is coming soon) when its taxes go up and social security benefits get cut, not relapsing toward a zero savings rate as was evidenced by the March personal income report. Likewise, small business shouldn’t be borrowing (on net) because it’s not done shrinking. The national economy is still vastly over-populated by redundant contractors, strip mall retailers, sports barkeeps, and home-canned pickle entrepreneurs — even though the housing ATM from which this legion of boom-time enterprises briefly suckled is long gone.
Big business isn’t borrowing either (except to term-out existing debt) and for good reason: At a subterranean capacity utilization rate of 70%, it doesn’t need external funding for the tepid level of capex needed to replace asset wear and tear or to fund targeted productivity initiatives. In short, the private economy won’t be “stimulated” by cheap interest rates because credit wasn’t previously rationed by high-priced money. Instead, credit is being liquidated, owing to the heavy burden of existing debt on income-challenged households and businesses.
At the same time, what the national economy does need is far less financial speculation and far more real savings. These objectives, in turn, are prerequisites to sustainable full employment and price stability — the Fed’s ostensible dual mandate. Accordingly, higher short-term interest rates — say in the 3%-4% range — would be far more compatible with the Fed’s mission than its current destructive embrace of ZIRP. And the fact is, ZIRP is incredibly destructive because it gives precisely the wrong signal to key economic constituencies, including speculators, savers, and politicians.
Thus, speculators are once again in high cotton. Yet if the Fed was actually healing the economy it would be attacking Wall Street’s bloated and distended asset/liability mismatch — a financial deformation that was originally incubated by the Fed’s vast outpouring of fiat dollars in the years leading up to September 2008. Instead, this proximate catalyst for another meltdown remains fully in place, defying every cannon of financial prudence.
When Bear Stearns suddenly evaporated, for example, it was funding a $400 billion book of longer-term, sticky or illiquid assets with $60 billion of overnight repo. Likewise, when GE Capital got its snout in the Federal trough it was funding $650 billion of even dodgier and more illiquid assets with $80 billion of short-term commercial paper it couldn’t roll when the crisis came.
Nothing has changed since the fall of 2008. In fact, the scam has only gotten worse — not because traders have become more greedy and reckless, but because the Fed’s enabling of yield-curve speculation has gotten even more blatant. As a matter of stated policy, the Fed now stands ready to provide unlimited credit to the repo and other overnight funding markets at 10-25 basis points, which is to say, for free; and, as a matter of practice, it remains so tongue-tied in its post-meeting statements that even the financially deaf will hear any potential policy rate change coming long before its happens.
As a consequence, the risk/reward equation for rank speculation on the yield curve has become downright mouthwatering. Based on the Fed’s promise of no policy surprises, daredevils throughout the financial markets have put on massive carry trades, believing — perhaps correctly — that they will have plenty of forewarning when it’s time to get out of risk assets. Meanwhile, funded by the Fed’s cornucopia of essentially zero-cost repo, these risk assets are earning handsome spreads and/or valuation gains, thereby minting profits while the speculators wait.
These massive trading gains being reported by Wall Street banks, however, do not represent economic profits from capital deployed in value-added service to the household and business sectors; that is, they are not comparable to returns from underwriting new equity issues for corporations or providing asset management services to households. Rather, they amount to pure rents extracted from valueless, hyperactive trading inside the Fed’s artificially steepened yield curve.
To be sure, the dead-weight economic cost of this pointless churning of the secondary markets in securities and derivatives may not be fatal. But at the end of the day, it does represent a massive, unjustifiable income transfer from the struggling multitudes to the fortunate few, and a demented social policy that forces investors to incur great risks to obtain any return at all on their savings.
As a high-yield manager noted upon the recent return of the junk bond index all the way back to par (from 55% at the bottom) “… the high-yield market is strong. The Fed.. is forcing investors into areas where they can collect a reasonable spread over Treasuries.” But what does herding granny into junk bond funds or junk stocks have to do with full employment, it might be asked.
Likewise, the distribution of national income is usually none of Mr. Market’s business. Ordinarily, it is the province of legislative busybodies grabbing for power behind the fig leaf of social justice. But when the central banking branch of the State massively rigs the financial system in favor of speculators, the resulting distribution of the goodies is inherently suspect.
Tomorrow, Part 2 of 3 parts
Just to reiterate what David Stockman said: Every time I run into someone who is very positive on the economy, I ask them how positive they would be about the economy if short term rates were back to 2-3%. They always respond that the economy would collapse. So my response to them is, “why do you love an economy that is so fragile that it can’t even tolerate reasonable short-term rates?”
At that point the person usually walks away from me with an odd look on their face. My conversation didn’t fit their feeble views of the economic future.
Good comment, Carl.
Why doesn’t David’s bio include the events from the last 5 years? Multiple civil lawsuits from shareholders and bondholders for fraud settled in cash paid by Stockman. SEC fraud suit settled for cash paid by Stockman. These things aren’t relevant?
Dear “Art,”
First, I don’t like folks who come in and flame through phony addresses. Show some moral courage. Second, I’ll let Mr. Stockman deal with his lawsuit himself. Third, what would you know about it? Are you David Lerach or someone? Fourth, if you have some cogent critique of his article, then we can talk. Fifth, did you ever pay Peter Schiff that penny? Sixth, next time you flame with a phony address, you’re spam.
But you didn’t answer my question. Did you know about it and decided not to include it? Or just didn’t do your homework? Fairly straight-forward question.
Yes I was aware. I’ve been involved in law most of my life, and because a person pays to get out of an SEC claim doesn’t give me a lot of information. What’s your point? Are you trying to discredit Mr. Stockman in this manner? Or do you have something to add to the conversation? And why won’t you use your real name?
Politician: Our debt is unsustainable, we are punishing our children and grandchildren.
Brad: No your not because we are leaving and never coming back. Take your own debt and shove it.
We can all lament the corrosive influence of the Fed over the past 97 years. However, what we need are acceptable institutional solutions which eliminate the acreation of Federal debt.
For instance, it makes little financial sense for the Federal government to borrow at interest its own “fiat” money.
A facility at Treasury could perform the function of funding the government’s budget without recourse to the Fed’s debt creating facilities. The analog, Lincoln’s Greenbacks and Kennedy’s Silver Certificates. In today’s economic environment, the Federal government could issue debt free currency until full employment was achieved. Thereafter, growth in GNP or an equally useful economic measure would assist in determining increments to the money supply.
Moreover, as David mentions above, the Fed has no compunction about issuing zero rate funds to member banks, it then ought not care, in terms of currency control, that the Treasury do for the Federal Government what the Fed does for private banking. Annual deficits would disappear. And, since there would be no debt service, income tax rates could be reduced considerably.
A second, short term alternative to Fed created debt would have the President declare a moratorium on all debt service payments for all public debt until GDP growth reaches some target rate for a year or two…(The moratorium would apply to that portion of public debt held by the Fed, not sovereign governments, or institutions and individuals, just that held by the Fed.)
A third alternative would be the replication, by 49 states, of the successful banking environment created in N. Dakota. Since 1918 N. Dakota has had a State owned bank which functions like a Regional Federal Reserve Bank but has no need to access Fed facilities. N. Dakota consistently runs budget surpluses and the bank has a 25% return on equity.
Im-jus-sayin.
We have to get outside of the box and think about protecting economic progress for the majority of Americans and not just the interest income streams of the banks which by definition thwart progress because those streams siphon off income surpluses.
I fear it likely says more about N. Dakota than it does about the effectiveness of State-owned banks. Sitting here in California, I can only shudder at the idea of what the criminals running this state would do with their own bank.