The Federal Reserve Is Taking Us into Uncharted and Deadly Waters
At the Federal Reserve semi-annual testimony before Congress this week, Chair Jerome Powell should have been asked whether the Fed has become the national Reddit.
The Reddit stock frenzy created a pool of motivated buyers, irrespective of the value of the underlying company.
For more complicated reasons, the federal government is the biggest Redditer of all, Reddit on crack cocaine. Instead of billions, the government plays in the trillions. Instead of a handful of small cap stocks, it has hijacked the entire stock market. But the mechanism is the same. Flood the market with funds, and for good measure force interest rates to zero, eliminating alternative investments. The recent congressional Reddit hearings are parody in comparison to the government's role in driving market prices, in particular the Fed.
Let's make it specific. When Joe Biden promises to spend $1.9 trillion, where exactly does that money come from? Beyond that, even excluding the $1.9 trillion, how does the government finance four years of deficits, which the Congressional Budget Office recently estimated at $5.9 trillion? That's an expected one-term cumulative deficit of $7.8 trillion. Where indeed does this money come from?
The wrong answer is tax receipts. In FY2020, federal budget revenues — i.e., tax receipts — totaled $3.4 trillion — $1.6 trillion from income taxes; $1.3 trillion from payroll taxes; $0.2 trillion from corporate taxes; and the balance of $0.3 trillion from excise, custom duties, estate taxes, and miscellaneous. Spending, on the other hand, totaled $6.6 trillion, versus the pre-COVID budget of $4.8 trillion. The result is a record $3.1-trillion deficit.
Scale matters here. One point nine trillion dollars is 40% more than the total regular spending of the entire U.S. government. And that is on top of $3.5 trillion in COVID spending already committed, of which some $1.0 trillion has yet to be spent. Put another way, Biden could triple income tax receipts in 2021, from all taxpayers, and still not pay for this year's forecasted $4.2-trillion deficit, including his plan. Taxing the wealthy does not work, either, as a 1% rise in the highest two tax brackets raises, by these standards, a mere $120 billion over 10 years, an amount that will decline as higher rates change behavior.
Bottom line: There is no money in tax receipts to pay $1.9 trillion, or indeed any of the $7.8-trillion unfunded spending coming our way.
The next option is to borrow the money from third parties. Here the problems begin to multiply. We as a country have already been tapping this well aggressively. We have to pay interest on this debt. Over time, the interest payments, which already approximate $350 billion annually, will swallow the discretionary budget. It addicts this country to maintaining artificially low interest rates. If rates were to advance back to historic norms, the country would immediately enter a deficit death spiral.
Lastly, and perhaps most problematically over the longer term, who will buy? Excluding the federal government as owner, foreigners already own more than 30% of our public debt, including China which holds in excess of $1 trillion currently. Will China continue to buy our debt so we can increase military expenditures to wage war with China? That sounds absurd now.
That leaves the final option of printing money.
From time immemorial, the printing press has been the preferred choice of weak governments. Easy money has no immediate or obvious cost since inflation and currency devaluation can take time to materialize. It does not require a willing buyer.
In a modern economy, printed money has a third virtue. The Federal Reserve increases the money supply by purchasing debt securities, with printed money, from banks or private parties. When the purchases are big enough, it dramatically increases the competition for interest-bearing assets, raising their price, which in turn lowers their yield. In 2020, the Fed used printed money to reduce interest rates from the 1.4% range to zero.
The stock market zoomed to historic highs on the back of this easy-money, zero-interest-rate nirvana.
Correlation between the Fed balance sheet and the U.S. stock market.
Source: Preston Pysh.
Historical perspective is needed here. Congress created the Federal Reserve system in 1913. In all those years, until very recently, the Fed's balance sheet was restricted to influencing the Federal Funds rates as the reference marker for all interest rates. As a result, the balance sheet expanded when the Fed purchased assets and shrank when it sold those assets, but it always remaining quite small as a percentage of GDP. Even as late as 2007, the Fed balance sheet was a mere $870 billion.
Then the 2008 financial crisis hit. It was only then that the Fed announced a new tool, usually referred to as Quantitative Easing, though the more precise term preferred by the Fed is Large Scale Asset Purchases. This was the first time the Fed aggressively pumped printed money into the economy via enormous asset purchases. By 2015, the Fed balance sheet peaked at $4.5 trillion.
With the crisis past, the Fed announced its intention to restore normality by selling assets. But as with all things governmental, norms once broken never are restored. The balance sheet went as low as $3.8 trillion in 2019, but the Fed balance sheet currently stands at a hard-to-fathom $7.5 trillion, which sets several dubious records.
It is the greatest one-year increase in the Fed balance sheet in U.S. history. It means that all COVID expenditures to date have been financed with printed money. And, given $2.3 trillion in expected FY2021 deficits, apart from $1.9 trillion in supplemental spending, the Fed balance sheet by year-end 2021 is expected to reach or exceed $10 trillion.
So there is the answer. All of the $1.9 trillion in proposed spending, and much more, will be funded with printed money, via asset purchases by the Fed.
The Fed does not explain what constitutes a normal balance sheet. Nor has there been candor with the American people that the COVID spending, all of it, has been, and will continue to be, paid for with printed money.
Rather, Treasury secretary, and former Fed chair, Janet Yellen cheerleads for $1.9 trillion in spending, without regard to its funding; inflationary pressure; waning need ($1 trillion unspent, a working vaccine; an underway recovery; the scientific prospect for herd immunity by this summer); and sheer political looting ($465 billion directly to individuals versus blue-state payoff money of $350 billion, $170 billion boondoggle for schools and colleges, $200 billion in leftover slush fund expenditures, and on and on). All this as the administration readies yet more trillions in spending in March for "infrastructure."
As a postscript, the Fed balance sheet explains when the stock market boom will end. The answer is 2022, and sensibly far sooner based on rational expectations. The unthinkable tsunami-like growth in the Federal Reserve balance sheet to $7.5 trillion has fueled the present record market highs. It is the huge pool of money that has led to relentless buying regardless of valuation, AKA Reddit on the grandest scale ever seen.
Wall Street takes comfort that ballooning the Fed balance sheet to $10 trillion in 2021 will support further market advances. Maybe so. But small comfort ought to be taken here. Unless the Fed is committed to owning these securities forever, and growing them further, the day will come when the Federal Reserve, at a minimum, stops growing its balance sheet. The Fed cannot permanently increase the money supply in excess of the demand for money without reintroducing stagflation to the national vocabulary.
If and when the Fed starts selling down aggressively, or that expectation becomes clear, markets will fall. Beginning in 2022, the deficit is forecast at "only" $1.2 trillion, which is not enough new juice into the system.
In the longest run, the unhinged spending-deficit–new money grift works only because the U.S. is the world's reserve currency. China understands this. As much as anything else, a prime Chinese agenda is to displace the dollar as the world's reserve currency with an "international" — i.e., non-U.S. — medium of exchange. Blockchain technology will make this possible even as reckless spending with printed money hastens our collapse.
Trust is the true coin of the realm. That trust is gradually but relentlessly eroding, as it should be when no one cares about a $10-trillion Fed balance sheet, a $1.9-trillion political payoff scheme long after COVID peaked, and the prospect of a one-term $7.8-trillion deficit, with more on the way, as far as the eye can see.
The CBO 2020 Long-Term Budget Outlook
If money on this scale is an unhelpful abstraction, then consider the truly hazardous cost of excess government spending. The U.S. has emptied its toolbox for future emergencies. Interest rates are at zero, the Fed cannot print more money with impunity, Social Security and Medicare are bankrupt, tax increases cannot remotely fill the gap, and the deficit forecast has already swallowed us whole.
This unnerving state of affairs has been long in the making and has many parents, Republicans and Democrats alike. But nothing in our history matches the radical acceleration into the abyss being pushed upon us now, exclusively by one party, and just as we should instead be repairing our finances.
William Levin is the founder and managing director of a New York investment banking firm.
