A Strange Liberty: Politics Drops Its Pretenses

The Great Crash of 2020 was not caused by a virus. It was precipitated by the virus, and made worse by the crazed decisions of governments around the world to shut down business and travel. But it was caused by economic fragility. The supposed greatest economy in US history actually was a walking sick man, made comfortable with painkillers, and looking far better than he felt—yet ultimately fragile and infirm. The coronavirus pandemic simply exposed the underlying sickness of the US economy. If anything, the crash was overdue.

Too much debt, too much malinvestment, and too little honest pricing of assets and interest rates made America uniquely vulnerable to economic contagion. Most of this vulnerability can be laid at the feet of central bankers at the Federal Reserve, and we will pay a terrible price for it in the coming years. This is an uncomfortable truth, one that central bankers desperately hope to obscure while the media and public remain fixated on the virus.

But we should not let them get away with it, because (at least when it comes to legacy media) the Fed’s gross malfeasance is perhaps the biggest untold story of our lifetimes.

Symptoms of problems were readily apparent just last September during the commercial bank repo crisis. After more than a decade of quantitative easing, relentless interest rate cutting, and huge growth in “excess” reserves (more than $1.5 trillion) parked at the Fed, banks still did not have enough overnight liquidity? The repo market exposed how banks were capital constrained, not reserve constrained. So what exactly was the point of taking the Fed’s balance sheet from less than $1 trillion to over $4 trillion, anyway? Banks still needed money, after a decade of QE?

As with most crises, the problems took root decades ago. What we might call the era of modern monetary policy took root with the 1971 Nixon Shock, which eliminated any convertibility of dollars for gold. Less than twenty years later, in October 1987, Black Monday wiped out 20 percent of US stock market valuations. Fed chair Alan Greenspan promised Wall Street that such a thing would never happen again on his watch, and he meant it: the “Greenspan Put” was the Maestro’s blueprint for providing as much monetary easing as needed to prop up equity markets. The tech stock crash of the NASDAQ in 2000 only solidified the need for “new” monetary policy, and in 2008 that policy took full flight under the obliging hand of Fed chairman Ben Bernanke—a man who not only fundamentally misunderstood the Great Depression in his PhD thesis, but who also had the self-regard to write a book titled The Courage to Act about his use of other people’s money to reinflate the biggest and baddest stock bubble in US history.

In response to the coronavirus crisis, at least ostensibly, both the Fed and the US Treasury went into hyperdrive during March of 2020. The Fed’s response to the crash strains credulity, simply because it has been so brazen. In fact, any article about the Fed becomes obsolete in just a few days, as it announces new programs, credit facilities, and purchases at a dizzying pace. In just the past six weeks the Fed announced $700 billion in new rounds of asset purchases from banks, to the point where the financial press has lost count of which “round” of quantitative easing we are in!

But more QE was just the beginning. Fed officials also cut the Federal Funds rate to nearly zero, and announced that bank reserve ratio requirements would be eliminated as of March 2020. This puts a new twist on fractional reserve banking, because it is hard to have a fraction when the numerator is zero.

Apart from this, the Fed also initiated a $1.5 trillion program of short-term lending facilities, with borrowers providing as collateral anything from Treasury debt to commercial paper to securities backed by student loans, auto loans, and credit-card loans. But there is more: for the first time in history, the Fed will spend billions purchasing corporate bonds, perhaps the biggest bubble of all in an economy full of debt-laden companies which took advantage of cheap interest rates to buy back equity and generally substitute financial engineering for real growth. Helpfully, the Fed chose the world’s biggest asset management firm to run the corporate debt purchase program through various Exchange Traded Funds. And that firm, BlackRock, happens to be the world’s largest provider of said ETFs.

As a result of all this, the Fed’s balance sheet already has surged to over $6 trillion in mid-April 2020, and can anyone doubt it will soon be $10 trillion? Meanwhile, Congress managed to get involved with monetary policy through the backdoor in its $2 trillion “stimulus” bill called the CARES Act. The Act contains $454 billion to back an entirely separate Fed loan program for banks and corporations, a sum the Fed can leverage up to 10 times or $4.5 trillion. This is done using a “special purpose vehicle” under the auspices of the Treasury Department. This represents the melding of fiscal and monetary policy, the unholy blurring of any distinction (much less independence) of the Fed relative to Congress and the executive. It also represents the potential for another huge spike in the Fed’s balance sheet.

Of course neither Congress nor the Fed can get the nation’s fiscal house in order, no matter how much they print and spend. In fact, the 2020 federal deficit is projected at $4 trillion, which would represent more than 100 percent of likely tax revenue! $1,200 relief checks from the CARES Act will not go far when people are prohibited from working, and very little of the bill’s spending will trickle down to individual Americans. The cascading effect across retail business and restaurants, landlords and mortgage companies, the travel industry, and local tax revenue will be overwhelming.

As this economic crisis unfolds, we will know the Fed has lost control if one of two things happen:

First, if the influx of new money and credit so rapidly created by the Fed causes (or at least worsens) rapid price inflation for consumers. Unlike 2008, this new money creation is not going primarily into the monetary base as commercial bank reserves. It is flowing out across the range of Fed purchases, and already in January and February the M2 money stock grew more than 15 percent. In 2008, economists of an Austrian bent warned, correctly, that a vast and sudden expansion of the Fed’s balance sheet would have very harmful consequences. They were derided when hyperinflation did not materialize, but in fact there has been significant price inflation across a range of assets. Since the Fed has opened the floodgates far wider than in 2008, and since the residual effects of aggressive monetary easing since 2008 are still felt across markets, significant consumer price inflation is a real concern. If prices begin to rise noticeably, we will know the Fed has lost the ability to push off the day of reckoning.

Second, look for hiccups in the market for US Treasury debt which has implicitly relied on Fed backing since 2008. The Fed’s willingness to buy up Treasuries in huge numbers from commercial banks signals to the world it will always act as a backstop and “make the market” as needed. Ultra-low interest rates engineered by the Fed ensure that debt service does not grow too large in the annual federal budget—less than $500 billion annually at present. This keeps Congress happy, knowing they can spend wildly beyond tax revenues without much pain. But this is perverse: if investors know the Fed will buy assets at a certain price no matter what markets do, they are not buying an “investment” but rather a guaranteed upside with socialized losses—every hapless dollar holder becomes a de facto surety for US Treasuries.

But what if they held a Treasury auction and no one bid? What if demand weakens, especially as Uncle Sam pays less than 1 percent interest on a ten-year bond? What if foreign buyers, representing almost 40 percent of US debt held by the public, simply lose faith that the profligate US government will ever get its fiscal house in order? If the Fed became the primary buyer at auction, that too would send a signal to the world—and a bad one. Rising interest rates for Treasury debt would be a calamity for the federal government budget, as even historically average rates above 5 percent would spike debt service above $1 trillion annually. The entire inflationary program, using monetary stimulus to prop up flagging demand, is utterly dependent on a steady market for US debt paying near zero interest. From Keynes to Krugman, this is the program. But like a game of musical chairs, nobody wants to hold low yield Treasuries if rates begin to rise no matter what the Fed does.

So what now? What should we make of the Fed today?

James Grant of Grant’s Interest Rate Observer characterizes the Fed’s recent actions as a “leveraged buy-out of the United States of America.” The Fed is assumed to have an unlimited balance sheet, able to provide financial markets with “liquidity” as needed, in any amount, for any length of time. Pennsylvania senator Pat Toomey urges the Fed to do more, and Congress to spend more, all in the unholy name of liquidity.

But liquidity is nothing more than ready money for investment and spending. In the current environment it is a euphemism for free manna from heaven. It is “free” money—unearned, representing no increase in output or productivity. It has no backing and no redeemability. And not only are there no new goods and services in the economy, there are far fewer due to the lockdown.

So monetary “policy” as we know it is dead as a doornail. What central banks and Fed officials do no longer falls within the realm of economics or policy; in fact the Fed no longer operates as what we think of as a central bank. It is not a backstop or “banker’s bank,” as originally designed (in theory), nor is it a steward of economic stability pursuing its congressionally authorized dual mandate. It does not follow its own charter in the Federal Reserve Act (e.g., impermissibly buying corporate bonds). It does not operate based on economic theory or empirical data. It no longer pursues any identifiable public policy other than sheer political expediency. Fed governors do not follow “rules” or targets or models. They answer to no legislature or executive, except when cravenly collaborating with both to offload consequences onto future generations.

The Fed is, in effect, a lawless economic government unto itself. It serves as a bizarro-world ad hoc credit facility to the US financial sector, completely open ended, with no credit checks, no credit limits, no collateral requirements, no interest payments, and in some cases no repayments at all. It is the lender of first resort, a kind of reverse pawnshop which pays top dollar for rapidly declining assets. The Fed is now the Infinite Bank. It is run by televangelists, not bankers, and operates on faith.

That faith will be sorely tested.

This article is an excerpt from the introduction to the Anatomy of the Crash ebook , published by the Mises Institute, 2020.