We really shouldn’t be surprised with the headline from last week that the Federal Reserve is working on a proposal to ease up on bank leverage limits. From the article in Bloomberg:
The Federal Reserve is working to relax a key part of post-crisis demands for drastically increased capital levels at the biggest banks, according to people familiar with the work, a move that could free up billions of dollars for some Wall Street’s giants.
Central bank staffers are rewriting the leverage-ratio rule – a requirement that U.S. banks maintain a minimum level of capital against all their assets – to better align with a recent agreement among global regulators, said two people who requested anonymity because the process isn’t public. The people said the Fed effort is drawing opposition from the Federal Deposit Insurance Corp., an agency with authority over banking rules that’s still led by a Barack Obama appointee.
The fact the Obama appointee is pushing back on the changes highlights the difference in the two administrations’ tack on policy.
Leverage is going higher
Now you might think adding leverage this late in the cycle might not be a prudent move. On the other hand, you might believe the US has been hamstrung by anti-business policies for too long and it’s time to let her stretch her legs unencumbered. It doesn’t really matter what you, or I, believe is the correct course of policy. All that matters is what is happening. It is foolish to not adjust your investment stance based on this change.
Make no mistake – this change in Federal Reserve policy is potentially a really big deal. To understand why, let’s recap how the economy got into the current situation.
How we got here
During modern economic history, credit growth has largely gone only one way – higher. As Western societies have layered more and more debt on the global economy, each recession has needed more and more monetary stimulus to counter-act the slowdown. This partly explains why each recessionary trough has seen progressively lower interest rates.
When the 2008 Great Financial Crisis hit, many market participants believed we had hit the Minksy moment. There had been so much debt piled onto the economy, there was simply no way it could continue to function without a cathartic cleansing.
Yet instead of allowing the system to reset in a painful debt destruction cycle, governments throughout the world engaged in a series of quantitative easing programs, the likes of which had never been seen.
At first, many market participants moaned about how this would unleash an even more destructive inflationary collapse. But much to the surprise of many, inflation did not take off, and slowly governments and Central Banks throughout the world were able to stabilize, and even start growing, the global economy.
The failure of monetarism
Why didn’t inflation take off? Monetary theory would predict that as you increase the monetary base, inflation or growth should be the result.
However, the part that many monetarists missed was that the velocity of money was not nearly as stable as their models predicted. As the Federal Reserve, Bank of Japan, ECB, SNB and all the other Central Banks shoveled money into the system, instead of it being taken up and lent by the private sector, it sat inert on banks’ balance sheets. When combined with many of the pro-cyclical cuts that were made on the fiscal side (tea party sequestration and German-led austerity demands were prime examples), it was extremely difficult for the economy to grow (or inflation to take off).
It was made even worse with the increased bank regulations and credit restrictions in the wake of the crisis. Instead of banks being encouraged to lend to companies and individuals that were struggling in the moribund economic environment, governments clamped down and made credit more restrictive.
All of these policies resulted in Central Banks having to shoulder more than their share of the burden in reviving the economy. Now you might believe that Central Banks should have accepted the lower growth and not taken the responsibility of reviving the economy. Could be. We will never know. It’s not the path they chose, so it doesn’t really matter.
Being the only game in town, Central Banks took extraordinary measures to stave off a return of the crisis. They expanded their balance sheets at an unprecedented rate. They cut rates to historically low rates. They did previously unspeakable things like pushing rates negative.
Eventually, it worked. Push enough liquidity into the system and you will get ahead of the monetary velocity decline.
The problem is that all this stimulus has expanded the monetary base in ways we could never have imagined before the crisis.
Remember the Y2K worry? For my millennial readers, in 1999 there were all sorts of worries that the computer systems would not be able to handle the switch over from 1999 to 2000. I know, ridiculous, right? But trust me, there were tons of people prepping for Armageddon. Google it. Some people spent turn-of-the-century New Years’ eve in bunkers.
So what did Federal Reserve Chairman Alan Greenspan do? He flooded the system with money. It seemed like the prudent macroeconomic move. The problem was that it created the fuel for the final stages of the DotCom bubble.
Now there was obviously much more going on during that period than simply the Federal Reserve stimulus, so it’s by no means a one for one relationship. Yet Greenspan definitely put fuel on the already lit fire and made the DotCom bubble all the worse.
Have we finally turned the corner?
Back to the current situation. Over the past decade, Central Bankers have had to shove way too much fuel into the economic system, hoping that by continually pouring it on, eventually it will light and help kickstart growth. It has been truly mind boggling. I know that we have all become immune to these Central Bank sheet expansions, but it’s not normal, and it’s way more dangerous than markets believe.
Due to all the counter-cyclical fiscal and credit constrictive policies that I have outlined, this chart is way steeper and taller than it should be.
Yet it appears to have finally started to work. Lately, global growth has been firing on all cylinders. It appears we have entered into a period of a coordinated economic recovery.
Chances are that even without any further action, the recovery has become strong enough that it has become self-reinforcing. In fact, we have hit a point where Central Bankers in stronger economies have even started leaning against the trend with higher rates.
Putting all the pieces together
Let’s think about the current economic environment. Due to counter-cyclical fiscal and credit tightening policies of the past decade, Central Banks have injected a preposterous amount of monetary fuel into the global financial system. Market participants have mistakenly become convinced this stimulus is not inflationary because the net result of the past decade’s financial science experiments has not been inflationary (at least not the type Central Bankers measure). But the reality is that monetary policy was made especially ineffective through fiscal and credit policies that were pushing the opposite direction.
But what has happened now? Instead of providing a headwind to economic growth, fiscal and credit policies have now become expansionary.
It’s ironic that eight years into this economic recovery the US government is now deciding to administer pro-growth fiscal policies. The time for the government to have pushed down hard on the fiscal pedal down was 2009-12. That’s when the economy was moribund and needed fiscal help. And it’s sad that now, with asset prices hitting new highs all the time, the Federal Reserve is deciding that it might be a good idea to allow the banks to increase their leverage. Really? Maybe instead of clamping down on credit policies in the wake of the GFC, regulators should have done the opposite. The reality was that the losses in the private sector were already enough to ensure prudent lending. The last thing the shaky economy needed was regulators decreasing leverage and restricting credit. Yet that’s exactly what they did.
It just goes to show you that governments are no different than individuals. They engage in the same sort of herding.
Although it is difficult to defend Trump’s erratic embarrassing behaviour, there can be no denying that he understands the animal spirits part of the economic equation. Instead of lambasting the private sector as a source of evil, he has done everything he can to encourage a return of the America of old. And you might disagree about the long-term wisdom of this policy, but that won’t help you with your asset allocation or trading. I am by no means a Trump fan, and although I try to keep politics out of these discussions, it is important to understand the effect he is having on the economy.
Trump is engaging in pro-growth fiscal policies at a time when unemployment is already low. And maybe even more importantly, his attitude is seeping into all levels of government. This recent Federal Reserve bank leverage policy proposal change is a perfect example.
America has elected a real-estate-developer-turned-reality-TV-star into the oval office. To think he doesn’t want easier money, laxer credit policies, more leverage, and higher deficits, is just naive. And it is even more foolish to believe that the Federal Reserve won’t underwrite these policies. Yeah, they will mouth some words about staying vigilant, but the risk is way higher that growth explodes and gets away on them than the other way round. After all, the people have spoken. They want growth. They are fed up with Japanese-like-lost-decade.
The next great crisis will be caused by Central Bankers not realizing that all this monetary fuel they have pumped into the system has finally ignited, and like a bonfire that gets out of control, they have no way of extinguishing it.
Don’t ever forget about the multiplier effect of the high-powered money that has been stuffed into the system. It used to be that it sat there inert because governments and regulators did everything they could to stop it from being used. Now, the shoe is on the other foot. Trump and other governments are actively encouraging for it to be used. Greenspan’s 1999 Y2K liquidity push caused some crazy stuff to happen, but that pales in comparison to what Central Bankers have injected over the past decade. The possibilities are frightening. I would definitely take the over for both inflation and growth in the coming years.
Thanks for reading,