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 19th 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. 5th 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 8th,
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 26th) 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.