“Hey wait a minute,” we hear you say. “The stock market is booming, close to the all-time high, and may be going higher. The jobless claims are down and the unemployment rate has been cut almost in half since 2011. The final employment numbers for 2014, just compiled last week, show a big increase in jobs.
“The dollar is soaring. And the sharp drop in oil may hurt some people, but cheaper gasoline is about the same as a massive tax cut for every family in America. If this is an economy in ruins, please sir, is there more?”
There are nits to be picked from each of those data points – employment statistics are notoriously suspect, and the roaring stock market will not last forever – but for the sake of argument, we’re prepared to grant them all.
And despite that, we still think a formal debate would demonstrate that the Federal Reserve’s unprecedented seven-year experiment in various forms of quantitative easing, now supposedly ended, has been net negative for the US in at least three important areas:
- It has depressed and distorted activity in the “real” economy, as opposed to the artificial economy of financially engineered paper assets;
- It has contributed mightily to the massively expanded income inequality that is disrupting the US social and political environment, and;
- It has greatly damaged the retirement system at precisely the moment it is needed most.
That’s a large argument, and we don’t have space to address all of it. So for the moment let’s stick to business – real business, not banking.
First, a note of caution. The Fed didn’t do all this by itself. There were lots of other influences contributing to the deterioration of US society over the past decade, and the Fed could reasonably make the case that it did what it did in a moment of crisis, for lack of a better alternative.
Regardless of the reasons, in general the results have been damaging to society at large, to individuals, and to many businesses. They may have saved the banks and the stock market – although the jury is still out on that question – but at the expense of everyone else.
The effect of quantitative easing (QE) is to keep interest rates extremely low. There’s argument about whether this is a bug or a feature – the principal beneficiary of low interest rates is the US government, which has some small influence on Fed policies – but nobody disputes the result.
Low interest rates sound wonderful. Everybody has a mortgage, and everybody’s mortgage is easier to manage, at least in theory. But excessively low rates distort almost everything else in the economy.
Business Activity Distorted
Suppose you run a business, and the cost of borrowing $1 million to expand your operations drops from 8% to 2.5%. Great. Now you have to decide how to invest that money for the best return. One way is by hiring more workers; another is to invest in modern equipment that increases productivity – i.e., it allows you to produce more with less labor.
If interest rates are high, the cost of investing in more equipment may be too expensive and lock you in to fixed payments that become hard to meet. If you hire more people and business goes bad, you can reduce your costs by laying some of them off. Your business has more room to maneuver.
Low interest rates encourage you to choose plan B, more machines, thus fewer workers. Good for you, at least for now, but bad for the people who lose their jobs … and arguably, for the society as a whole.
Now suppose you have been running your business for 20 years, and you borrowed $1 million for better machines back in the days when interest rates were 8%. Now you are vulnerable to competitors who can borrow much more cheaply to buy modern machines that allow them to sell at prices below your cost.
You go out of business and are replaced by your competitor. (This is the “creative destruction” so beloved of economists who don’t face unemployment in their 50s). But this is just churn, not economic expansion.
You have been replaced by your competitor, and a bunch of people in your company lost their jobs to a bunch of people in the new company. But there is little net increase in economic activity and the cost to the society at large is enormous.
In this case the effect of the greatly reduced interest rates has been to misdirect investment into areas that produce a net loss to the society as a whole.
And because one of the toxic consequences of misdirected investment is increased unemployment, and because increased joblessness reduces overall demand, your new competitor may not be doing so well either. At a minimum his business is now dependent on the cost of credit remaining low. When credit dries up again, as it did in 2008, he’s vulnerable.
What About Stocks?
Looking into the future, none of this is positive for the stock market. Corporate profits are high, and so are price to earnings multiples. Companies have cut costs relentlessly, mainly by reducing labor costs. And many companies, encouraged by low interest rates, have taken on about as much debt as they can afford.
So where is future growth going to come from? Lower costs? Higher multiples? Increased debt? Most of the juice has already been squeezed from those apples, and it is hard to see much more expansion there. If the Fed really does raise interest rates, the expectations for growth will be even lower. Some companies will find themselves in a much more difficult environment.
That’s one of the reasons investors are so jittery, and the market is thrashing round without making much real progress.
We’re short-term traders, and we make money on the way down just as well as on the way up. Maybe better.
But for financial managers with a few billion in assets under management, trying to find a little real growth, or for pension funds who used to earn 8% annually in risk-free investments, and now have a tsunami of benefits that have to be paid, 2015 is liable to be a difficult year.
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