WASHINGTON – I indicated a while back that whoever would be elected President of the United States on November 8 –Clinton or Trump– it was unlikely that she or he would have the fortitude and the political backing enabling her/him to seriously focus on the real, yet silent systemic crisis affecting the U.S. economy: artificially depressed interest rates. I still hold this opinion.
Financial and economic distortions
Let’s look at the issue. We are now dealing with the consequences of several years of Fed-mandated zero interest rates policies, or ZIRP. These policies have created enormous distortions affecting now the entire fabric of the American economy, its economic policy making process, and financial markets. What started as extraordinary monetary easing in order to mitigate the risks of a post-2008 financial meltdown, morphed into a real monster.
No, we are not necessarily on the proverbial edge of the abyss. The world is not coming to an end. At least not today. Nonetheless, a sad combination of wild (and prolonged) experimentation on the part of the Federal Reserve –way beyond the limits of reason– and a mixture of political cowardice, ideological infighting, and intellectual void on the part of the Congress and the Obama White House created this truly unprecedented hazard.
Fed policies now drive markets
After years of zero interest rate policies, the US Federal Reserve managed to accomplish something quite unique. Its policies on interest rates –and not economic fundamentals– now determine in large measure investment decisions, and therefore assets valuations.
Disconnect between the economy and markets
Put it differently, prices of major assets, stocks first and foremost, no longer depend mainly on how the U.S. economy and the world economy are actually performing. They are largely dictated by Fed’s policies and its perceived future moves on interest rates. Which is to say that Fed moves now determine asset prices. And so we have had and are still having today an almost total disconnect between the actual conditions of the economy and the valuations of basic economic assets. Investors follow Fed mandated interest rates. They base their investment decisions on Fed moves, and not on corporate performance. This is most unhealthy.
This obvious divorce between market valuations and underlying economic realities this time is not about market speculators. This is not yet another bubble created by crazy investors. This is a Fed-engineered disconnect between the real economy and financial markets. The Fed did this. yes, the Fed, the once revered custodian of national financial integrity.
Markets follow the Fed
Simply stated, several years of interest rates repression induced (forced?) most investors seeking a return on their capital to migrate to stocks, whose valuations are now inflated, because that’s what everybody is buying, since there are no other realistic investment choices.
As a result of this unprecedented distortion, stock prices now are not affected –as they should be– by expectations on future corporate performance and sector strength. No, they are affected mostly by speculations on what the Fed may do next. It is now accepted as a “normal” phenomenon that US stocks respond with sudden swings to any hint of significant changes in interest rates policy by the Fed.
In other words, these days stock valuations respond mostly to developments that have nothing to do with the real economy.
How did all this begin?
Well, and why did the U.S. Fed get into this crazy game? At the beginning, in the immediate aftermath of the Great Recession of 2008, it was all done with good intentions. Fed officials were hoping that by pushing interest rates down to zero, and keeping them at zero for a while, both corporations and individuals would gain confidence and have an extra incentive to borrow more and therefore kick-start into higher gear the wounded US economy struggling to come back after the horrible 2008 financial debacle.
It was hoped that this strong monetary medicine would help, giving time to the slow-moving US Government to concoct market-friendly reforms, (such as lower corporate taxes, streamlined regulations), aimed at creating a more pro-investment, pro-growth policy environment.
And here is where everything went wrong. The U.S. Government, torn apart by bitter partisan politics, has done practically nothing. Since the end of the Great Recession nothing, absolutely nothing, has been done to reform federal spending, this way “bending’ the curve. Likewise, nothing to reform and simplify the horrendously complicated U.S. tax code, with the goal of making it more business friendly. Nothing to improve the fundamentals of the U.S. “economic eco-system” in order to encourage new enterprise creation.
Sure enough, after massive stimulus ordered by Washington financed mostly by issuing bonds, (read: more debt creation), the U.S. economy rebounded. But it has been a feeble recovery, with unimpressive growth.
Weak economy, strong markets
And yet, despite all this, the stock market shot up. While this year Wall Street growth has been modest, it is clear to most observers that current valuations are not justified by the performance of the real economy.
While consumer spending is relatively healthy, the fundamentals of the U.S. economy are not good. There is very little new investment, while increased amounts of regulations affecting practically every economic sector suffocate existing small businesses, at the same time creating disincentives to new business formation.
Here is the monster
And so, here is the monster. America has at best a mediocre “doing business” environment. Our public finances are in a dreadful state, with more debt added to already historically high debt. There is little new investment, while more small businesses close down than new ones are established. In other words, the real economy is either stagnating or slowly declining, (at least in some sectors). And yet, the stock market has done great, mostly because of Fed policies.
What we got, after years of ZIRP, is a horrible distortion, whose ramifications we do not even begin to appreciate.
The rosy scenario is that the Fed finally would see the danger of the effects of its policies. Therefore it will slowly jack up interest rates, this way allowing time for investors to devise and implement a gradual and orderly reallocation of capital. While this readjustment takes places, the stock market will experience some corrections. But nothing terrible will happen, as investors will have time to make the appropriate portfolio diversification.
But what if it all happens in a sudden big burst? What if the hoped for incremental correction turns into a stampede? What if trillions of dollars now invested in obviously inflated stocks are vaporized in a matter of hours?
So, here is the thing. Just like a sorcerer apprentice, after 2008 the Fed went into uncharted territory, hoping that zero interests would work like the magic trick that would revive the moribund U.S. economy. Worse yet, even though the magic did not happen, The Fed kept on this ZIRP course for many years. This prolonged intervention “rewired markets”. It created new, and truly unhealthy, incentives for financial markets. They now respond mostly to Fed signals, as opposed to economic fundamentals.
And there is more. Corporations now respond to short term financial incentives. Many of them do not make long term investments. Indeed, it is a lot easier to support your market valuations through stock buy backs funded by money borrowed at practically zero interest than to plan growth strategies that require real capital investments.
How do we get out of this?
And now, to make a bad situation really treacherous, the Fed does not know how to extricate itself from the trap it created for itself and the entire U.S. financial system. Leaving interest rates near zero for much longer is a really bad idea. However, the danger now is that any action that may be read by the market as a quick return to historic interest rates may give the signal to a chaotic exit from artificially priced shares.
No help from policy-makers
As for getting any real help from policy-makers, forget about it. On November 8 we had the end one of the most acrimonious and divisive presidential campaigns in recent American history. President-elect Donald Trump, the uncontested winner, should realize that almost half the country is still against him.
This is not an auspicious beginning for a new President who should instead have the political flexibility deriving from a strong mandate. Trump needs to engage both the Nation and the Congress in order to put in place, as soon as possible, a new fiscal, economic and tax policy environment finally conducive to real investments and real growth.
What is the end game?
While few policy-makers will say this in public, it is clear that the U.S. economy looks reasonably healthy mostly because it is on Fed-administered monetary drugs. The current high stock market valuations are illusions. At some point this whole thing will fall apart. How fast and how dramatically, is anybody’s guess.