The Fed and Un-Free Markets

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

But in the decade after 2008 increases in M2—total money supply including all of the cash people have on hand + all checking accounts, savings accounts, short-term saving and CDs—were far above the 2% goal (in the 4%-9% range)—but no inflation occurred.

Many supporters of Friedman had predicted inflation as government spending and debt continued to soar, but it never happened. Why?

Two big things. First, after the 2008 financial collapse most banks needed to repair their balance sheets, so absolutely no anything-goes easy-lending was taking place. While the government was growing, the private sector was on a very slow path from deep recession to very slow recovery.

Second, Milton Friedman died in 2006, when the traditional measure of the national was debt $9 trillion /spending $2.7 trillion / deficit $350 billion.

In 2022, those numbers have increased to debt $31 trillion / spending $4.7 trillion / deficit $1.4 trillion.

Friedman also never lived to witness the Fed deploying such an enormous balance sheet. In 2006, it was under $1 trillion but recently it was just under $9 trillion. Buying such massive amounts of US treasury notes and mortgage securities, the Fed has been keeping interest rates artificially low. Instead of allowing the marketplace of buyers and sellers to determine the real cost of borrowing, the government purposely distorted the price.

This has been named the Modern Monetary Theory (MMT).

Such historically low interest rates impacted the traditional valuation of the stock market. Without getting in the weeds, a discounted cash flow model is going to assume a certain interest rate—the lower the rate, the higher the stock valuation.

Another way to look at it: interest rates were never as low as the S&P 500’s dividend. But the Fed essentially made the cost of borrowing at 0%; this boosted the stock price valuation, which in turn boosted the stock dividend.

MMT has kept the cost of servicing the $31trillion of debt so low that Congress’s profligate spending stayed under the media’s radar. And this has been done at the worst time, since the US’s aging population is making the entitlement programs go broke at an even quicker pace.

Why should we care? This will negatively affect our personal retirement plans as profoundly as it will impact the fiscal health of the nation.

What Milton Friedman would certainly have recognized was the unprecedented amounts of government money given to consumers during the pandemic. Of course, this would cause inflation. And it did. The Fed not only failed to warn the public about this at the outset but then predicted that any inflation would be “transient.”

Lesson learned the hard way. Yet, the Fed has been very slow to sell of its assets (from $9 trillion to about $8 trillion instead of quickly back to $1 trillion) which means that the S&P 500’s Price Earnings (PE) ratio is still historically high. The Shiller PE Ratio is at 28x when the average is about 16x.

So, has the lesson been learned, or is the manipulation still going on? Even if the worst of inflation is behind us, Americans still may pay the price for an overvalued stock market.

One ongoing debate is about demand side vs supply side economics. Enemies of supply side economics demean it by labeling it “trickle down” economics—trying to convince voters that it’s a scheme for the wealthy so they don’t pay their fair share of taxes.

What the government did, with its pandemic payments, is an example of demand side economics. And what we got was a huge dose of inflation.

The case for supply side economics is that it creates tax incentives for businesses to invest capital, which in turn creates jobs, which in turn increases everyone’s wealth, as employers must pay more to attract workers, who now have more choices among employers.

Growth without inflation—if you can deal with the political side of the debate. In fact, economic history shows that the wealthy actually pay more in capital gains taxes when high tax rates have been substantially lowered re: the Laffer Curve:

https://www.investopedia.com/terms/l/laffercurve.asp

But things in the US are not quite as dismal when you look elsewhere:

- In the UK, Brexit was a potential blessing, but only if they could become more of a low-tax, low-regulation, low-entitlement, free-market, free-trade zone. Former Prime Minister Truss’s record short-term in office was doomed from the get-go as her modest supply-side proposal was demonized by almost all.

Actually, it was a coverup benefitting those elites managing Britain’s retirement fund, who were on the wrong side of an options bet that assumed that artificially interest rates would never increase. Now its citizens get the worst of all worlds—slow private sector growth and government/big business corruption.

- In China, the long-predicted real estate bubble has finally burst. Just as the pandemic is about to kill millions of its elderly. Just as its government has decided that it no longer needs capitalism. Just as its population is declining, with a far too few young workers to support those elderly. Just as its middle class has lost its retirement nest egg—namely real estate, as it may take a decade or two for it to recover to its recent valuation.

The amazing story of China was that the success of capitalism was achieved by its entrepreneurs, despite the Communist Party. It was really done behind its back. Of course, they never got the rule of law right, as contract disputes ruled in favor of US investors were routinely ignored, and successful businessowners were eventually extorted by being forced to do business with government-owned banks. Plus, the regional governments are almost totally dependent on its income from real estate revenues.

As a US investor, it looks clearer and clearer that those investments in China will suffer from what is termed geopolitical risk. Let’s see how seamlessly firms like Apple and Tesla can relocate their plants to places like India and Mexico, which have their own economic issues.

Meanwhile, one other truth observed by Milton Friedman is worth recalling: true capitalism is morally good since it occurs only when each party voluntarily enters into an honest agreement that will benefit both sides.

And this all before the recent bank runs…