Garrett Fisher
March 25, 2020
Prior to 2008, the economy featured a classic signature of a bubble: excessive asset prices detached from reality, where asset price increases compound due in part to speed and momentum and in part due to excessive leverage. To revisit how we got there, it is essential to look back to the preceding years. While a real estate boom was developing, a boom in lending occurred simultaneously. Mortgages were issued to borrowers without any realistic basis to assume that loans could be repaid, those mortgages packaged and sold, and buyers of said mortgages tended to be large financial institutions. Unregulated credit default swaps were generated, which technically should have insured banks from failures in these mortgages. Many of these CDS’ were functionally insolvent (recall the unregulated nature of the market). When the crap hit the fan, mortgages defaulted, CDS’ defaulted, and banks were hemorrhaging capital. It did not help that commodities, real estate prices, and stock values had also formed bubbles, and the whole thing came to an abrupt end.
Why the terminus of these values mattered is due to the banking system. Banks that thought they were solvent turned out not to be. Two major investment banks failed. Wachovia was experiencing a bank run. A variety of other banks (Indy Mac, Washington Mutual, etc.) triggered actual failures, where the FDIC had to intervene.
The problem with such a situation is that once dominoes in the banking system get pushed over, they begin to knock the rest over. When banks fail, uninsured deposits evaporate, which not only harms depositors; it literally dries up money supply by erasing cash. Depositors get scared and make runs on banks, which accelerates the problem. Banks stop lending. Liquidity dries up. Costs get cut. Layoffs ensue. With asset prices and markets seizing, share offerings or new indebtedness is no longer accessible. The Dow evaporated half its value, GM & Chrysler failed, AIG failed (rendering many required insurance products unavailable), Morgan Stanley, a third investment bank, went belly up….
Eventually the government stepped in to stop the dominoes. Between increasing FDIC insurance, forcing capital to the banks, and providing stimulus, the idea was to prevent the situation from accelerating into a full repeat of the Great Depression. One of the reasons the Depression was so awful was that the government initially did the reverse after the stock market crash of 1929: contracting credit, putting up trade barriers, and the like.
Once the shock of 2008 was over, it took years for the real estate market to process a growing wave of foreclosures as prices dropped from bubble pricing to more realistic fundamentals. Unemployment rates ever so slowly worked their way down, nursed by near zero interest rates and a newfangled concept: quantitative easing.
Prior to 2008, the Federal Reserve largely fulfilled its mandate through setting the federal funds rate, which is the interest rate that feeds most borrowing and deposit savings rates. By “leaning in the wind,” the Fed was trying to keep inflation in check while trying to realize maximum employment. By current standards, the practice constitutes extremely fine and iterative adjustments.
The crisis of 2008 brought on a variety of imaginative instruments, where the Fed kept markets pried open, dollars flowing through the system, and avoided seizure of money markets and other essential functions. At the time, there was a thing called “bailout fatigue,” as it became tiring to hear of yet another program that had not existed before. However, when it was all said and done, most of these items were mechanisms to keep markets open as opposed to outright stimulus or grants to affected institutions. Many were wound up, and the economy began to crawl out of its hole.
Another problem showed up across the pond starting in 2009, and then again in 2011. Europe experienced a triple-dip recession that was similar to the Great Recession that started in America, a product of their own debt bubble. First it was Greece, which had cooked the national books, floating sovereign debt based on fudged numbers in such excess that they could not pay it (resulting in the “national bankruptcy” I talk so much about). Other countries had varying levels of bubbles: Spain and Ireland come to mind. Italy and Portugal had their own sovereign debt crises that happened all at once. The problem was particularly fierce in that various European banks held such sovereign debt, which was now appearing to be at risk of default. America’s problem looked to happen in Europe with a twist: banks holding sovereign assets with declining value, rendering them at risk of insolvency.
Europe had to do similar things as America: pouring money on banks while the European Central Bank engaged in very similar programs as the Fed to keep markets pried open. Deteriorating European economic conditions naturally did not help global trade, and the United States began to see the need for continuing monetary policy accommodation, yet rates were nearly at zero. How could the Fed fulfill its mandate, when it was effectively out of ammunition?
I will pause for a second to note that this is the kind of situation that exemplifies the fear of the 2013 article: if lowering rates was the only conventionally accepted tool available, then we were screwed if more rate lowering was needed. We would have been forced to “take our medicine,” endure the consequences of the situation, and deal with economic contraction.
But we didn’t.
Enter Quantitative Easing, known as QE. To effect the same result as a reduction in interest rates, the Fed devised a program to print money and purchase either Mortgage-Backed Securities or Treasury Bonds off the open market. This would serve to a) directly lower mortgage rates by virtue of increasing MBS bond pricing and b) increase money supply by adding dollars to the system.
The idea worked, in that it aided the economy, and the dreaded day of reckoning did not come. However, the Fed did pump roughly $4T into the system, for which one would have assumed the Fed would need to reverse course. My 2013 article was in the middle of QE, and I thought to myself that, to get back to a sense of normalcy, metaphorically known as “paying off the national mortgage,” we would have to stop QE, reverse QE (through the sale of these bonds, achieving the opposite), and then raise interest rates. Could we really do all that before the next recession? My conclusion was that the next recession would do us in as these tools would not work, and we likely would not have reversed our position.
Well, how wrong I was.
When the stock market achieved 16,500 on the Dow, I was skeptical of how far it would go. At the time, I was reflecting on the fact that the 2007 high was incrementally higher than the 2000 high (itself four times higher than before the 1987 crash) and given inherent tepid growth (albeit consistent), I really felt things would reverse soon.
By late 2017, the Fed began to reverse QE, about halfway through its rate increasing cycle. To my surprise, a sweeping change to the tax code was passed late in the year, which was expected to produce enormous deficits. While the idea was sold to the people that the new law would somehow be revenue neutral; it was not. Deficits skyrocketed to roughly $1T per year, late in an economic expansion, during a period with astronomical Treasury debt, well in advance of a recession, and while the Fed was beginning to attempt to withdraw its excess stimulus out of the economy. Economists howled that we were pouring stimulus when it was not needed, eliminating tools in the event of a downturn, and running incredible deficits that would have unknown consequences.
And then, everyone stopped caring. Nothing bad happened. The Dow, which had already run on a tear above my fear point of 16,500, continued its methodical ascent to stratospheric highs. Were we experiencing MMT? Is this a New Economy? If anything, the stress of caring is reduced when employment is high and stock portfolios are doing well.
Yet, during the entire process, I couldn’t help but note that part of the situation felt different. Sure, economic fundamentals still hold true and I expected we would face a reckoning, yet something about the situation lacked the classic signs of a bubble, which told me something new as afoot.
Remember that a bubble is an unsustainable rise in asset prices out of herd mentality. It is usually debt-fueled, so by the time the whole thing comes crashing down, the outcome is quite poor. Bubbles differ from pure cyclical rises and falls. This situation smacked of imbalance, but it did not show signs of asset prices spiraling out of control, which I believe is due to an adjustment in some realities. I will now consider some elements which have changed from the Great Recession:
- The most important element of 2008 was the failure of the banks. Had the government not stepped in, toxicity stemming from mortgage-backed securities would have toppled the banking sector, creating a painful domino effect. Out of discipline, a society does not want an unfettered banking sector; some discipline should exist as these institutions lend depositor money. If bailouts were handed out indiscriminately, then the problem would recur; thus, a fine line was walked where banks were propped up out of pure necessity. Banks in 2020 are not inherently toxic.
- Interest rates have been at historic lows. Traditional finance assumptions with long-term average interest rates have the pressure of the time value of money. When that is normal or even high, then the underlying collateral must perform or it soon is pressed into default. Zero and negative interest rates are the norm in many places in the world, reducing pressure on borrowers and governments alike to address fiscal imbalances.
- It appears that there is a lack of a bubble “signature” in asset prices. While the stock market high of February 2020 was relatively significant compared to the 2007 high, it lacked a typical furious late stage rise to astronomical heights, something one finds in pure bubble scenarios. Instead, the rise was methodical, iterative, consistent, and over time. Some fundamental reasons for stock market valuations are as follows:
- The 2017 tax cut significantly reduced the tax bill for corporations. That in and of itself allowed for a spike in earnings per share, which is a fundamental driver of valuation.
- Many large companies undertook stock buyback programs, which use their [now larger] profits to reduce shares outstanding, thereby increasing earnings per share merely by a shift in capital.
- For some (though not all), P/E ratios were not necessarily absurd. While they were definitely cyclical and therefore priced at the higher point of the business cycle, evidence of a bubble is lacking.
- With low interest rates, interest-bearing products are less attractive than equities, as returns are higher owning shares versus fixed income. In the 1970s while inflation was high, equities performed comparatively poorly, due in part to the attraction of bonds and other interest-bearing options. The reverse is true with low to no interest rates in the last decade, driving share prices higher and return on capital yields to equilibrium.
- For reasons that I do not fully understand, US government record annual deficits have become normal for a few years, without any real public concern or consequence. It is likely that the situation cannot go on indefinitely, though I note that it is something that is profoundly different than in the past.
- The most important difference is Quantitative Easing. Conventional wisdom says that the printing of money has a direct consequence, which should be consumer inflation due to an excess of money supply. In the case of QE, targeted purchases were made by the Fed to lower mortgage and US government interest rates, resulting also in the provision of liquidity to the markets. The stated goal of keeping interest rates low (in effect furthering standard monetary policy) worked, with the reality that the Fed’s balance sheet has grown to a record size. Had QE not occurred, the economy likely would have languished for multiple years, if not produced a double or triple dip recession.
- When it comes to QE and government deficits, it is important to note that nobody is going to require QE to be paid back at any point in time. When the banking system nearly went over a cliff, it was due to the fact that the constructs of society and government would have enforced upon banks that they uphold their depository obligations, which forces the banks to ensure that their borrowers do the same. If a large enough portion of the underlying obligations fail, then the system collapses. The Fed, on the other hand, has no single or collective entity demanding that it take any particular action. While its decisions may have deleterious consequences in the long haul, there will not be a single catalytic moment that tips the Fed into failure.
- I perceive that there is likely a connection between high corporate profits, stock market performance, Fed QE, government deficits, and low interest rates. As such large parts of the economic puzzle, these components are likely functioning symbiotically, at least for the moment, so as not to create a specific trigger [yet] that causes failure.
I note these differences from 2008 to highlight the many reasons that my ‘economic fundamentalist’ article of 2013 was partially incorrect in that I expected a recession much sooner. These changes have created the longest economic expansion in history, though remember my preceding article in this series, where it is common during any boom to proclaim that “recessions are a thing of the past.” So far, 100% of the time, those illusions have been wrong and economic fundamentals speak loud and clear. The question then becomes, how would economic fundamentals exert themselves, and what form might it take?