By: Rutvij Thakkar
The stock market has witnessed its worst half in fifty years [1]. The median consumer price index (this accounts for food and energy spending, as realistic inflation measures should) has hit an all-time high of 7.217 since its conception in 1983 (in the last ten years, the highest this indicator has reached was 3.970) [2]. On June 13, 2022, gas prices hit nearly double their pre-pandemic price at $5 per gallon [3]. To top this off, public debt as a percentage of GDP looks to have stabilized at one-hundred and twenty percent [4]. Putting this into perspective, this is around the same rate that Greece was at going into the 2008 financial crisis [5], and currently the Greek economy is still in shambles. Under the spotlight currently is the specter of inflation, fueled partially by excessive government spending via stimulus and partially by quantitative easing, which makes the stimulus possible.
But we must remember that the government indeed cannot spend money it doesn’t have. Funnily enough, the government’s creditworthiness and ability to borrow are directed entirely by the bank of banks, the United States Federal Reserve. The original idea of the Federal Reserve wasn’t so transparently conflicting in interest because it was a way that private banks could self-regulate with almost no interference from the national government. During the panic of 1907, J.P. Morgan, Paul Warburg, and many other bankers decided to form a decentralized series of central banks throughout the country, responsible for ensuring the stability of our currency, unemployment, and inflation [6]. At its inception, the United States Dollar was backed by the gold standard, meaning that any holders of the currency were able to exchange them at any Fed location for solid gold. Once Richard Nixon took the United States off the gold standard, however, the field opened up to all sorts of financial engineering, which would influence the world’s economy at an unforeseen level.
The first thing that changed was that instead of banks being able to exchange dollars for gold, they would simply have to retain a certain amount of their assets in Federal Reserve stock. This concept is known as fractional reserve banking, and it would ensure that banks wouldn’t over-lend and cause economic instability. Banks could lend more and expand the economy if the required rate was lowered. However, as of the 21st century, the required rate is virtually zero [7]. Another innovation has been to manipulate overnight lending interest rates because, due to fractional reserve banking, banks have to borrow from each other to meet their reserve requirements. The overnight lending rate set by the Fed is also close to zero right now, and this has been the case since the 2008 financial crisis when the Fed bailed out failing corporations and banks for making highly-leveraged investments in the housing market. In 2008, we saw the introduction of open market operations, or the ability of the Federal Reserve to buy and sell bonds. We saw the Fed’s balance sheet of United States Treasuries expand from $800 billion to $2 trillion. We are now ending this last period of expansion with $6 trillion in treasuries on their balance sheet [8]. The Fed’s actions have lowered our economic strength significantly as the total deficit of the United States grows to $30 trillion. Foreign interests such as China have bought up US treasuries in order to manipulate their international currency, the yuan, while strengthening their domestic renminbi internally.
Of course, this $30 trillion deficit figure is the raw amount of debt right now, but the actual budget deficit counting the net present value of social security entitlements that taxes cannot cover may be much closer to $47 trillion [9]. So back to open market operations, since the Federal Reserve has bought up treasuries, the interest rate that they pay has gone down. The reason for this is quite simple, when the principal of an annuity rises (the price being bid up), the interest rate lowers. This allows the government to lever up, but it also allows banks to be flush with cash as they can offload treasuries from their balance sheet and get cash to lend out at dirt-cheap interest rates. Since March 2020, the Fed has bought $80B in treasuries and $40B in housing-backed securities (the same instrument that caused the 2008 financial crisis) each month, bringing their total balance sheet to $9 trillion, about half of the United States GDP [10]. Keeping reserve requirements at zero, and overnight interest rates zero were theoretically enough to make the potential money supply of the economy infinite, but adding to this the ability of the government to spend excessively, and you get the 8.6% inflation number (which is truly far from the real inflation felt by the median consumer).
It should come as no surprise then, that over 80% of all dollars in circulation were created in the past two years. The M1 money supply hit well over twenty trillion after the pandemic policy hit, a complete shock to any natural economy after being at just four trillion prior and a bit over one trillion before 2008. Each dollar printed says on it, “this note is legal tender for all debts public or private,” but just how reliable will these IOUs be when there are so many of them flooding the market? We already see signs of destruction within our own borders as the dollar loses its purchasing power, but now even international economies are changing their reserve currency. Typically, low interest rates are reserved for creditworthy borrowers, but as of right now America shows no capability of paying a single cent of the deficit back. This instability has led to countries like Russia and China planning their own reserve currency [11] because America has shown that you don’t have to uphold any obligation that the dollar signifies.
Now with just a nominal 0.75% increase in interest rates, we have seen everything from overvalued technology stocks to real estate mortgage providers suffer. And even though these companies may practice good fundamentals and be responsible for real innovation, they have to see their stock values and employment suffer because of the Federal Reserve’s ability to influence the economy. In the past year, the Nasdaq is down 22% while gold is down 2% and oil is up over 60%. These types of swings are not telling of a healthy economy, but rather one that’s being played by the board of governors. As Fed Chairman Powell still states that the economy’s fundamentals are strong, the common middle class person sees their income mobility and purchasing power at all-time lows.
I’m not necessarily one to suggest another piece of legislation, but maybe Milton Friedman put it best:
EPSTEIN “… you long ago proposed that we simply pursue a policy of steady growth in a particular monetary aggregate. But wouldn’t that require a central bank to implement?
FRIEDMAN Yes, but I would substitute a computer for it, not a central bank. All you would have to do is have it buy or sell X dollars of securities. It is purely a technical matter. [12]
Federal Reserve Co. Federal Reserve Bank of Boston MarketWatch The Financial Times Stocktwits, Inc.
