The Road: Where we are, How we got here, and Which way to go

(Originally posted on Mises.org:   https://mises.org/wire/current-crisis-has-its-roots-central-bank)

            We have been locked down for weeks.  Classes have been cancelled.  Only essential activities are allowed.  While there is so much to cover and analyze, I want to focus on the economics of the situation.

            To understate it, the situation today is simply not good.  The Covid-19 crisis has caused the world to lock down the population, which essentially ceased most commerce.  While all businesses are affected in some way, a report by the US Chamber of Commerce shows that 24% of businesses are completely unable to conduct business in the emergency state, and further states that 43% of all small businesses are less than six months away (and 10% are less than one month away) from permanently closing their doors.  From their highs in February, the DJIA is down approximately 20% and the Nasdaq is down about 15%.  The initial claims for unemployment insurance since the US Department of Labor’s March 19^th report totals in excess of 22 million people.  A rough calculation places the current US unemployment rate above 17%.  Yes, the situation is not good.

             

How did we get here?

            The obvious answer is that a virus has swept across the globe and caused all of our woes.  While this is the proximate cause of the current recession, it is not the only cause.  In other words, our economic weakness didn’t start in February or March; it has been building for years. 

The most recent recession was over a decade ago.  Here is a quick history beginning with the 2007-08 recession.  In the period that is now called “the housing bubble,” banks bought assets that were backed by mortgages.  These mortgages were driven by politics and an expansionary monetary policy.  People were loaned mortgages that were simply beyond their means.  Eventually reality hit and borrowers started to default on the loans.  As the defaults piled up, the mortgage-backed assets lost value, resulting in the banks’ balance sheets showing that they were in the red.  (The value of their assets fell while their liabilities didn’t, which caused their net equity to plummet and in some cases even turn negative.)  This crisis generated a political response in the form of the Troubled Asset Relief Package (TARP) and the Federal Reserve’s secretive bank bailout was conducted through its facility accounts.

The lesson learned by the banking system was that even though profits are private, losses (if you are too big to fail) could be socialized (i.e., covered by the tax payer).  The consequence of this lesson was to continue to engage in riskier investments on larger margins and make oneself so large in the process that if anything happened, one would be deemed essential and bailed out.

A banking bubble is precisely what has happened since the end of the last recession.  In the years after 2009, the larger banks grew and acquired smaller banks.  Meanwhile the economy grew at an anemic annual rate of 1.6% between 2009 and 2016.

It was against this backdrop that the political winds shifted in 2016.  After Trump was elected, the Congress pushed through a cut in the corporate tax rate (from 35 to 21%).  While this repatriated some overseas profits and stimulated economic growth (averaging 2.5% annual real GDP growth since January 2017), it was not enough to overcome the underlying fragility built up by the previous malinvestments.  Over the summer and fall of 2017, corporate profits began to soften and lose steam.  In nine of the ten quarters since QIII:17, nonfinancial corporate business profit returns fell.  As a result, the value of the banks’ assets softened as well.

At this point, the profits weren’t negative in absolute terms, but they were shrinking from what they were just a year prior.  In other words, the economy was still growing, but it was slowing down.  As profits lessened, we saw y-t-y Real Private Fixed Investment fall from 5.2% in QII:18 to 0.1% in QIV:19. 

Making profits, retaining earnings, and reinvesting these funds into companies is a form of savings.  This fund of savings supports the investments made in the structure of production.  Without these savings, the economy falters.  An alternative way to temporarily prop up investment and consumption (without a firm foundation of savings) is through credit expansion.  However, the problem is that credit expansion creates the malinvestments which we have been building since the end of the previous recession.  At some point, the expansion has to give way to a crunch.  The economy was on the path towards this crunch long before Covid-19 became a reality. 

            Furthermore, a general slowing of the economy also occurred as Real GDP y-t-y growth fell from 3.2% in QII:18 to 2.3% in QIV:19.

With declining profits, a slowdown in investment for future growth, and a slowing economy, the banks’ asset values continued to decline, assets which were highly leveraged.  By law, a large bank must maintain 10% as required reserves.  As the value of the assets depreciated, the banks had to make up that difference to maintain the balance on their balance sheet, resulting in borrowing from other banks.  As we see in the figure below, the short-term rates started to climb in 2015/16, but accelerated their climb in 2017 and 2018.  Part of this climb was due to Federal Reserve monetary tightening, but a large part of it was coming from the banks looking to shore up their crumbling accounts by borrowing funds.

The result of this scramble for funds was a brief semi-inverted yield curve in the summer (June – Sept) 2019.

Today, an inverted yield curve is a financial sign of a forthcoming recession.  As I have shown in my Sept. 5^th article “Inverted Yield Curves, Recessions and You,” a recession was projected to take place between October 2020 and April 2021. 

To counteract and stop the yield curve from fully inverting, the Fed took an unusual step and did something it had not done since October 8^th, 2008.  In September 2019, the Fed injected massive amounts of liquidity into the repo market.  These injections continue today. 

Furthermore, the Fed declared (on March 26^th) that banks no longer needed to maintain a 10% reserve ratio.  The reserve ratio was waived entirely and set to zero.  The combined result of these two actions was intended to make the banks financially sound.  Instead these actions signal an underlying fragility of the fractional reserve system based upon a fiat money.     The bottom line is that, in this crisis, the banks are being bailed out yet again.  What is wrong with the current policy is that by bailing out the banks, they have not learned the correct lesson that investment contains risk.  If these risks are transferred to the taxpayer, the banks will simply continue to build up malinvestments as they get new cash infusions.

The current path is wrong

            Austrian Business Cycle theory explains that for the economy to establish a sound foundation, it must get rid of the malinvestments which have built up in the market.  Simply put, the economy requires a liquidation of the malinvestments.  If there are a lot of malinvestments to be liquidated, then collectively that process is known as a recession.  In an economic downturn, companies go out of business.  This step is unfortunate, painful and sadly necessary.  A person with a cavity needs to see a dentist and have the tooth drilled before a firm foundation can be established.  No one likes to get their teeth drilled, but if they don’t go through the short-term pain, the long-term problems fester and grow. 

            The method of converting from a recession to a recovery is through the liquidation process.  Imagine a store that is unable to sustain itself.  What happens?  It closes, of course, but the story doesn’t end there.  What happens next is the liquidation process, best illustrated through an example.

            Imagine a boutique cupcake shop that has a weekly shortfall of $1,000.  (I am just using $1,000 as an example, the real number would be much larger.)  If the company has a gross margin of 25%, the store would have to sell an additional $4,000 in total sales to make up the shortfall.  If the government is going to stimulate demand by giving money to consumers, then the government would have to give these customers $4,000 per week to prevent the store from closing.  As we can see, demand-side stimulus is expensive.  If, instead, the government cut the store’s taxes by $1,000 per week, it could achieve the same result.  Thus, tax cuts are better policy than demand-side stimulus.

            However, let us suppose that this cupcake company still fails.  The next step is that the bank (and other creditors) foreclose on the shop.  The company has a liquidation sale.  The ovens, tables, chairs, and even the curtains are sold to whomever might purchase them.  The money is allocated to the claimants (creditors and equity holders) in accordance with Chapter 7 of the Federal Bankruptcy Reform Act of 1978.  The claimants are paid according to the absolute priority rule where the common stockholders are the last in line.  (It should come as no surprise that the lawyers always get paid first.)

            Notice that the equipment—the ovens, tables and the chairs—don’t simply disappear.  They are sold to other users.  In these liquidation sales, the buyers are not paying top prices.  In fact, during the economic downturn, prices tend to fall (deflation).  When these new buyers purchase this liquidated capital equipment, they are converting malinvestments into proper investments.  The more flexible the capital is the faster it can be added to other parts of the economy and the quicker the economy can recover.  If, however, the capital equipment is very specific and specialized, then those tools might simply be thrown away and their total value is lost.  To simplify our cupcake store example, suppose that a single buyer purchases the whole store.  Since this buyer has purchased this store for a fraction of the original price, the new owner can make the very same products, sell them at the previously listed prices, but instead of losing $1,000 per week, the store could very well make a profit because its cost structure is much lower.

            In this liquidation process, the banks would lose a part of the value of their loans.  Through these liquidation sales, they will only get a fraction of the value loaned out.  These losses should be made painful to the banks due to their miscalculations.  However, the recent actions taken by the Federal Reserve has protected the banks from these painful lessons.

A new path

            The takeaway points are these: the bubble was caused by massive credit expansion.  The recession was inevitable, and the proximate cause was the forced closures due to Covid-19.  As the economy falls into recession, a continual inflating of the money supply bubble will not create a foundation for future economic growth.  Expanding the money supply will only delay the inevitable and ultimately make the situation even worse.  Furthermore, demand-side stimulus will not produce the “V-shaped” recovery.  Economic growth is generated by saving, investment and capital formation. 

            A three-pronged recipe emerges to quicken a solid and sustainable recovery.   The first ingredient is to build up savings relative to spending.  Savings are the cushion for a falling economy.  It is savings that bidders use to buy the liquidating businesses.  Without buyers of the liquidating capital, the recession cannot be converted into a recovery.  Thus, policies that can quicken a recovery are those that stimulate savings (not spending).

            One troubling point is how little Americans save.  In February 2020, the personal savings rate in the US was 8.2% of disposable personal income.  One of the most prominent features of the CARES Act of 2020 was the personal cash injections directly into people’s accounts.  The argument was that people needed that money to pay for rent, food and other basic necessities.  In contrast, the 2000/2001 tax rebate, as argued by President Bush, was for consumer spending.  In fact, the Bush stimulus was considered a failure because so few people spent the money on consumption.  Unfortunately, neither the 2000/1 nor the 2020 policies help to build up our savings fund.  The better approach is for the government to reverse its spend-and-inflate policies.  The cutting of taxes on activities that defer consumption will ultimately lead us out of the recession more quickly.

The second ingredient is deflation.  Economists have correctly associated deflation with recessions, but they have wrongly concluded that if we avoid deflations, we avoid recessions.  If a deflation is artificially created by a government, then yes, a recession will be the result.  However, deflation is the natural way in which an economy repairs itself.  It does so on two fronts.  The first is through the liquidation process.  In our example, the store had an oven.  Suppose that it was originally purchased at a price of $5,000.  If the new buyer spends $3,000 to acquire it, he has $2,000 which he could allocate to other factors of production.  Thus, as capital equipment prices fall, it becomes easier for new entrepreneurs to get started in the recovery process.  The second way in which deflation is beneficial is for the consumers.  As prices fall, their purchasing power grows.  This increase in purchasing power is especially important for those who are now unemployed.  If the weekly grocery budget was $300 per week, now the same amount of food can be purchased for less.

            The third ingredient is anything that can expedite the liquidation process.  Laws should be reformed to make the bankruptcy process easier.  Additionally, mergers and acquisitions should also be made easier. 

            During this crisis, it is unfortunate that many people are using this opportunity so advocate for socialism, nationalization, and the adoption of modern monetary policy.  Every time socialism has been tried, it has failed to produce enough wealth for its people.  The nationalization of industries have failed because bureaucracies simply cannot engage in economic calculation.  And while modern monetary theory may seem new and novel, it is nothing more than the repackaging of the ideas of the “monetary-cranks” of the nineteenth century.  It is now more critical than ever to return to what we know works—free markets.  History shows us time and time again that free markets generate sustained economic growth.  Adam Smith found the formula as early as 1755.

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.

It is not a coincidence that when nations liberalized trade and opened markets, there was an explosion of wealth for all—the rich, the poor and everyone in between.  This simple insight set off an upsurge of growth that has had a greater impact on humanity than any virus, natural disaster, or war.  It is time to simply let individuals be free.