The cold, hard truth is that this is the worst economic decision that a society can make.
Wealth will be gathered from all by devaluing the dollar, enabling a few in Washington to redistribute as they see fit. Instead of the invisible hand funneling wealth to the productive and successful, much will go the well-connected.
Will there be a price to pay?
Most of us are familiar with stock market corrections, the most recent taking place in March of 2020. For whatever reason, a market selloff begins, building momentum as the panic sets in, with more and more stocks being put up for sale. As long as the supply exceeds demand, the prices continue to fall, stabilizing only when supply and demand are once again in equilibrium.
Those that panic and sell during such a correction tend to lose wealth, while those with both cash and nerves of steel, who buy when everyone else is selling, tend to gain wealth.
Unless they are in the process of issuing stock to raise cash, the price of a company’s stock does not have that much impact on the company itself, thus a stock market correction, while good content for financial talking heads, does not in itself directly affect the economy. Think of it as an indicator that there is a perceived problem with the economy, causing investors to run for cash.
Of greater concern, and not so familiar to most, is a bond market correction. The bond market in the U.S. alone is valued at $40 trillion, double the value of the stock market, with about $700 billion in bonds traded every day.
The lack of familiarity can be attributed to the fact that there is not a transparent bond market available to individual investors, i.e., no NYSE for bonds. Nevertheless, most of us are invested in bonds via our IRA’s and 401k’s. After all, if no one invested in bonds, how would you take out a home or car loan? How could governments borrow if no one is lending?
In my prior blog (Understanding the Wealth Flow of Bonds), it was noted that if interest rates, for whatever reason were to increase, the value of bonds would fall, and just like with the stock market, potentially providing the catalyst for a bond market selloff, as bond holders, fearing that the value of their bonds may drop even further, attempt to sell their holdings all at once.
Which in turn pushes up interests’ rates even higher, because as the demand for bonds decreases relative to the supply, those that need to borrow are forced to offer better terms, namely, higher interest rates.
Unlike a stock market correction, a bond market correction will have a very direct impact on the economy as the cost of borrowing increases for all, and we are a very debt driven economy.
OK. So how to prevent such a bond market correction? The obvious solution is to not let interest rates increase, to prevent the “spark”. Which is exactly what the Federal Reserve has been doing for some time, by creating bank credit that is used to purchase debt. This artificial demand for debt is referred to as “Quantitative Easing”, which was so named to discourage anyone from understanding what it actually is.
If the demand for debt falls (normally resulting in higher interest rates), the Federal Reserve steps in, reestablishes the demand for debt, thus keeping interest rates low.
Sounds magical, what is the tradeoff? That would be an increase in the Monetary Base:
Which has dramatically increased from $3.4 trillion to over $5 trillion in 2020 alone.
Also reflected in the increase in the M2 Money supply:
The zillion dollar question is, can the Federal Reserve do this forever? Just keep absorbing debt (which coincidentally enables our Federal Government to operate at a deficit), by increasing the Money Supply, which is essentially the amount of dollars in circulation.
If you are a proponent of Modern Monetary Theory, then yes, you believe that this can go on forever.
I personally do not subscribe to this theory, because the price to be paid will be a devaluation of the dollar, coupled with a less efficient economy.
Will this increase in the money supply eventually devalue the dollar? In the long term, no doubt. In the short term, as in year 2021, not so clear, because the forces of demand and supply on the dollar, which establish how much wealth a dollar stores, are more complicated than you would think.
Some of the forces on the value of the dollar are:
- The faith in the dollar as a money
- The money supply (per capita)
- The aggregate (total) supply of goods and services
- The aggregate (total) demand of goods and services
- The velocity of money (transactions per day per capita)
- The Forex (Foreign Exchange)
- Demand for the dollar as a global reserve currency
For example, one impact of the Covid partial economic shutdown has been an overall drop in the demand for goods and services, a decrease in the aggregate demand. In other words, people have been spending less. A drop in aggregate demand tends to increase the value of the dollar, because as demand for products and services decrease, there will be an oversupply of products and services, resulting in price reductions. Which is the same as a dollar buying more, a deflationary force.
Which can help explain why there has been no measurable increase in inflation in 2020, even as the money supply dramatically increased. The inflationary force of increasing the money supply countered by the deflationary force of a dramatic reduction in aggregate demand.
What can we expect in year 2021? The deficit spending will continue of course, increasing the money supply, but does it not stand to reason that with a vaccination available and distributed, people will start spending again, driving up aggregate demand?
Instead of cancelling, there will now be two inflationary forces on the dollar, rowing in the same direction.
If inflation were to increase above the target 2%, expect the Federal Reserve to take countering measures, the opposite of Quantitative Easing, otherwise known as “Quantitative Worsening”. That is right, they would very reluctantly increase interest rates, because no one wants high inflation. Been there, done that.
Which brings us back to the bond market correction scenario. Will this happen in 2021? Will we return to “normal” interest rates? What does that imply?
There is a price to pay for shutting down an economy, for paying able body people not to work. Not sure what it is exactly, but I suspect that we are about to find out.