“Eleven Years After the Credit Crisis: Debt, Interest Rates and Inflation” Sydney Williams
The TED spread – the difference between Three-month U.S. Treasuries and Three-month LIBOR and an indicator of perceived credit risk in the general economy – declined from 314 basis points to 131 basis points during the fourth quarter of 2008, after reaching a high of over 458 basis points on October 6. (Historically, the yield spread had been closer to 50 basis points). The S&P 500 bottomed on March 9, 2009 at 676.53. The Second Quarter of 2009 marked the end of the 2007-2009 recession. The rate on Fed Funds, which began 2008 at 4.25%, ended the year at 0.25%. Despite having spent almost half a century on Wall Street, I am an observer not an expert on credit markets, so what follows are opinions that should be taken with the proverbial grain of salt. It is my contention, however, that monetary policy over the past decade has been driven by political wants not economic needs.
In my opinion, the incoming Obama Administration, in 2009, used the credit-driven recession to justify a political agenda of increasing the role of government and “…fundamentally transforming the United States of America,” as Mr. Obama put it five days before the 2008 election. Apart from demonizing Republicans, the first thing the new Administration did was to call the seven-quarter recession a “Great Recession,” reminding people of FDR and the Great Depression. Certainly, the bankruptcy of Lehman on September 15, 2008, and the ensuing credit crisis, made for a frightening few weeks, but the scare was over by the end of the year. While Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and President of the New York Federal Reserve Bank Timothy Geithner have been criticized by some for their handling of the crisis, it is my belief they saved the system. Monday morning quarter-backing may argue that there were some things they did they should not have done and other things they did not do they should have done, but the bottom line is that, while Lehman want bankrupt and other banks were forced to sell out, by the end of December the crisis was largely resolved, as could be seen in the decline of the TED spread mentioned above and in the fact that high-yield bonds had begun to rally a month before year end.
For six and a half years, while the economy expanded from $14.2 trillion in 2009 to $18.2 trillion in 2015, the Federal Reserve left the Fed Funds Rate at 0.25%. It was only in the fourth quarter of 2015 that the Federal Reserve finally lifted the rate to 0.50%. The rate remained at that level until December 2016 when it was increased to 0.75%, just before the Trump Administration took office. During 2017, the rate rose, in three increments, to 1.50%. In 2018, the rate rose in four increments to 2.50% where it remains today – higher than it was but still low by any historical measure. However, once again, political pressure is being put on the Fed, this time by President Trump – and silently acquiesced to by members of Congress – to lower rates, a mistake, in my opinion. It is expected that this afternoon the Fed will reduce rates by twenty-five basis points.
Low rates trouble me for three reasons: first. they incentivize borrowing, discourage savings and hurt the retired. Second, they mask the cost of the debt our government has accumulated, which makes more difficult economic expansion. Third, low rates and cheap money make more likely a return to inflationary forces.
Non-financial corporate debt has increased to about 45% of GDP, or about $9 trillion, roughly where it was prior to the last two recessions. The $13.7 trillion in household debt is at record levels, driven by growth in student loans, but, as a percent of GDP, household debt is below where it was in 2008. The U.S. personal savings rate, at 6.2% of disposable personal income, has been flat for the past ten years, despite rising incomes in a recovering economy.
The size of government debt has increased political pressure to keep rates low. In 2000, the U.S. economy generated $10.3 trillion in GDP on total local, state and federal borrowings of $7.2 trillion. By 2018, the U.S. economy had doubled to $21 trillion, while debt more than tripled to $25 trillion. Interest expense is a rising cost. Should interest rates return to their average post-War levels, interest expense for the federal government would approximate 20% of the budget, or close to $1 trillion of a $4.7 trillion budget. This was a problem foreseen by our Founders. In his pamphlet, “Poor Richard’s Almanac,” Benjamin Franklin wrote: “Think what you do when you run in debt; you give to another power over your liberty.” An unsustainable debt load, made easier by lower interest rates, makes more likely systemic risk to the economy.
Inflation can be seen as a Janus, depending on whether one is a borrower or lender, a progressive or a conservative. There are those who are concerned with the “Japanification” of the economy, where deflation becomes entrenched in a vicious, downward cycle. Japan, however, is different than the U.S. in many respects, but particularly in terms of demographics. Its total fertility rate (TFR) is 1.46 and has been below the replacement rate of 2.1 for several years, while the U.S. has a TFR of 1.8 and only recently went below replacement rate. We have an abundance of raw materials. They have little. They have an homogeneous culture, while we are diverse.
Milton Friedman, in his 1963 text Inflation: Causes and Consequences, wrote: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Today, money is cheap in all Western and developed nations, as interest rates inform us. For decades, many economists have claimed inflation is a function of slack or tautness in spare capacity in the economy, including labor. But, as well, positive forms of deflation are affected by productivity gains associated with disruptive technologies and by the importation of cheap consumer goods from abroad. But, now big technology companies have been coming under government scrutiny and tariffs are making more difficult the import of lower-cost goods.
Low rates are a world-wide phenomenon, especially in Europe and Japan. The key short-term interest rate in Japan is -0.01 percent. In Europe, benchmark interest rates are set by the governing council of the European Central Bank (ECB) and are set at zero, while they are -0.75% in Switzerland. Mario Draghi, out-going president of the ECB is concerned about the EUs economy; last week he said this is a “whatever it takes moment,” suggesting he is considering negative rates and possibly some form of renewed quantitative easing – to, hopefully, stimulate growth while cheapening the value of the Euro. Low rates are good for borrowers but bad for savers. Some inflation is wanted by governments, as it eases the repayment of debt. However, the lender suffers as he receives depreciated dollars. Two percent inflation reduces by half the value of a dollar every generation. Very low and negative interest rates are the last resort of politicians who failed to implement fiscal policies, probably because the latter would require a reduction in regulations and tax cuts to stimulate private demand, something inimical to progressives who favor big government.
Populations in all western countries and Japan are aging and declining, with fewer in the work-force and more in retirement, a trend that is accelerating. The lack of an intelligent immigration policy only aggravates the situation. In an environment with a shrinking labor force, greater needs of retirees and minimal investment returns, politicians have promised more than they can deliver, particularly in funding the social welfare state. No one wants to see people starve, the ill unable to receive medical care, or the aged unable to live well, but there is also a need to keep the economic engine going. Without economic growth, our civilization will collapse. Politicians see low interest rates and inflation as a way out of their predicament. But, is not this a temporary reprieve? Is it not future generations who will bear the cost? Consider the advice George Washington offered in his 1796 Farewell Address. He was speaking of the dependency of the new country’s strength and security on public credit and on how we should use it sparingly: “…avoiding likewise the accumulation of debt, not only by shunning occasions of expense but by vigorous exertions to discharge the debts…not ungenerously throwing upon posterity the burthen, which we ourselves ought to bear.” A voice of reason in a politically-heated time. The 2008 credit crisis was an existential threat that had to be responded to with unconventional means. Today, in more conventional times, in relying on central bankers rather than legislators, we are creating self-inflicted wounds.
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