David, can you explain how the ‘Fed put’ works on the stock markets and bond markets? How exactly does it translate into artificially higher stock prices and lower interest rates?
The Fed injects massive amounts of liquidity into Wall Street through
the dealer system – that is, the 21 authorized treasury-bond dealers.
The liquidity comes in the form of new credits to their bank accounts
supplied by the Fed in return for the governments bonds, notes and
bills, and even the GSE (Government-sponsored entity) obligations that
it buys from them. The credit that the Fed supplies to the dealers is
manufactured out of thin air; therefore it expands total credits and
liquidity in the system. The dealers use it to buy other types of
securities – stocks, bonds, derivatives positions and so forth.
Historically, the purpose of the Fed’s open-market intervention in
this form was to encourage the banking system to extend credit to the
business and household sectors, thereby stimulating economic growth, as
predicated by the Keynesian model. That was always a one-time parlor
trick, however, because with each cycle of easing leverage ratios in the
business and household sectors were ratcheted steadily higher.
Household debt ratios, for example, went from 80 percent of wage and
salary income prior to 1975 to 220 percent by 2007.
The problem today is that we have reached ‘peak debt.’ The household sector has $13.3 trillion of debts1, even after the modest post- crisis deleveraging; the ratio is still sky-high at 180 percent of wage and salary income.
Consequently, the household sector has been unable to borrow more
money, no matter how much credit the Fed has injected through the
dealers. That’s very different from where this whole Keynesian financial
bubble started 40 years ago when we had, more or less, clean household
Underlying this domestic debt spree is the crucial fact that Nixon
fundamentally changed the monetary régime in 1971; he closed the gold
window, letting the Fed operate in an unfettered way. Household credit
began to rise inexorably with each of the Fed’s easing cycles, until it
reached the 2007 peak.
Today, money printing is not working in the traditional sense. It is
not stimulating additional credit, spending, or ratcheting up the
borrowing of the household sector because we have reached a condition of
“peak debt”. In essence, the credit channel is now clogged and broken.
Accordingly, the Fed’s injections of liquidity never leave the ‘canyons
of Wall Street,’ to use a metaphor. Instead, it has essentially fuelled
more carry trades and speculative buying of financial assets – stocks,
bonds, derivatives, commodity futures, and so forth.
That creates overvaluations and financial bubbles that eventually
break and smash the entire mainstream economy in the process. We have
seen it two times now during this century alone; we are on the verge of
seeing it a third.
The most dangerous element in our economy is the Fed, which I call a
rogue central bank. It’s following a Keynesian model that was never
valid but that now is not effective at all. It simply fuels enormous
financial bubbles that are ultimately destructive in the long run when
they burst. In the short-run, they lead to massive windfall gains for
speculators and the ‘1 percent,’ undermining public perception of what
capitalism is all about.