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The Impact of Fed Policy on Long-Term Economic Health

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This is a more pragmatic, even wonkish post about the current state of the economy. Sometimes it is necessary to dive into a prosaic topic to better understand our world and how we can be good stewards of what we have in our control. While it is prosaic, it is important.

The federal government’s response to the Covid-19 pandemic has been nothing short of massive and unprecedented. The federal government has appropriated trillions of dollars and spread it out into the economy in a variety of ways. The purpose is not to examine all the minute ways that this program has worked its way into the financial and business ecosystem, nor is the purpose to dissect the morality of such a program (spoiler, it is completely immoral). Rather the purpose here is to step back and take a look at the larger context and see what the long-term effects this policy may have on the economy as a whole.

First, we need to understand how the government is financing all this spending. The federal government is issuing massive amounts of new debt in the form of government bonds. Clearly, if the government issues a substantial amount of new debt instruments this will cause an increase in the interest rate. This is because of simple supply and demand. The more bonds that are issued the less each one is worth, therefore the issuer (government) has to entice buyers to purchase them. This is done when the government raises the interest rate. Yet, we have not seen rates rise. This is easily explained by the fact that the Federal Reserve has been “monetizing” the debt issued by the federal government. They do this by creating money out of thin air and using the newly created money to purchase the additional governmental debt (I need not go into the specific mechanism the Fed use to do this). In addition to this, the Federal Reserve will be buying the bonds of corporations as well as those of the federal government. The immediate effect of this policy is to artificially maintain a lower interest rate.

The longer-term effect of an inflationary policy is to create a condition of capital consumption. Capital is simply another name for the tools used to produce goods and services. The more capital (tools) we have the more goods and services we can produce. This increase in productivity is the basis of an economy that is expanding and a society growing wealthier. If the economy is consuming capital, then that economy will be able to produce less goods and services and will grow poorer. This process is the financial equivalent of eating your seed corn. This occurs because in an inflationary environment prices will always be higher than they would be otherwise. This causes businesses to mistake paper “profits” for actual profits and to then underinvest in capital expansion or even maintenance. This process is summed up nicely here.

Of course, all of this inflation and artificial lowering of interest rates causes the boom and bust cycle of the economy. This is why the growth in the money supply plays such a critical role in the creation of the boom bust business cycle.. This draws upon the insights of the Austrian Business Cycle Theory. The endgame to all of this is not pretty.

In recent years, most central banks have concentrated on policies that push down selected types of market yields, in particular those in the funding markets for government debt, mortgage debt, and bank debt. However, this has a large impact in other asset markets. In a search for yields, investors increasingly use their funds to purchase, say, stocks and real estate. As a result, these asset prices rise, thereby lowering their future returns. In other words: the zero-interest rate policy of the central banks drags down basically all kinds of yields with it. This may go on for quite a while.

But once all market interest rates hit zero, the real trouble starts: the boom turns to complete bust. Credit markets shut down, borrowers can no longer roll over their maturing debt, and no investor is willing to lend new funds. To prevent credit defaults and the collapse of the debt pyramid, central banks would presumably step in as “lenders of last resort,” refinancing basically all kinds of borrowers in need (this is where we are currently). An outright inflation policy would begin. Nevertheless, capital consumption and economic regression would set in (as outlined above). The nation’s living standards would nosedive; this policy then throws a large number of people into outright misery.

Applying the Austrian Business Cycle Theory to real-world developments yields the following insights: Central banks have done nothing to put an end to the boom-and-bust cycle. Instead, their unscrupulous interventions in credit markets just prolong the boom. However, it would be mistaken to assume that by bringing market interest rates to zero, a perpetual boom could be created. Such a policy is self-defeating: once the government has forced all market interest rates down to zero, the capitalistic economic system will collapse. Then—at the latest—the boom will definitely turn into bust.

The bust at this point will last for a very long time. If the policy is not reversed the currency will eventually implode. The choices at this point are rather stark. Either the government institutes a new monetary regime, or the economy completely collapses. In either case, the dollar would likely lose its reserve status in favor of another currency or perhaps gold. This would leave the United States with no choice but to live within its means and would likely result in a general default of U.S. debt.

What should we do until then? The short answer is to stay the course. Stock markets have traditionally provided a hedge against inflation as these assets usually rise faster than other prices for reasons outlined above. So, for the time being there seems little reason to change course from your long-term investment strategy, whatever that may be at present. There is no need to panic but there is always a need to be aware of the situation. We are not called to be naïve but to be as wise as serpents (Matt 10:16). We need to try to protect ourselves and our families as best we can from the vicissitudes of this world. Yes, we are to trust in God, but that trust is made manifest by using the brains he gave us to get the best outcome we can. There is a storm coming that is going to be bad, very, very bad. I am certainly not the only one warning of this storm but warning you I am. I will continue to do so as it gets ever closer.

Praise Be to God

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