Category: Money and Monetary Policy

The Federal Reserve recently lowered its benchmark interest rate. Meanwhile yields on 10 and 30 year U.S. Treasuries are at or near record lows, as are rates around the world. And according to recent news articles, nearly 25% of government bonds worldwide have negative yields, some $15 trillion worth. Moreover, the likelihood of negative rates in the United States seems greater with each passing day, especially given the political pressure being applied by those in power.

I’ve written elsewhere about the immense dangers of easy money and modern central banking policy. However, given today’s downward trend of interest rates, a decade after the 2009 financial crises, I wanted to write a short post summarizing the major downsides of prolonged and artificially low interest rates. To keep this discussion at a breezy pace, I am not going into the wonkish mechanics of monetary policy nor will I burden you (or me) with any more numbers or statistics. I will simply attempt to make the case that the side effects of low rates are vastly underappreciated, and highly damaging

However, before we start discussing these downsides, indulge me for a very quick and high level primer on the theoretical rationale for low rates.

The rationale for low rates

Economists and central bankers are trained to believe the following: when the economy is experiencing negative or slow growth, and when unemployment is unacceptably high, it is the central bank’s duty to lower interest rates. Why, you ask? Because companies are more likely to invest in building a new factory or opening a new store when the funds needed to do so are cheaper. And building and operating a new factory or a new store requires additional employees. Thus by making the funds necessary for investment less expensive, central banks expect the unemployment rate to decline. Factories get built that otherwise would not have been built. Stores are opened that otherwise would not have opened. Employees are hired that otherwise would not have been hired.

In a similar way, low interest rates encourage consumers to spend more money. Like businesses, they too have an easier time borrowing to finance such purchases as houses and automobiles. In addition, low interest rates act to discourage saving since the amount earned on savings (the interest income) is reduced. In both instances, increased consumer spending acts to decrease unemployment as additional workers are needed to provide the incremental goods and services being purchased.

The simple rationale for low interest rates that I just described relies on several key assumptions. The most important is that the money that companies borrow because of low interest rates winds up being invested in job-creating ways. The second is that the money is invested in job-creating ways in the domestic economy, and not overseas. The third assumption is that interest rates can only remain low whilst unemployment is high. Once everyone who wants a job has a job (known as “full-employment” or the “natural rate” of employment), cheap money no longer works to goose hiring and economic growth. Instead, low interest rates cause prices to rise (inflation) as companies have to raise wages to hire not the unemployed, but those employed by competitors. The last major assumption is that monetary policy is a short-term solution to a temporary (not a long-term or structural) problem of high unemployment.

Unfortunately, all four of these key assumptions are false, undermining the theoretical rationale for low interest rates. The vast majority of the money invested because of low interest rates has been invested in unproductive and job-destroying ways, as we shall shortly see. Second, much of what has been invested in job-creating ways has gone overseas as U.S. companies accelerate the trend of outsourcing and offshoring. Third, the official unemployment rate in the U.S. is at record lows (currently 3.7%), far lower than what economists used to consider full employment even during high growth eras. Lastly, we’re now going on a decade of historically low interest rates (never before seen in thousands of years of recorded history) with no end in site. Clearly not a temporary solution to a temporary problem.

In short, low interest policy doesn’t do what economic theory says it is supposed to do. But who cares right? No harm, no foul? Wrong. The problem with low interest rates is not that they don’t work. The problem is that the side effects are enormous. Let’s now move on from the discussion of theory to the very practical. What are those terrible side effects? What are the most significant downsides of perpetually low interest rates?

The missing inflation

One of the things most confounding to central bankers and mainstream economists is the lack of inflation given a decade of extraordinarily low interest rates. Recall that economic theory says that once employment is full, further monetary stimulus should cause a rise in inflation. And yet the key rates of inflation such as the consumer price index (CPI) have rarely exceeded the 2% target set by central bankers. Central bankers have hence concluded that full employment must not be yet met, and further stimulus is both necessary and good.

A while ago, I wrote a lengthy post explaining the conundrum of the missing inflation which I of course encourage you to read. For our purposes here, however, we need to concern ourselves with only one aspect of that explanation. Inflation is hiding in plain sight and it is having a terrible effect on consumers and the overall economy. Why economists are blind to this is one of the unsolved mysteries of the universe.

The missing inflation can be put into three categories. The first is non-tradable goods and services or more simply stuff that can’t be made in China and other low-cost producing countries. Prime examples of that stuff? Real estate, education and healthcare. Over the prior several decades of easy monetary policy, and certainly over the past 10 years, the inflation rate on these three giant categories of consumer spending has vastly exceeded the rate of the CPI. And while this inflation hurts nearly everyone, it especially impacts younger workers who face the trifecta of enormous students loans, unaffordable health insurance and sky-high home prices. We will come back to this point later when we talk about weakening demographic trends.

The second category of the kind of inflation not found in the CPI is financial asset inflation (which also includes real estate). The damage of asset inflation is at least threefold. First, it all but guarantees lower returns going forward, in essence taking consumption, income and wealth that should be in the future, and should belong to today’s younger generations and shifting it forward to today’s older, wealthy generation. This is a generational transfer of wealth that is both unfair and exacerbates income inequality. Second, as we will discuss in further detail, asset inflation affects income inequality even further as the wealthy who hold financial assets see their wealth climb even higher. Third, asset inflation increases instability in the financial system and with it, the inevitable risk of future financial crises and meltdowns.

The third type of inflation that is missing from the CPI is something that typically keeps economists at central banks awake at night. This is the classic wage/price spiral, a cycle of continuously rising wages and rising prices that feed on each other. The difference, however, is that the inflationary wage/price spiral occurring today is not happening to the average consumer represented by the CPI. Instead, this inflation is happening to the highly skilled and to the wealthy.

Evidence for such a wage/price spiral can be clearly seen when examining the salaries of technologists in San Francisco or those of financiers in New York, and the things they buy. We’ve experienced a continuous cycle in such cities of rising income, rising real estate prices and rising restaurant and luxury hotel prices. You can also see the dramatic inflation in the skyrocketing prices of scarce and luxurious collectables favored by the wealthy and ultra-wealthy such as modern art, fine wine and professional sports teams. The higher the prices or the more stratified the goods, the higher the rate of inflation. Not only does this trend exacerbate income inequality, as we will discuss later, but it causes vast distortions to the economy as an inordinate amount of economic resources are utilized producing luxury goods and services for the few, rather than middle class goods and services for the many.

The mortgaging of the consumer

We’re already discussed the idea that one of the primary goals of easy monetary policy is for consumers to spend more and save less. And not just spend more and save less out of income, but to incur debt to spend more. The impact of both the disincentives to save and the low income earned on the little money that is saved, is an overly indebted consumer class with no rainy day funds, no retirement savings, no equity in their homes and one completely dependent on government funds for retirement. Add to the mix insolvent pensions (discussed next), soon-to-be insolvent social security, rising healthcare costs (discussed previously) and bad demographics (discussed later), and you’re left with a ticking time bomb for the consumer middle class.

The implosion of pensions

While interest rates have caused a slowly ticking bomb for consumers, the clock on pension implosion runs much faster. Pensions have to invest workers contributions in order to meet projected retirement payouts in the future. Similarly, insurance companies have to invest insurance premiums to meet their forecasted insurance payouts. Pensions along with insurance companies represent by far, the largest pools of savings in the economy.

Historically these types of institutional investors invested prudently in relatively safe assets such as government bonds. But as you of course know, returns on relatively safe assets such as government bonds are paltry given the workings of central bankers. The only way for pensions and insurers to even attempt to achieve the returns required to meet future liabilities is to take on more and more risk.

The obvious problem of taking on more risk is that it is, well, riskier. Pensions have increased their holdings of stocks in lieu of government bonds, of high yield debt in lieu of highly rated debt, and especially of so-called alternative assets such as private equity and hedge funds. When the next financial downturn hits (and in the life of a pension or insurance policy, it certainly will), riskier assets will prove a disastrous investment.

To add insult to injury, many of these pensions, specifically those of state and local governments are already woefully underfunded, and people are generally living longer. Together, you have all the makings of a crises that can only result in either drastic cuts to basic government services, drastic cuts to retirement income, or more likely, both. This inevitable outcome will not be pretty.

Insolvent pensions are actually the smaller of the two evils of too much investment in risky assets. The less obvious but more damaging result is that investors such as pensions are subsidizing investments that are directly detrimental to jobs, to the middle class and to the long-term health of the economy. Specifically, they are subsidizing financial engineering, M&A and unproductive technology companies. These are the subjects of the next three sections.

The job destruction of financial engineering

As I mentioned earlier, due to low interest rates, institutional investors have been forced to put money into riskier stocks and highly leveraged or high yield debt. If that money was in turn invested by companies in new factories and stores we would likely conclude that monetary policy is working. But it’s not, and it isn’t. Most of the money is going instead to what we can loosely categorize as financial engineering: stock buybacks, mergers and acquisitions, hedge funds and private equity.

The economic problem with investing in such financial maneuvers, is that such financial maneuvers nearly always result in fewer jobs, not more. Funds used to buyback stock could have been used for investment in new products or new services, in capital expenditures, in R&D. Acquisitions nearly always result in job cuts in the name of synergy and often in increased outsourcing and offshoring. Hedge funds, always short-term oriented, and especially the activist variety, put immense pressure on companies to downsize, to under-invest and to return money to shareholders, money that otherwise could have been invested productively. Private equity forms do the same to their portfolio companies, and with the greatly increased risk of value and job destroying bankruptcies.

The creation of M&A fueled monopolies

As we’ve already discussed, low interest rates leads naturally to inflated equity prices, riskier investments and increased financial activity such as mergers and acquisitions (M&A). We’ve also mentioned how M&A leads to the destruction of jobs. However, there is an even worse impact of the M&A activity in the cheap money era. It has led to unprecedented and massive consolidation in nearly all industries, and the creation of monopolies.

Highly consolidated industries and monopolies always result in some combination of higher prices, less innovation, worse service and (obviously) fewer choices. Facing little competition, monopolies tend to under-invest in product development, in customer service, and in basic R&D, and over-invent in political lobbying in order to maintain their market position and keep out new entrants. Moreover, size begets political power and political power begets size as monopolies lobby for regulation, tax advantages and subsidies. Lastly, industry consolidation is perpetuated as monopolies have the subsidized funds to acquire any and all companies they view as potential competition. While this has happened in virtually all industries, as I stated above, nowhere has this been more prominent than in technology.

Contrary to what is believed in conservative and libertarian circles, it is monopoly, not government that is the true enemy of the free market and the true enemy of freedom.

The parasite of subsidized technology

I’ve talked about how much of what has been invested in the era of low interest rates has gone to financial engineering such as M&A rather than used by companies to build or expand their businesses. It is certainly unfair and untrue to state that there has been no real investment in businesses. This is especially true in the technology sector. However, even more so than in finance, the investment in technology has been generally unproductive, job destroying, and altogether calamitous for the economy.

The parasitic nature of technology, specifically the internet is a topic I wrote about in depth here. We have been trained by both economists and the media to think of technological advancement as a positive for the economy and for the world. In a world of normal interest rates that might have been true. But in today’s world, the impact is decidedly negative. I’ll go as far as to say that the internet might just be the worst thing to ever happen to human beings.

Let’s take the behemoth Amazon, my favorite internet punching bag. Amazon has, in fact, created hundreds of thousands of new jobs. The problem, however, is that Amazon’s retail operations (the vast majority of its revenue) has come at the expense of traditional retailers. For every job Amazon has created, several more have been destroyed, with an outsized negative impact on small, local retailers and local commercial real estate. Job destruction of this nature is pervasive throughout the tech industry, and given its disruption of traditional industries, pervasive throughout the economy.

Naturally, there are those who say that the Internet represents creative destruction at its finest. That such job destruction is both productive for the economy, and inevitable. Such people are mistaken. The vast majority of tech companies, Amazon included, either lose enormous sums of money with unsustainable business models, or at best, earn far lower margins than the traditional companies they have disrupted (margins that would be totally unacceptable in investors in a world of normal interest rates). Uber, Netflix, Twitter, Tesla, WeWork are just a few more examples of highly disruptive technology companies that have lost, or continue to lose billions. These companies are completely subsidized by the unceasing flow of cheap money.

As destructive as the technology industry has been to jobs, we are unfortunately just scratching the surface of the damage these companies have done to society as a whole. By making information free, by violating copyright, by failing to police their content as a traditional publisher would, by abusing their monopolistic and political power, technology companies have among other things, incited hatred and terrorism, undermined elections, destroyed privacy, decimated journalism, undermined truth and fact, increased loneliness, reduced a sense community, cut attention spans, killed intelligent thought and debate, popularized and brought into power fringe politicians and caused irreparable damage to democracy and freedom.

Every day another article or academic study appears in one form of media or another about the damage that technology companies and the internet have caused. A consensus seems to be building that both the underlying cause and the solution to society’s internet problem are anti-trust laws. That lax anti-trust enforcement allowed these tech companies to become so powerful and that only strict enforcement can now restrict that power. This consensus is wrong. The real culprit is the subsidy of easy money. These companies would never have become as powerful without the perpetual low interest rates. And the only way to reduce their power is to take away that subsidy.

The cancer of income inequality and the demise of democracies

As I’ve written about in great depth and in summary form, the central banking policy of low interest rates is the single most important cause of the drastic increase in income inequality of recent decades. To best understand this trend, it helps to separate income inequality into two types: the decline of the middle class and the rise of the super wealthy.

The story of middle class decline is as follows. The entrance of China and other low wage manufacturing countries to the global economy caused wage pressure in high wage countries such as the United States. Regulations, unions and legacy pension costs together wouldn’t allow wages to fall to remain competitive. Instead factories, businesses and entire industries went bankrupt and closed. Laid-off workers were forced to take jobs in much lower wage service jobs, as second-class citizen contractors lacking benefits, or more recently, in the gig economy.

Meanwhile, while prices of goods from China (and elsewhere) did decline, the overall price level did not. Why not? Because the central bank kept their foot on the monetary gas pedal. Partially because of their illogical fear of deflation, partially due to their naive desire to eradicate the business cycle and partially because of a series of Wall Street bailouts. The money had to go somewhere.

As we discussed earlier, what prices went up the most? Real estate, healthcare and education. These all became unaffordable to the middle class. Further, low interest rates allowed more borrowing in order to fund those purchases of Chinese goods, and outsourcing and offshoring were expanded due to M&A transactions and hedge fund short-termism. All of these factors acted to accelerate the globalization trend farther, and with far more impact on U.S. jobs than it otherwise would have had there been normal or market interest rates. In short, declining wages, fewer jobs, rising prices, and over-indebtedness created middle class despair.

The second, and even worse type of income inequality that the entire world has experienced is the the wealth accumulation by the rich and the super rich. Here the blame lies even more so at the door to the Federal Reserve and the world’s other central banks. The low interest rates that have caused the subsidies to financial engineering such as M&A, and to growth and risky investments such as technology have caused the income and wealth of public company CEOs, tech entrepreneurs, venture capitalists, hedge funders, investment bankers, private equity partners, and many others to skyrocket. With risk and correspondingly growth subsidized, all of the economy became a “winner take all” game. And of course the inflation in financial asset prices due to low interest rates perpetuates the growth of inequality.

Combine these two trends of a sputtering middle class and the wealthy getting wealthier and more politically powerful and you sow the seeds of populism, socialism, unrest and ultimately revolution.

The strangulation of economic growth

Central bankers, politicians and nearly all voters focus only on short-term results. This is one of the inherent problems of democracy. In this last main section, I want to talk about long-term economic growth. In many ways, this serves as a summary of everything we’ve covered before. We’ve discussed how low interest rates have shifted spending forward by decades which will result in lower economic activity in the future. We’ve talked about how pensions won’t have the money to pay retirees. We’ve also mentioned how asset inflation sets the stage for future financial crises. But those are not the only, or even the worse impacts on tomorrow’s economy.

Over the long-term, economic growth is essentially a function of two basic factors: productivity growth and population growth. Low interest rates kill both. As we’ve discussed a number of times, subsidizing risk has led to under-investments in basic R&D and long-term product development. It has led to stagnating monopolies and unproductive technologies.

But perhaps most importantly, it has led to under-investment in employees and their skills. With layoffs and downsizing always around the corner, lifetime employment dead, independent contractors and gig workers flourishing, employers no longer invest in their employees, and employees no longer invest in their employers. Productivity is a difficult concept and misunderstood by many. While technological breakthroughs like the cotton gin, electricity, the automobile or the computer get the headlines, they are rarely what drives productivity growth. What more typically drives productivity growth are the small, incremental improvements made by long-term employees increasing their skills and knowledge, and invested in their jobs and careers. Without such long-term employees, these kind of productivity improvements wither away.

The second variable of long-term economic growth is population growth, which is itself a function of two factors, child birth and immigration. And yet again, monetary policy has negatively impacted both. Young people crushed by student loans, sky-high real estate prices, unaffordable healthcare and poor job prospects delay getting married and having kids. Or worse, fail to do so entirely. At the same time, middle class despair together with technology-fueled misinformation and nativist sentiment supports populist-style leaders and erodes support for immigration.

Taken together, population growth is stifled. This is exactly the situation of Japan where three decades of suppressed interest rates have caused a demographic implosion, in essence, a dying country. The United States and Western Europe are following in Japan’s ever diminishing footsteps.

Conclusion

Well meaning but unwise central bankers have backed themselves into a corner as the world has become addicted to cheap money. Unaware of the consequences, blind to reality, slave to erroneous theory, and bullied by political pressure, economists in power have suppressed interest rates, causing immeasurable economic distortions and societal damage.

Continue current policy and yes, you likely delay the inevitable restructuring of the worldwide economy. In the meantime, the middle class continues to be crushed, income inequality keeps rising, productivity stagnates, monopolies flourish, demographics worsen, political power consolidates, truth and fact lose significance, populist and socialist leaders surge, democracy and freedom crumbles.

But assuming we survive all these things – and we may not – sooner or later we will experience a crises that no central bank can print their way out of. One that dwarfs the financial meltdown of 2009. When, I don’t know. Perhaps months from now, perhaps years, perhaps decades. But for sure it will come.

Normalize interest rates now and the value of financial assets will plummet. Wall Street and Silicon Valley will crater. Unemployment will rise. The global economy will likely go into a depression. But the world that will emerge, and it will emerge, will be more productive, more equal, more fair and more free.

Making the right choice isn’t easy. It may be politically impossible. But the first step must be education. Until central bankers, politicians, the media and voters awaken to the reality that the downsides of low interest rates far, far outweigh the upsides, the U.S. and the world will continue forward, on its disastrous course.

The one question I’ve been asked more than any other over the past few months is what do I think of Bitcoin and other cryptocurrencies. Specifically, are they the future of money? The answer is no.

There are a host of reasons why cryptocurrencies like Bitcoin will probably not supersede government fiat money. Lack of security, hackability of accounts and price volatility are foremost. Perhaps these are solvable. However there are three reasons why Bitcoin definitively cannot and will not ever be considered mainstream money.

1. The environment impact of Bitcoin (and similar blockchain based cryptocurrencies) is atrocious because the electricity requirement for Bitcoin mining is enormous. Sooner or later (and this has already begun), municipalities, governments and regulated utilities will prohibit and/or tax cryptocurrency mining due to its environmental impact. Further, private individuals will be shamed from using such currencies as the environment impact becomes more widely known.

2. There is unlimited supply of cryptocurrencies. To be clear, the supply of any single currency, such as Bitcoin, is not unlimited. In fact, for Bitcoin the ultimate supply is capped (in and of itself another problem since the quantity of money should more or less grow with the economy). But there are literally thousands of such currencies that exist today and untold more that can exist tomorrow. With the underlying technologies public knowledge, there are no barriers to entry to prevent new cryptocurrencies from being created, and no limit to the supply of money.

3. The foundation of cryptocurrencies and blockchain technology is that they are decentralized. That is, accounting and transaction records exist not on a single computer (i.e. of a government or a bank) but on many private computers. The purpose, of course, is to keep transactions private and out of the view of government agencies. How long do you think governments would allow this to continue if more and more financial transactions became untraceable, unregulatable and untaxable? Not very long, methinks. Simply put, the governments of the world will not allow cryptocurrencies to become mainstream money.

If not mainstream money, what will cryptocurrencies like Bitcoin be useful for in the future? Same uses as today. Black market activity and speculation. Nothing more, nothing less.

An economics student with whom I’ve been corresponding recently relayed to me that his economics professor stated that the Federal Reserve’s policy of quantitative easing (QE) did not equate to printing money. This question causes a lot of confusion between economists and non-economists so it seemed like a good topic for a quick post.

So, should QE be considered money printing?

At first glance it should. In fact, if you Google the term “quantitative easing,” Google provides the following definition, “the introduction of new money into the money supply by a central bank.” Similarly, Wikipedia starts off its entry on quantitative easing with, “Quantitative easing (QE) is a monetary policy in which a central bank creates new electronic money in order to buy government bonds or other financial assets to stimulate the economy…”

Before we go further, let’s understand the basic mechanics of quantitative easing. In a nutshell, the Federal Reserve (or any other central bank) purchases long-term bonds from banks and other financial institutions using newly created money. Now, when we use the term “newly created money” we do NOT mean that the Fed prints a whole bunch of brand new Ben Franklins ($100 bills, for those of you reading this outside the U.S.). Instead, the Federal Reserve makes an electronic entry in its computer system, indicating brand new money.

Let’s say that the Fed purchases $1 million of bonds. On its balance sheet, the Fed records a liability of $1 million reflecting the brand new (electronic) money that it created and records an asset of $1 million reflecting the bonds it just bought. The Fed’s balance sheet is now larger by $1 million than it was prior to the purchase.

Now let’s look at the balance sheet of the bank that sold the bonds. On the asset side, the bank now holds $1 million of additional cash (in the form of reserves) courtesy of the Fed’s new money. Also on the asset side, it has decreased its holdings of bonds by $1 million. Hence, there is no change to the net value of the bank’s assets (and no change to its liabilities).

The simple answer to whether quantitative easing is printing money is clearly yes, since the Fed creates new money in order to purchase bonds. As we’ve seen, the Federal Reserve’s balance sheet increases by $1 million. The commercial bank’s balance sheet doesn’t change (the makeup changes but not the amount). So the net effect to the entire system is a $1 million increase. However, to economists, the story does not quite end here.

Economists argue that while the Fed is technically creating new money, it is not actually increasing the money supply. And here we find that the question of whether or not QE is money printing is really a semantic argument rather than a true economic argument. In essence, it boils down to whether “printing money” is the same thing as “expanding the money supply.”

The argument that economists make is that what the Federal Reserve is really doing is an asset swap. The Fed is merely swapping newly created money for bonds. The key point economists are trying to make is that once the Fed owns those bonds, they are not really part of the economy and should not be counted as part of the money supply. In essence what economists are saying is that ONLY the private sector banking system, by making a new loan, can expand the true money supply. The central bank cannot expand the money supply by creating electronic money.

Is this true? First, it depends on what your definition is of the “money supply.” There is no one agreed upon definition of the money supply and in fact economists have different measures of the money supply (e.g. M1, M2, M3). Ultimately, you must pose the question, “what is money?” The true meaning of money is equally important, complex and misunderstood and something I do not dare tackle here, but hope to in a future (and much longer) post. For now, I reiterate what I said earlier in this post, that whether quantitative easing is or is not money printing is really a semantic discussion, and not an important one.

There are much more important, and economic (rather than semantic) questions to discuss regarding QE, which we will turn our attention to shortly. However, before moving on, I want to add one point to the discussion. I would argue that when the Federal Reserve purchased bonds from the private sector financial system, it paid MORE than fair market value, given its massive size and status. Hence, by overpaying (compared to what others would have paid), QE was not exactly a one-to-one asset swap.

For example (and I’m making up numbers here) if the true market value of a bond was $80 and the Fed paid $100 then the $20 difference should indeed be considered “money printing” even if you take the position that QE is, otherwise, an asset swap. To be fair, not being a bond trader, I have no idea to what magnitude the Fed overpaid but I would bet that they did, especially for the mortgage backed securities (MBS) that the Fed purchased (the Fed purchased both US treasures and MBS in its three rounds of QE).

There’s an additional argument that some economists and commentators make with regards to QE not being money printing. They claim that even though the Federal Reserve expanded its balance sheet by trillions of dollars under QE (and ZIRP), because there was no meaningful inflation (not to mention poor GDP growth and poor employment figures), Fed policy cannot and should not be considered to be “printing money.” I’ve written previously (here) a post on why the Fed’s extraordinarily loose monetary policy hasn’t led to inflation. Briefly, however, I believe this line of argument is faulty for two reasons.

First, it is erroneous to equate expanding the money supply with inflation. This fallacy is, in my opinion, one of the reasons why the Fed (and other central banks) have caused so much damage to the world’s economies. I have and will continue to write about this topic elsewhere, but simply put, measures of inflation such as the CPI and expanding the Fed’s balance sheet are two different things. It is even less true to say that the money supply can be equated to economic growth or employment.

Second, and much more importantly is the counterfactual. How do we know what would have happened in the absence of QE? We know that the U.S. economy (and many others) was facing enormous deflationary pressure after the financial crises. This is precisely why the Fed along with other central banks resorted to unprecedented and extraordinary policy. It is certainly possible, and perhaps likely, that absent QE, the economy would have experienced substantially lower GDP, lower employment (higher unemployment) and even lower inflation (or deflation).

If true, then QE was certainly inflationary even if the CPI was ONLY 2%. In short, to state that a massive amount of QE cannot be considered inflationary (or be considered printing money) simply because the economy did not overheat is bad science and holds no water since we have no idea what would have happened without QE.

As I wrote above, I believe that the question of whether quantitative easing is technically “money printing” or not, is a semantic one and of little importance. What is important are the following three questions: 1) what was the purpose of quantitative easing, 2) did it work and 3) was it justified.

What was the purpose of quantitative easing?

At the highest level, the goal of quantitative easing was to help the economy. First, to help prevent the economy from falling into a depression and to help stave off deflation (both, real fears to central bankers after the financial crises).  Second, to help expand the economy faster, to reduce unemployment, grow wages and increase inflation.

Specifically, as we’ve already discussed, the Federal Reserve was buying long-term bonds (Treasuries and MBS) in order to reduce long-term interest rates. This was a new policy because historically the Federal Reserve only purchased short-term debt in order to target short-term interest rates. However, given that targeted short-term interest rates were already at zero because of the central bank’s zero-interest rate policy or “ZIRP,” the Fed decided to target long-term rates.

The stated goal of lower long-term interest rate was to encourage borrowing. For example (in theory), lower long-term rates should lead to lower mortgage rates, which should induce more people to buy new homes. Similarly, lower rates should make it cheaper and easier for businesses to borrow to build new factories or open new stores. The end result (again in theory) being more economic activity, higher GDP, more jobs and lower unemployment rates.

There were at least two other goals of QE, both significantly less talked about by central bankers, for what should be obvious reasons. One was to help members of the banking sector “repair” its balance sheets. The idea being that an unhealthy bank is unlikely to lend. A bank with a healthy balance sheet more likely to lend, and thus aid the economy. That’s the polite way of looking at it. The more cynical viewpoint is that QE represented further bailouts to the banking sector. (One of the reasons why, as I discussed above that I suspect that the Fed was paying above market prices, especially for MBS, whose value otherwise should have been marked down).

The second less discussed goal was to directly increase the price of financial assets. This idea is known in econ-speak as the “wealth effect,” an idea in which the Federal Reserve seems to believe. Other things equal, lower interest rates raise the value of all financial assets. The wealth effect posits that individuals whose financial assets have risen in value (and therefore have more wealth) will consume more. More consumption (other things equal) naturally leads to a faster growing economy, more investment and less unemployment.

Regardless of which of the Fed’s motives you believe were more important, in all cases the intent of QE was to spur lending in order to grow the economy faster (or prevent it from shrinking). And, as I stated above, every loan that the banking sector makes is considered an expansion of the money supply. So (and this is a key point), whether or not the act of quantitative easing by the central bank is technically “printing money” or not, the INTENT of QE is clearly to expand the money supply.

Did quantitative easing work?

Remember, the purpose of quantitative easing was to lower long-term interest rates in order to induce more lending, more investment, more jobs and more economic growth. Did it work? Well, after trillions of dollars of bonds bought by central banks, the answer is…wait for it…we have no idea. On the one hand, the U.S. economy (same story for other economies that experienced QE) did not experience very strong GDP growth, employment and wage growth, nor did headline inflation (CPI) reach the Fed’s target of 2%. On the other hand, economic growth, though weak, was at least positive, the employment rate did decline significantly and the economy avoided the Fed’s worst fears of deflation.

Economics is not a science primarily for the following reason: economists cannot run experiments. That is to say, economists cannot rerun the financial crises hundreds or thousands of times with and without quantitative easing to determine whether or not QE was effective. And as I stated above, we have no idea what the economy would have looked like in the absence of QE.

Personally, I would guess the following: quantitative easing was somewhat effective in preventing the worst effects of the post financial crises deflationary pressures and had somewhat of an effect on increasing GDP and reducing employment. I would further surmise that QE was nowhere near as effective as the Federal Reserve (and other central banks) had hoped.

Was quantitative easing justified?

Up until now, pretty much everything I’ve written would be considered mainstream economics. Here, in this final section, I will deviate. The question that remains, and the most important one in my mind, is SHOULD the Fed have engaged in quantitative easing.

It has become standard economics since Keynes in the 1930’s to focus exclusively on the short-term results of economic policy and to ignore the long-term effects. I’ve already stated that I believe that QE aided the economy in the short-term by increasing GDP and lowering unemployment. To mainstream economists, that is good enough. Not to me. The question that needs to be asked (but never is), is whether the long-term negative effects of quantitative easing outweigh the short-term benefits. I believe they do, and massively.

Quantitative easing (along with ZIRP) has re-inflated an asset bubble that has been trying to burst for 30 years and delayed the inevitable restructuring that must occur. It has bailed out banks and rewarded bankers that deserve, and need, to fail. It is has subsidized “investment” in non-productive financial activity such as M&A, stock buybacks and parasitic technology companies, all which destroy jobs, at the expensive of long-term job creating real investment. It has been the primary cause of increased income inequality, which if not reversed, will destroy liberty (and lives) throughout the world.

In the near-term some of us might be better off because of quantitative easing. In the long term, we are all worse off.

Since the financial crises of 2008, the Federal Reserve has expanded its balance sheet from about $850 billion to about $4.5 trillion. In other words, the Fed has created $3.6 trillion of new money, representing more than 20% of U.S. GDP.

Back in 2008 and 2009 lots of smart people assumed that money printing of that magnitude would surely cause serious inflation, if not hyperinflation. And yet, with all that new money, inflation, at least as represented by the Consumer Price Index (CPI) has remained below the Fed’s target of 2%. Why? Why hasn’t the Fed’s extraordinarily loose monetary policy led to significant inflation?

In no particular order, here are seven possible explanations. Which ones are true? All of them.

1. Banks have not lent the money

Of all the reasons for why the Fed’s extraordinary monetary policy hasn’t led to inflation, this one is both the most obvious and the least controversial.

The mechanism of monetary policy is for the Federal Reserve to buy securities (e.g. government debt) from banks with newly created money. This newly created money is then available for banks to lend to businesses and consumers. Since banks historically earned no interest income on this idle money (“excess reserves”), banks should have incentive to lend the money in order to earn interest income.

The fable told in economics textbooks is that of the money multiplier and the reserve requirement. The story goes that once reserves are created on a bank’s balance sheet, the bank will then lend out all of it except the portion it is legally required to hold. For example, if $100 of new money is created by the Fed and deposited in a bank, and if the reserve requirement is 10%, then the bank will lend out $90. But that’s not the end of the story.

That $90 can then be used to buy machinery or hire workers or build a house, and that $90 will ultimately be deposited back at another bank (or the same bank, it doesn’t matter) by the receiver of the money (the machinery vendor, the worker or the homebuilder). Now the banking system can lend out another 90% of that $90, or $81. This process continues indefinitely ($100+$90+$81+$73+$66, etc.) and ultimately, $1000 of money is created, equal to the original amount divided by the reserve requirement (in our example, $100/.01). In other words, the money multiplier is 10, since 10x the Fed’s original deposit is created.

If this was the way the world really worked, then the $3.6 trillion created by the Fed would have really led to something like $36 trillion of new money (the reserve requirement in the U.S. is 10% on most balances). This would equate not to 20% of annual GDP but 200% of GDP. With that amount of newly created money, it is a near certainty that inflation would have followed.

Clearly, that hasn’t happened. Massive inflation hasn’t followed because the banks haven’t lent the money. The so-called multiplier effect simply hasn’t occurred. Instead, banks have kept most of the excess reserves on their own balance sheets, to the tune of $2.5 trillion. There are a number of reasons why.

First, the Fed, beginning during the financial crises began paying interest to banks on excess reserves. Hence, since banks do earn some income on unused reserves, they have less of an incentive to lend. Second, thanks to extraordinarily low interest rates set by the Fed (the Fed is targeting an interest rate when it buys securities with newly created money), banks earn relatively little interest income on the funds that they do lend. Why earn only a little income on risky lending when you can earn only a little bit less income without taking risk?

Third, banks are still repairing their balance sheets that never fully recovered after the financial crises of 2008. And given the severity of the last financial crises, banks now realize that they had better keep more reserves ahead of the next (inevitable) crises. Fourth, the Fed and other bank regulators, through various regulations and “stress tests” have significantly increased the amount of capital banks are required to have, and curtailed the amount of risk banks can take.

Lastly, and most importantly, banks haven’t lent because they can’t find very many creditworthy borrowers that want to borrow. Consumers, as a group, are still over-indebted. And businesses are facing the twin hurdles of global oversupply and “disruption” from easy-money fueled technology companies. With this onslaught, it is no wonder why most businesses have no appetite to borrow and to invest.

Before we move on, let’s revisit the stated purpose of easy monetary policy: to encourage banks to lend. As I said above, that banks aren’t lending all the money that the Federal Reserve created is common knowledge. And as I also mentioned, the Fed and other government regulators are actively forcing large banks to reduce risk. Seems a bit contradictory, doesn’t it?

This begs the following question: what is the true purpose of easy money, if not to directly stimulate the economy through increased lending? To recapitalize (bail out) banks? To raise asset prices? To simply appear to be doing something to help the economy, so that you’re not blamed for the next downturn?

2. The money has flowed overseas

Textbook economics dictates that the Fed can at least influence, if not control the level of inflation. By lowering interest rates and printing money, the Fed can stimulate lending, which stimulates businesses activity, which results in increased employment, which results in increased aggregate demand, which puts pressure on wages and ultimately prices.

However, as we’ve already discussed, banks aren’t lending as much as the Fed would like to U.S. consumers and U.S. businesses. But perhaps they are lending the money overseas? This is what is known as the “carry trade.” Made famous over the past two decades involving the Japanese Yen, it applies equally well to the United States. Simply put, borrow where interest rates are low (e.g. Japan and the U.S.) and then lend the money in emerging market countries where both interest rates and growth prospects are higher. In other words, freshly printed (digitally, that is) Federal Reserve money winds up not in the U.S. as intended, but instead financing Spanish real estate or Brazilian mines or Chinese factories.

So perhaps the textbooks are correct that low interest rates and new central bank money will lead to higher GDP and ultimately inflation. But in a world of free-flowing capital, that higher GDP and even inflation can just as easily occur in other countries rather than the country in which the money was created. In other words, in the small, closed economies of the ivory tower, perhaps an all knowing central authority can indeed control inflation. In the real world, perhaps not.

3. The CPI is understated

Like all government created economics statistics, the CPI is an enormously complicated statistical measure that very few people understand. To quote Wikipedia, the CPI is “a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.” But what are those representative items? What I buy and what you buy might not be the same. And what prices should be used? Prices in New York? In Detroit? In rural Alaska? And how should we collect these prices? And how often?

Yet those are probably the easy questions. There are much harder ones. What about quality changes? How should new cellphone features be factored into the price index? How about safer cars? Or less legroom when flying? And how about substitution effects? If the price of steak goes up, I might switch to chicken, which is cheaper. Since I no longer buy steak, should the price index only account for chicken? But if I really prefer steak, isn’t that really a reduction in my utility, and hence similar to a quality decline in my food consumption?

Perhaps the most controversial input in the CPI is how it accounts for housing, the single largest expense for the average consumer, and thus the largest component of the CPI. Rather than directly include the change in the price of houses, like it does for other consumer goods, the CPI takes into account something called “owner’s equivalent of rent” (OIR). This is a measure, based on surveys, for how much monthly rent homeowners believe that could get if they were to rent out their homes.

Leading up to the financial crises, housing prices where increasing at a rate double that of OIR. Many have suggested that the Federal Reserve ignored the obvious signs of the housing bubble because they were focused on inflation indices such as CPI, which vastly understated the inflationary impact of rising house prices.

The CPI is truly a black box, and I will be the first to admit that I have little understanding of what exactly is contained in that black box, or how that black box is constructed. And to be fair and truthful, you can find plenty of economists who will argue that the CPI overestimates true inflation (mostly due to quality increases) rather than underestimates inflation.

However, one thing is undeniable. As much as I hate to sound like a conspiracy theorist, I would be remiss to point out that the government has a huge incentive to understate the CPI, for at least two reasons. First, because many government entitlement programs, most notably social security are tied to cost of living increases. The lower the official inflation rate, the lower the entitlement payments the government is obligated to make. Second, inflation is a key component of reported economic output (i.e. GDP). The lower the inflation rate (in this case the GDP deflator), the higher the headline real GDP figure. All the better for incumbent politicians.

Long story short, given the government’s bias for lower inflation, I would guess that true inflation is perhaps 1-2% higher than the reported CPI number. But whether I am right or not, here’s the most important thing to remember. Measuring inflation is enormously complicated and messy. Even without a bias, this is art not science. So why should a central bank rely on such a figure, a figure who’s margin of error is probably at least a full multiple of itself, to justify printing trillions of dollars? To me, this is unwise, unscientific, undemocratic and bordering on criminal.

4. Asset prices are inflated

Take someone off the street (Main or Wall) and ask them what they think of the Federal Reserve. Assuming they know what the Federal Reserve is, they might say the Fed is doing a good job or a bad job. They might say that the Fed should do more to help the economy or less. They might say that the Fed should lower interest rates further or raise them. But if you ask them, regardless of their economic beliefs, to state one criticism of the Fed, I’d bet most would say the following: the Fed contributes to rising asset prices and to asset bubbles.

Remember the discussion of owner equivalent of rent from above? Just in case you don’t, we said that the housing component of the CPI reflects an estimate of changes in housing’s rental price rather than its sales price. Why is that? Because renting a home is considered consumption while buying a home is considered investment. The CPI is meant to measure consumption. Not investment. And therefore, not asset prices.

The Fed won’t admit they they create asset bubbles. But they do. Easy money in the 1990’s led to the first tech bubble. Easier money in the 2000’s led to the worldwide real estate bubble. Even easier money now has led to a bubble in all financial assets. Stocks, bonds, real estate, art, wine, you name it.

Let’s talk finance 101. Mathematically, the flip side of a low interest rate (technically, a low cost of capital) is a high valuation. In fact, the Fed has explicitly stated that they believe in what is known as the “wealth effect.” If your stock portfolio is higher and the value of your house is higher, then you are more likely to spend money, which should help the economy. Whether or not this wealth effect is real is irrelevant here. What is relevant is that higher asset prices are both a mechanical consequence AND a desired outcome of central banking’s loose monetary policy.

While the CPI might not reflect inflation, asset prices do. And the more risky the asset, the more the asset has been inflated. If this sounds scary, it should. Sooner or later, asset bubbles burst. When they do, financial crises tend to follow.

What asset inflation also means is that investors are paying more today for income tomorrow. We see this looking at metrics like Price/Earnings on stocks (very high) or Capitalization Rates on real estate assets (very low). These two metrics (essentially inverses of each other, hence the opposite direction) reflect, respectively, the high price paid today for a dollar of earnings from public companies or a dollar of cash flow from real estate investments.

Said another way, paying a high price now means that future rates of return on financial assets will likely be much lower than they have been in the past. This is great for today’s sellers of assets, who are receiving very high (inflated) prices. Sellers can use that money to consume, theoretically helping the economy (another impact of the wealth effect). However, buyers of financial assets pay more now, and will receive lower cash flows later on, reducing future consumption. So, not only does asset inflation result in those dangerous asset bubbles, it also pulls consumption forward, meaning lower economic growth in the future. Not to mention, you’re killing the business models of insurance companies and pensions, which rely on investment income to meet future obligations. Truly a disaster waiting to happen.

Long story short, while the $3.6 trillion the Fed has printed (and the corresponding reduction in interest rates) may not have led to very high CPI figures, it has helped lead to asset inflation. And the riskier the assets, the more inflated they are. This has gotten the world into trouble before. It will do so again.

5. Inflation is much higher for the wealthy

When we were talking about the CPI, I mentioned that there are many assumptions that have to be made in order to construct such an index. For instance, what products to include. Also, who to survey. In reality, the government folks (the Bureau of Labor Statistics or “BLS”) who are responsible for publishing the CPI do construct several different indices based on who they survey. For example, they have separate price indices for urban consumers and rural consumers. They also have a price index for consumption by the elderly.

To my knowledge, none of those price indices show inflation levels that would worry the Fed. However, I believe there is a subset of American (and global, for that matter) consumer that is experiencing inflation on a level that should concern the central banks of the world. That consumer is the wealthy.

Whereas the CPI has been running under 2% for many years running, I believe that a properly measured index for wealthy consumers would show inflation running at somewhere between 6-10% annually. In other words, perhaps 3-5 times the CPI. And the richer the consumer, the higher the inflation.

What has happened to this segment of consumer is a classic wage/price spiral. In a textbook wage/price spiral, money printing heats up the economy causing prices to rise. Workers seeing prices rise, demand higher wages. Higher wages result in businesses raising prices to offset higher wage costs. Higher prices cause workers to demand even higher wages, etc, etc, etc.

In today’s world, that is what is happening but the money first flows through Wall Street, and then flows to the owners and operators of high risk assets, such as hedge funds, tech entrepreneurs and public company CEOs. Those “workers” see their cost of living go up (e.g. housing prices in Manhattan or Greenwich, CT) and demand higher compensation and the cycle continues.

I freely admit that I don’t have hard data to back up my contention. However, observation and intuition says that the annual increase in the cost of living in a “1%” city like New York or San Francisco has clearly increased well beyond 2%. So have the costs of eating in a 4-star restaurant, imbibing a grand cru burgundy, staying in a Four Seasons hotel, paying full-fare for an Ivy League education (or buying your kid’s way into Harvard) and many more such worldly pursuits.

To be clear, I’m not advocating that you feel sorry for the rich. Not at all. For incomes of the wealthy have increased correspondingly. Remember, the point of this article is to explain why the Fed’s loose monetary policy hasn’t led to inflation, at least as measured by the CPI. However, in my view, it has led to very high inflation for this subset of consumers. Moreover, the asset inflation that I talked about above, plays a large role here too. For who owns most of the financial assets in the world? The wealthy. So just as there is price inflation for the 1%, there is massive wealth inflation.

If this sounds to you like I’m blaming the Federal Reserve for the enormous increase in income inequality over the past few decades than you are exactly correct. Regardless of intention, good or bad, the money that the Fed, and other central banks have printed has, for the most part, not flowed to Main Street. And it has not flowed to the middle class. Instead, it has gone to the wealthy, the super-wealthy, and the uber-wealthy. It has gone to Wall Street and to New York. It has gone to Silicon Valley and to San Francisco. It has gone to hedge funders and investment bankers, to tech entrepreneurs and venture capitalists, to CEOs and star athletes and perhaps worst of all, to politicians or at least ex-politicians.

6. The Fed is chasing its own tail

The next explanation for why the Fed’s easy monetary policy hasn’t led to inflation is what I will call the Fed chasing its own tail. What I mean is that contrary to intention, cheap money actually leads to lower prices rather than higher prices.

Let’s once again review the textbook rationale for easy monetary policy. Printing money and lowering interest rates leads to more lending and borrowing, and therefore to more investment and more spending than would otherwise happen without easy money. The implicit assumption is that the economy is operating under capacity (i.e. there is unemployment) and therefore, that the additional spending and investment expands the economy until it reaches full capacity, at which time inflation should occur.

Other things equal, I agree that low interest rates and easy money leads to more investment and, especially to more riskier investment. However, like everything in the real world, other things are not equal. As I wrote about extensively here, I believe that a substantial portion of the investment fueled by easy money actually retards economic growth, lowers employment and reduces overall prices (though not to the wealthy, as discussed above).

The prime (get it?) example I used in my previous article was of Amazon (see, “Amazon Prime”???). Amazon is a company that absent cheap money would likely not exist since it has no ability to actually make money. Yet, it has “disrupted” traditional retailers, resulting in hundreds of thousands of lost jobs, a multitude of retail bankruptcies and yes, lower prices.

This trend is prevalent throughout the economy with few companies or industries spared from Fed subsidized tech disruption. In other words, easy money does indeed spur some (i.e. tech) investment. But when taking into account the disruptive secondary effects, we find that overall investment, employment and economic activity are actually lower. Prices are lower too, contrary to what the textbook models state. Consumers benefit from lower prices for the time being. But mostly, the benefits accrue to a handful of venture capitalists, tech entrepreneurs and highly skilled developers, all part of the 1%.

7. Deflation is winning

I now present to you one final explanation for why central bank money printing has not led to inflation: it is being offset by deflation.

Let us remember why the Federal Reserve and the other central banks of the world are pursuing extraordinary monetary policy, to the tune of trillions of dollars created and zero or even negative interest rates. They are doing these things in response to the financial crises of 2008 and the global “Great Recession” that followed. Governments and central banks were, and are, desperate to prevent falling prices. This fear has led to a money experiment never before seen in 5000 years of recorded history.

We need to ask ourselves why did the financial crises happen in the first place. Obviously many, many books have been written about the causes of 2008. Unfortunately, nearly all of them have been wrong. As briefly as possible I’ll try to summarize the true causes.

The financial crises, like all financial crises, was a natural, market reaction to an economic bubble fueled by cheap money, subsidized risk and the perverse, short-term incentives that stem from cheap money and subsidized risk. What made this crises worse than most in recent history was that the market was trying to correct not years of financial mismanagement, but decades.

Erroneously believing that monetary policy could (and should) smooth out the business cycle and prevent recessions, the Federal Reserve has repeatedly printed money, set interest rates below their market rate and bailed out banks and other financial services firms. Each time it has done this, it has led to an even larger asset bubble and further reinforced the message that risk takers will be bailed out. Naturally, each bailout has been larger than the one before. 2008 was very large. Yet, the Fed, continued and wildly expanded its playbook, still believing that the cure for too much money is more money.

Unfortunately, the cure for too much money is not more money. Money needs to be extinguished. Oversupply needs to be reduced. Companies without profitable business models need to disappear. Over-leveraged banks, regardless of size, need to fail. Investors who took stupid risks need to learn painful lessons. This is the only way a free market can work. And this is the only way an economy can grow over the long-term.

Even though the central banks of the world have created trillions of dollars of new money, that new money is still fighting against gravity. That gravity is a massive deflationary current worldwide stemming from decades of easy money. So in one sense, what the Fed is doing is working. Prices are not declining, and are, in fact not far from the Fed’s target of 2% inflation. Moreover, we are not, at least officially, experiencing “depressionary” conditions.

Why hasn’t trillions of new dollars caused inflation? It has, but we don’t notice in measures such as the CPI because it is fighting the gravity of deflation. Sooner or later, however, gravity wins. It always does.

Conclusion – what comes next?

The past eight or so years have seen the central banks of the world print trillions of dollars. We see negative interest rates in parts of Europe and in Japan, something that has never happened before in human history. Now we hear calls from many mainstream economists for central banks to raise their inflation targets even higher, and louder and louder shouts for “helicopter money.”

Yet, inflation remains “stubbornly” below the target set by the Federal Reserve and most of the world’s central banks. Meanwhile, the world’s economies are growing slowly, if at all. And while the stock market and other financial asset prices continue to rise, income inequality continues to worsen, as does the political unrest that income inequality fosters. We see unemployed young people with student loans they will never repay. We see unprecedented amounts of homeless on our city streets. We see anti-capitalist, socialist and fascist politicians worldwide gaining votes and gaining power.

From this mess there are two conclusions one can draw: either central banks aren’t doing enough or what they are doing isn’t working. Mainstream economists have concluded the former. Print and spend, is what they say. How much to print and spend? Until it works. What if it still doesn’t work? Then print and spend some more.

However, one need only look at Japan to see this folly. More than two decades of extraordinary money printing and extraordinarily low interest rates have done nothing to awaken Japan from a generation-long depression. Meanwhile, Japan’s population ages and shrinks, an effect, not a cause of a stagnant economy.

I said it earlier and I will say it again. Easy money and subsidized risk cannot solve the problem of an economy ailing from decades of easy money and subsidized risk. But central banks and politicians will continue to try it. Because they have no understanding of what truly ails the economy and know no other way.

So what happens next? With no end in sight to more money printing and continued low interest rates, is inflation ultimately inevitable? Not necessarily. The U.S. and the rest of the developed world can continue limping along with slow growth, low inflation, continued income inequality, worsening demographics. We are all Japan.

Sooner or later, another financial crises will hit. Perhaps months from now, perhaps years, perhaps even decades. Will the central banks be able to save us again? For sure, they will try. But eventually they will fail. Whether the endgame is massive deflation or hyperinflation is unknowable and probably immaterial.The result will be the same. Crises. Depression. Ultimately, a financial reset.

It will be very painful. But it is, unfortunately, very necessary. And just maybe, 100 years from now, historians will look back and ask themselves how could we have been so primitive, so unwise, so naive to think that printing money is a good idea.

It goes without saying that the Federal Reserve’s monetary policy has been extraordinarily loose since the financial crises of 2008.  The Fed has had a zero interest rate policy (ZIRP) for 7 years now, not to mention its 3 rounds of quantitative easing (QE).  The Fed’s balance sheet has grown over this time period from approximately $800 billion to $4.5 trillion.  And even if the Fed raises rates 0.25% as it is expected to do in December 2015, it will be years (or perhaps generations) before we see anything like normal monetary policy.

There are many, many reasons to criticize the money printing policies of the Federal Reserve (and all the other central banks of the world).  They blow serial asset bubbles.  They create moral hazard.  They favor borrowers over savers.  They cause future inflation.  They bail out undeserved banks. They create “too big to fail” conditions.  They encourage risky investment and speculation.  They contribute to income inequality.

Even supporters of easy monetary policy, a group to whom nearly all mainstream economists and politicians belong, will admit to some, if certainly not all of these risks.  But, they would argue that these risks are worth it.  Worth it to help the economy recover from financial crises.  More specifically, worth it to help employment.

As you might know, when it comes to monetary policy,  the Federal Reserve has two congressionally mandated goals.  One is stable prices.  The other is maximum employment.  Since inflation, at least as measured by the Consumer Price Index (CPI), has been quite benign, the Fed has felt compelled, or at least free, to focus on helping employment.  Hence the policy of low interest rates and printing money.

Related post: Why does loose monetary policy help employment (the mainstream argument)?

Low interest rates and printing money should lead to more borrowing, more consumption, more investment and more jobs.  But, and this is a big BUT, what if that’s not what happens? Put simply, what if the Fed’s policy of easy money is actually destroying jobs, not creating them?  That’s what I think is happening.  Let me explain why.

The Subsidy to Growth

First, recall one of the most fundamental principles of finance: the value of any asset, such as a company or its stock, is inversely related to its cost of capital. In other words, the cheaper a company can access money, the higher its valuation. Since interest rates are the primary driver of a company’s cost of capital, the Fed’s loose monetary policy acts as an enormous subsidy to all companies and all asset classes.

But, the Fed’s valuation subsidy does not impact all companies equally.  By suppressing interest rates the Fed has encouraged and even forced investors to take on incrementally more risk.  Or in technical parlance, risk premia have been compressed. The higher the risk of the investment, the more that the risk premium has been reduced, and the greater the increase in asset value.  So while all assets have received a valuation “subsidy” due to easy monetary policy, high risk companies have received a proportionally larger one.

You may be thinking, how can the Fed “force” investors to take on risk. We live in a free country.  Nobody is forced to invest in risky assets, right?  Not exactly.  Consider an insurance company or pension fund that has future liabilities that it must fund.  If the insurer or pension fund cannot meet its necessary investment return from safer assets then it has no choice but to take on more risk. The same concept holds for any investor that requires investment income, either now or sometime in the future.  Need a 6% return but very safe assets pay nothing?  Take on more risk.

In fact, risk premia are compressed not only by artificially low interest rates.  They are suppressed even further by another central banking policy, known as the “Greenspan put.”  Simply put (no pun intended), the Federal Reserve has made it very clear, since at least the stock market crash of 1987, that it will provide liquidity to support asset prices in the event of market “dislocation.”  Hence, with the implicit promise of a bailout, risk premia are even lower and valuations even higher.

By encouraging risk and suppressing risk premia, the Fed has subsidized high risk companies.  Who are these high risk companies?  More than anything else, these are high growth tech companies.  We see this subsidy through the high public valuations and trading multiples of the Facebooks, Twitters and Amazons of the world.  We see it through the private valuations of the “unicorns” such as Uber, Airbnb and Dropbox.  And we see it through the basic business model of venture capital where a higher and higher valuation for a winning investment can support more and more losing ones.¹

Creative Destruction or Subsidized Disruption?

Why is it a problem that the Federal Reserve is subsidizing high growth, high risk companies at the expense of lower growth, lower risk companies? Isn’t that a good thing and isn’t that exactly what the Fed should be doing to help grow jobs?

Unfortunately, the answer is no. High growth/high risk companies, as best exemplified by the tech industry are not adding to overall U.S. employment. In fact, in today’s world, high growth companies are typically net destroyers of jobs, not creators.  To use the trendy term, tech companies are “disrupting” traditional employers.

There is no better example than the internet retailer, Amazon. Amazon is great (at least in the near-term) for consumers.  You can shop in your pajamas, pay rock bottom prices and get fast, free delivery. And certainly, Amazon’s stock performance has been great for its investors and its management. But has Amazon’s enormous growth really benefited the U.S. economy? In terms of employment, the answer is clearly no.

As you can see in the table below, Amazon had about $100 billion of revenue over the past twelve months and accomplished that with approximately 154,000 employees. So in one sense Amazon created 154,000 jobs, or about 1.5 jobs for each $1 million of revenue.

Sounds like that’s great for the economy, right?  But that’s not the whole story.  For the most part, Amazon’s revenues come at the expense of traditional retailers.  So the question to ask is how many people would traditional brick-and-mortar retailers have employed if they, and not Amazon had generated those revenues.

Again, looking at the following table, we can see that Amazon’s competitors, such as Walmart, Barnes & Noble and Toys R Us employ far more people for each dollar of revenue.  A simple average of this metric for 6 traditional retailers indicates about 4.9 employees per $1 million of revenue, far higher than Amazon’s 1.5.  And this figure is probably understated since smaller privately held retailers probably have even more employees per dollar of revenue.

So for each $1 million of Amazon’s revenue, around 3.4 jobs in the U.S. economy are lost or never created.  Based on its most recent twelve months of revenue, Amazon is directly responsible for the destruction of more than 300,000 jobs.

 

 

Now you may be thinking, doesn’t this sound like capitalism at work, like creative destruction? Old companies and old technologies being replaced by new companies and new technologies? The automobile replacing the horse and buggy?  The digital replacing the analog?

In a proper world with normalized interest rates, you would be correct. Investors would make discriminating decisions on where to invest their money based on a company’s business model, its projected profitability and cash flows, and its perceived risks. Let the company with the better product or the more efficient operations win, and if that company happens to be more productive and employ fewer people, so be it.

But thanks to the Federal Reserve, we don’t live in such a world. We live in a world where the cost of capital especially for high growth companies is much, much lower than it should be. This is a world where companies are too easy to start and money is too easy to raise. A world where growth trumps profitability and where not even a plan for revenue, let alone actual revenue is a prerequisite for an IPO or a multi-billion dollar valuation.

This is a world where established companies with real business models and real profits are “disrupted” by an endless wave of companies, large and small, with full bank accounts and empty business models. Facing this subsidized onslaught, good companies, those that are profitable (or would otherwise be), forego hiring or worse, are forced to shrink or go out of business.

Amazon, with about 20 years of operating experience, has yet to show that it can be consistently profitable. Given the total absence of barriers to entry in Internet retail, it likely never will. Absent easy money, Amazon would probably not exist, and certainly would not be the disruptive retailing giant that it is.

But this phenomenon of Fed-subsidized job destruction is not limited to the retail sector. It is happening in nearly all sectors of the economy.

Profitless companies like Twitter and Pinterest along with a near infinite number of money-losing Internet content providers have decimated the journalism and print media industries with their free content to the tune of significant job loss.

So-called “sharing economy” startups like Airbnb, a company with a $25 billion valuation and a business model based substantially on flouting local occupancy laws is doing its Fed-subsidized best to disrupt traditional hotel companies such as Starwood and Hilton, companies that employ hundreds of thousands.

Stock market darling but profit-challenged Netflix, a company with about 2000 employees, having put video retailer Blockbuster (60,000 jobs) out of business some time ago now has its well-funded sights set on disrupting the TV and Cable industries.

These are just a few prominent examples of Internet companies that probably shouldn’t exist, fueled by cheap money, eliminating American jobs.

Conclusion

Traditional critics of the Federal Reserve’s extraordinarily loose monetary policy cite the blowing of serial asset bubbles, potential future inflation and “moral hazard” as cautionary tales. But as we’ve seen, the Fed’s actions have a much more direct and immediate effect on the economy. Current monetary policy is hollowing out the economy by subsidizing companies that destroy jobs, to the benefit of a few fortunate investors and entrepreneurs, and to the detriment of many working Americans.

Monetary policy is also an example of the failure of mainstream economics.  That is, the failure of mainstream economic models to reflect the complexities of the real world.  Textbook models assume that printing money encourages risk taking.  This is correct.  They further assume that risk taking will lead to investment and job creation.  This is also correct. But they fail to realize that much of this new investment competes with established businesses and many of these new jobs come at the expense of a substantially higher number of existing ones.

To be fair, normalizing monetary policy will be a very painful process. In the short-term, many startups and even large tech companies will fail. Asset prices, including real estate and the stock market will decline.  It is highly likely that the economy will fall into a recession. Politically this is very hard to stomach. But stomach it we must if we ever want to return to a vibrant economy with real and sustainable job growth.

 

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¹ Assume a venture capital firm requires a 20% annual rate of return (IRR) and invests $1 million per company.  Further assume that after 5 years time, the VC firm can exit one successful investment and all the other investments fail with zero return.  If the successful exit has a valuation of $25 million, the VC can fund approximately 10 total investments.  If the exit has a $100 million valuation, the VC can fund about 40 investments.  If the exit is valued at $1 billion, then the VC can afford to fund more than 400 investments.

 

That low interest rates and printing money leads to higher economic growth, job creation and a reduced unemployment rate is both textbook economics and conventional wisdom.  Whether it is true or not is another story, but here’s the rationale.  There’s at least four related mechanisms at work.

First, low interest rates encourage businesses to borrow.  For businesses, projects that might have been prohibitively expensive to fund at higher interest rates and a higher cost of capital can get funded.  Business expansion will naturally lead to a need for more workers.  Similarly, entrepreneurs will have the ability to raise money to start companies that would not have been founded in a higher interest rate environment.  More new businesses will again lead to higher employment.

Second, consumers, like businesses, will spend and borrow more.  Low interest rates discourage savings, since a saver earns less interest income.  Less savings means more consumption.  Plus, consumers are more apt to borrow money to fund consumption of homes, cars and other items.  Higher consumption means greater demand for goods and services, which encourages businesses to expand and of course, hire.

Third, low interest rates encourages banks to lend by increasing the amount of lendable reserves on the balance sheets of banks.  The Fed does not technically set the key interest rate that banks lend to each other (the Federal Funds Rate), but targets a rate by buying and selling securities (e.g. government debt) from banks.  Buying securities from banks adds newly created money to bank reserves that can be lent out to businesses and consumers.   Since banks earn little or no income on these excess reserves, they have an incentive to lend them and earn more interest income.  More lending for consumption and especially for businesses investment leads to job creation.

Fourth, low interest rates raise asset prices, which encourages consumption through what is known as the “wealth effect.”  Other things equal, the lower a company’s cost of capital, the higher its valuation. And this is true for all financial assets, including stocks, bonds and real estate.  In fact, raising asset prices is a direct objective of easy monetary policy.  The idea being that individuals with fatter brokerage accounts will go out and spend more money, thus encouraging business investment and employment, just like we mentioned above.  Whether this “wealth effect” actually happens is not without controversy, but it has been supported by statements from Fed policy makers, including former chairman Ben Bernanke.