Crashing Without a Net

 

"It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so."

    The Big Short

 

Today people "know for sure" that the more money the Fed prints the more the stock market goes up.   Using Fred Graph we can make the following: 

 

With this view people may think that the Fed can always print money and always make the stock market go up, but this just ain't so and will get them in trouble. 

A more accurate way to think about it is that stocks are correlated to long term bonds but a bit more volatile (here we use 1.5 factor).   This Fred Graph shows this:

 The Fed can often manipulate the bond market by buying/selling bonds and adjusting the Fed Funds rate.   As the Fed buys bonds they are printing money and driving up the price of bonds (and lowering interest rates).   The stocks go up as the bonds go up.   So often the Fed printing money does make the stock market go up, but again that is too simple a way of thinking about it and will get you in trouble.

The trouble comes when inflation comes, as it has now.   By law the Fed has to fight inflation.   The way to fight inflation is by not printing so much money.  If they are not printing so much money then they are not buying so many bonds, so bond prices will come down.   As bond prices come down, stock prices will also come down.

The famous Fed Put is where the Fed steps in and stabilizes markets.  This does not work when there is high inflation and interest rates are already at 0%.    In previous market crashes the Fed could lower interest rates and so make bond prices and stock prices go up.  However, with interest rates already at 0%, the Fed can not lower them any more.   Bonds are already at historic highs, so they can not be driven up any higher.  High inflation tends to push bond interest rates up and so make bond prices go down.  In previous market crashes inflation was low so the Fed was cleared to print money.   Today we have high inflation, so the Fed's hands are tied.   The Fed Put has expired.

In previous crashes the Fed was able to step in and halt a crash, making for a quick bounce back.   Current investors believe the "Fed has their back", but this just ain't so.   Today we are crashing without a net.  This crash will probably be worse than anything in recent memory.

PS.   Powell understood the danger of low interest rates making the current bubble and yet did it anyway.  Here is Powell from 2016:

 "... it’s plausible to me that rates will have to remain very low for a very long time to achieve stable prices and full employment, but that such low rates will drive excessive credit growth and create irresistible upward pressure on asset prices, including real estate prices. I’m thinking of a situation in which a broad range of asset prices are moving up well beyond what fundamentals would justify; where the other tools we have don’t seem to be addressing the problem or have failed to do so; and where low interest rates are pushing up asset prices and driving credit to excessive levels, probably over many years, and thus are a principal cause of the threat. Recalling that we have had two major real estate blowups in the past 25 years, ..."

Deep Reasons for Current Trouble

 

There are a few deep reasons for the trouble coming to the USA which I will go over here.

At Best a Necessary Evil

There is some minimal government with police, courts, and defense that is sort of a necessary evil.  While such a government is a cost to the economy, it is better to pay this much cost than to suffer anarchy.   After this, the more government the less real economic growth.   The USA devotes too much of the economy to government and so not enough to real growth.   At this point, the size of the US government is far beyond optimal.

Dutch Disease and Resource Curse

There are the related concepts of Dutch Disease and Resource Curse.  Countries that have some valuable natural resource tend to suffer worse governance and to suffer in other areas of their economy.   Back in 1711 the Spectator wrote, "It is generally observed, that in countries of the greatest plenty there is the poorest living."   It is easier for a bad government to get control of some natural resource and then stay in power.  If they have to tax the general economy there will be some resistance to government excess.   So when there is a valuable natural resource, the odds of having a bad government go up.  

The US ability to print the world reserve currency is like having a valuable natural resource.

Triffin Dilemma

The Triffin Dilemma is the problem of a country with a world reserve currency.  For the country's own benefit (say when there is a Pandemic) there is a huge advantage to printing lots of money.  But if done too much this harms the rest of the world and makes them not want to keep using that currency as the world reserve currency.   You can view inflation as a tax.  The country with the world reserve currency can impose an inflation tax on the whole world.  However, if the inflation tax gets too high, the world can rebel and stop using that currency.   Taxes always cause modifications in behavior.  

The current inflation is reported as a CPI of 7%, but really the inflation is over 10% (the owners equivalent rent component of the CPI is a cheat) and going up fast.  This is an intolerably high inflation rate for a world reserve currency. 

Alternatives to the Dollar

If countries don't want to keep paying the inflation tax to the US they have to reduce their usage of dollars.  Many people can not conceive of any alternative to the US dollar but there are some.   

Central banks in other countries could use gold as reserves instead of dollars. Before Bretton Woods central banks each kept their own gold reserves.   Imagine that country X has 75% dollar reserves and 25% gold reserves.  In this case, if the dollar were to get hyperinflation and go to near zero, their currency would drop by a factor of 4 and then stabilize.  They would have suddenly moved to a gold standard.   So countries may end up moving to a gold standard without planning to do so.   At this point, it would be wise for central banks to have some gold just in case.  It seems central banks around the world are increasing their gold holdings.  If central banks only have dollars then if the dollar gets hyperinflation their currency will also get hyperinflation.

If people live in a country where the central bank is still only using dollars as reserves, they could save in Bitcoin instead of the local currency.

Spain and New World Gold

Spain took huge amounts of gold and silver from the New World.  Since gold was the world reserve currency then, getting all this gold was a bit similar to the US ability to print the world reserve currency.   This did cause prices, measured in gold, to go up by about a factor of 6 in 150 years, but this is only 1–1.5% per year.  While Spain was bringing in the gold and silver they had significant power but after the flow stopped they were a shadow of their former selves.  Similar to the resource curse, the rest of their economy was sort of hollowed out.

Dollar Losing World Reserve Status

It is in the interest of other countries to move away from the dollar, and so not pay the dollar inflation tax.  As countries do this the dollar will be less and less used.  China and Russia have worked to de-dollarize their economies.    The same amount of dollar creation will create more inflation when there are fewer countries using it.  But more inflation will push countries to flee the dollar even faster.   So there will be a positive feedback loop and leaving the dollar could happen very fast.

USA Just Another Banana Republic

If the dollar is not the world reserve currency, then the USA becomes just another Banana Republic that is printing way too much money.  Half their spending power comes from printing money.  The US will effectively lose a huge amount of its power, similar to when Spain could no longer bring gold from the New World.  The USA will be a much weaker country.  

The US manufacturing in 2021 was $2.3 trillion.    The Fed's balance sheet has on average increased by more than this per year in the last 2 years.  I think it is fair to say that money printing contributes more to the US economy than all of manufacturing.  

Without reserve currency status, it is nearly impossible to keep spending  twice what comes in as taxes without getting high inflation.    However, it is probably not possible for the USA to cut spending back to the level of taxes they will be collecting once things go bad.  Also, much of their spending is indexed to inflation and some of the bond payments as well.    Sadly, the USA is probably headed for hyperinflation.