No Free Lunches

Alesso, Heroes (We Could Be), 2014

The Heroes Act. Is it a bill or lyrics from a song by Alesso?

[Ed. note: I always knew Pete was hipper than me, but embarrassed to say I had never heard of a non-Bowie musical reference to heroes. So you can imagine my relief when I read that this Alesso guy added David Bowie and Brian Eno to the songwriting credits for Heroes (We Could Be) in 2015, telling the Daily Star, “I just didn’t want to get sued. They aren’t similar, but we needed protection in case we pissed off Bowie.”]

The Heroes Act appears to contain classic pork barrel-like provisions in a Congressional election year. Even by its name, it seems to exalt the federal government (Congress) – forget about party – as a savior in a ‘bold response to the coronavirus pandemic and economic collapse.’ Yes, the states and local governments need support, and the bill provides for $500 billion and $375 billion, respectively. This makes sense, but throwing in the kitchen sink does not. Does the Fish and Wildlife Service need to be included alongside the USGS for a cool $90 million? The connection to the coronavirus is tenuous.

Setting aside arguments for or against specific provisions in the bill, we bring this up because the almost $3 trillion bill cuts to the heart of (at least) one thing that equity market participants are missing.

All of this stimulus will come at a staggering cost to growth and potentially at a cost that threatens the functioning of markets and our capitalist democracy.

While risk-asset markets and the economy are sometimes disconnected, they often suddenly and dramatically reconnect when emotion exits and reality enters. We maintain that the recent rally is a bear market bounce and that the correction over the past couple of days is the start of a more sustained selloff. We believe market participants will eventually catch on to the fact that THERE ARE NO FREE LUNCHES OVER THE LONG-TERM.

The consequences of such aggressive fiscal policy may have initially been perceived as unequivocally positive by risk-asset markets. Over time, however, unintended consequences now hidden and unknowable, will likely manifest. Aside from the unknowable, there are unintended consequences that market participants might come to appreciate in the near future. First, massive fiscal deficits kneecap monetary authorities and make them simply knaves of fiscal policy actors. Monetary policy loses its efficacy as a stimulative tool and becomes only a palliative one. This is why deficits DO matter. Deficits may not matter when myopically considering they can be monetized, but monetization does not happen in a vacuum. Monetization occurs at a cost to the monetary authority in the form of opportunity cost. Next, in recent history, fiscal policy has been notoriously slow and inefficient at stimulating GDP growth.[1] Lastly, monetization of deficits without taxation as a source of funds for spending presents potentially existential problems for a capitalist democracy.

Recent experience demonstrates that, in the absence of Fed action, U.S. rates may rise radically in the face of massive T-bill or coupon issuance. Recently, long-thought-dead bond vigilantes jumped out of their graves in the face of Treasury issuance need to fund deficits. Figure 1 shows the dislocations in March 2020 when the Treasury market began to absorb the fact that long-dated coupon issues would explode to fund the deficits needed to combat the pandemic. [Ed. note: the overnight gaps are interesting to me, too.] In September 2019, repo rates went to about 7% intraday when bill issuance exploded in the face of insufficient system reserves. This occurred well in advance of the pandemic. In the latter case, it was not until the Fed acted by expanding its balance sheet quickly by almost $1 trillion through term repo operations that the repo market stabilized. In the former, it was not until the Fed announced unlimited quantitative easing (QE) that coupons stabilized after several days of incredibly sloppy and illiquid trading. These periods were the catalysts for a shift in the role of Fed policy from a stimulative to palliative one.[2]

Said differently, it’s not a question of whether the Fed has tools, it’s a question of efficacy of the tools employed. Do the tools available actually work as intended? Both traditional monetary policy (through open market operations that manage to Fed fund target rates) and extraordinary policies like quantitative easing (that suppress the term premium of interest rates) work through a rates mechanism. By first order effect, buying USTs (either long or short dated) lowers targeted interest rates. By second order effect, those lower rates may help suppress risk premium (credit spreads). They may also suppress spreads by first order effect if a central bank is buying risk assets directly. When rates are near or below zero, these policies maintain the status quo – at best. They lose marginal benefit. In fact, they may even do more harm than good because they encourage ‘malinvestment’ and create overcapacity (as in U.S. E&P). This oversupply leads to price disinflation and even deflation. This lack of efficacy (at best) or harmful side-effects (at worst) are what ultimately pushes the Fed to focus on ‘wealth effect’ or ‘confidence’ channels. This is what led it to buy corporate bonds. It had nothing left. It can’t afford defaults to shake confidence in equities or destroy the wealth that it has helped create for corporations and individuals through low rates.

Even if one rejects the notion that monetary policy has lost its efficacy or believes that fiscal policy has immediate and multiplicative benefit to an economy, then there’s an entirely different question that ought not be ignored. Importantly, if debt monetization is a panacea, then what of taxation as the source of funds for government spending? If one argues no taxation is needed, the entire system of taxation and spending comes into question. Why even bother to tax? Taxation, authorization and appropriation are some of Congress’ most important roles. If there’s no need to tax to fund spending, then what does that mean for a legislative system based upon that basic equality? Are we as Americans once again (as during the reign of the English monarchy) ceding authority to undemocratic institutions (i.e. – the Fed)? What incentives does such a system create to spend without limitation on any pet project that a Congressman or Congresswoman deems suitable for their district – as long as the Fed chooses to monetize it? It seems clear that it creates a world rife with economic inefficiency, corruption and moral hazard.

What about the rest of the world’s take on such a U.S. system? Do other nations simply sit by and watch the U.S. and Japan monetize their debts without trying to do the same?[3]

Of course not. They will certainly try and have already started. There is now talk of emerging market central banks ‘joining the QE party,’ as this Economist article points out. This will likely not end well as it risks destroying the creditworthiness of already challenged EM economies. Their growth is essential to the world. We are the leader in global monetary policy and one size simply does not fit all. Yet, that lesson seems already lost on those central bankers outside the U.S. that do not appreciate the benefits of our reserve currency (and the worlds’ continued structural need for the U.S. dollar).

This discussion goes well beyond esoteric considerations of monetary policy and Modern Monetary theory (MMT). It ultimately cuts to the heart of sustaining our democracy and the checks and balances that make it work. U.S. democracy works because of these checks and balances, which exist in a fragile equilibrium that the Fed’s willingness to monetize deficits will now upset – unless it is checked by a newly created system of checks and balances. Our powerful democracy has far less cronyism and corruption than many others. The flow of funds from taxpayers to a government for the people and by the people is the foundation of it all. Wholesale debt monetization without appropriate taxation threatens this balance and concentrates power with the monetary authority. Perhaps most scary, is it allows legislators to act without worry about where their self-interested spending eventually goes. As in many countries, a good deal of that could end up in their own pockets. That’s the end game if we are not vigilant.

[1] Using Jordà’s (2005) local projection method we find no evidence that government spending multipliers are high during high unemployment states. Most estimates of the multiplier are between 0.3 and 0.8.

[2] We’d been concerned that the Fed would be backed into this corner, and it was at the heart of our 2020 Outlook, in which we argued that limited policy space would be a challenge to U.S. equity markets.

[3] By the way, Japan’s equity purchases – an attempt to juice equity valuations – have not been particularly successful, as Figure 2 shows. P/Es are actually lower there than in the U.S.

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  1. “Perhaps most scary, is it allows legislators to act without worry about where their self-interested spending eventually goes.”

    And that is at the root of crony capitalism……elites screwing the pubic and presenting the bill to the government.
    Reminds me of Indonesia under Soeharto……authoritarian and extremely corrupt, where crony capitalism was THE way of life.
    Nobody paid anywhere close to their real taxes.
    Made no sense when there was always the ‘hidden tax’ of bribes every body had to pay to get anything done….

  2. Avatar for roro roro says:

    In reference to Pete Cecchi’s No Free Lunch fake outrage by Senators must be all show at suddenly discovering at the Powell/Mnuchin testimony the “$454 billion CARES Act wasn’t really just $454 billion. It is to be leveraged up by factor of 10 to 1 into a $4.54 trillion bailout for Wall Street. The $454 billion is designated by Fed’s SPVs as “loss absorbing capital,” meaning taxpayers will eat the 1st $454 billion in losses”. And, no one in Congress knew before voting on it?

  3. Avatar for Kpaz Kpaz says:

    For many, many years now, taxation has had nothing to do with the budget at the Federal level and everything to do with the behavior of the taxpayers. It’s like the drain at the bottom of the fiat system bathtub. Breathe…

  4. Welcome to the long now

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