Anyone else ready to retire the term “grim milestone”. I wake up every morning to the TV talking heads bemoaning “another grim milestone” of new COVID cases and related deaths. Give it a rest, maybe try a new schtick: “more good news today on the COVID front – new cases continue to fall around the country”.
There is also plenty of negative media chatter about the steep negative economic shock that has caused an economic depression, which must then be ranked for misery against all past economic crises.
Yes, the US unemployment rate is reaching unimaginable levels, small businesses are in dire straits and the economic contraction in 2Q20 will be record-setting bad. 1Q20 GDP was announced this week at (4.8%). After all the negative headlines, this figure does not seem apocalyptic to me.
Looking back, there have been numerous US economic depression events: 1797, 1807, 1815, 1837, 1857, 1873, 1907 and 1929. Historians will likely add 2020 to the list based on the dour economic news.
However, there was only one “Great Depression” and comparing our current economic situation to it is a disservice to those who survived the worst economic calamity in history.
The Great Depression endured for ten years – a decade of misery. US GDP fell a cumulative 50% and the unemployment rate reached 25%. The stock market sunk 80% and took nearly twenty years to climb back to its high-water mark.
The entire banking industry collapsed. FDIC insurance did not exist and cash savings for many Americans were wiped out. Coincidently, biblical drought conditions led to severe food shortages and nearly mass starvation. Plus, even worse economic conditions in Germany led to the rise of the Nazis and eventually WWII.
The Great Depression started with the crash of a bubbly economy and a stock market collapse in 1929, each precipitated by a massive over-extension of credit by unregulated banks.
Conditions then worsened due to stark wealth inequality, stupid government policies including stiff new trade tariffs and misguided fiscal restraint.
An ignorant Fed Reserve raised interest rates during the contraction, did not intervene to save the banks nor provide liquidity by increasing the money supply. In its defense, the Fed was only a teenage institution when the Great Depression un-folded and we all know how well teenagers make decisions.
Moreover, the US dollar was then still on the gold standard, which may have handcuffed the Fed’s ability to easily print money.
Talk about a stressful time, yet three positive things did come out of the Great Depression: The Greatest Generation, the repeal of Prohibition and the advent of creamed chipped beef on toast, also known as SOS.
Today, America has a multi-faceted safety net that is helping to blunt the effects of the current economic crisis. Much of it was constructed from lessons learned from the Great Depression and Great Recession.
We now have a regulated, sound banking system and the fiat US dollar is the world’s safe-haven currency. That status is saving our bacon right now.
We have unemployment insurance, a well-developed healthcare system and a still-functioning food production / delivery network, none of which existed in the 1930s.
We also have strong federal fiscal support and a zealous Fed Reserve that are holding the economy together until the lockdown ends.
That’s the positive take on the current state of affairs. The federal government may spend in excess of $5 trillion in rescue / bailout / stimulus money, all financed with more government debt. For perspective, the 2008-2009 stimulus package was a mere $850 billion and caused quite the stir.
This pandemic is a war and you spend whatever it takes to win. However, there will be financial repercussions after our national debt runs up to $30 trillion on what was a $22 trillion economy.
Higher taxes and future spending cuts will happen but will be postponed by spineless politicians until the US dollar starts to weaken. US dollar currency weakness will ultimately force the government’s hand to balance the country’s finances. Once the disinflationary impact of the lockdown is burned off, inflation will likely become a serious concern.
In the meantime, the Treasury will keep issuing government debt to finance deficits and the Fed will continue to be the predominant buyer. At this pace, the Fed will own more than 50% of all US government debt soon!
What gets really complicated for investors is how the Fed is redefining our understanding of central banking. Consider:
• The Fed is buying massive amounts of Treasuries securities, new and existing, which is quantitative easing;
• It’s buying massive amounts of mortgage loans;
• It’s now lending money directly to municipalities;
• It’s now lending money directly to US businesses;
• It’s now directly purchasing corporate and high yield bond in the open market.
What’s interesting (disturbing?) is the Fed is not expressly allowed to do most of these things! To get around the lack of statutory authority, the Fed, in cahoots with the Treasury Department, is setting up special purpose vehicles, funded with newly printed money, to lend and invest.
The effect of the SPVs is to merge the Fed and Treasury into one entity and blur the central bank’s independence. As an analyst remarked: “meet your new Fed Reserve Chairman, Donald J. Trump.”
Moreover, the Fed’s balance sheet is now pushing $7 trillion of assets and could grow to $11 trillion before long, twice the size of the ’08-’09 crisis. Unwinding it all could be problematic for investors in the future.
A key issue for investors is price discovery. If the Fed is intervening in private capital markets to prop up companies and sectors, how do you quantify true risk and value? It’s like playing an arcade game that doesn’t require quarters because you don’t lose, you just press a button and the game restarts.
The Fed has crossed a financial line and risks distorting private capital market prices and muddying up the measure of future investment risk and return. That could be a true Pandora’s box.
Until next time, be healthy….Tim