Monetary easing and bailout expectations are embedded in post-2008 central banking, often justified on the grounds of systemic stability or public expectations. The truth is that on top of nurturing moral hazard, the Fed put impedes innovation and productive investment.
Go Big or Go Home
Repugning accommodative monetary policy does not work well with the zeitgeist of 2021. Following the Covid catastrophe, going big is the only game in town – and this time in both the monetary and fiscal realms. A pandemic-induced transformational necessity justifies Joe Biden’s historically unparalleled spending plans to accelerate the net-zero transition, boost digitalisation and enhance education and health. Public support of clean technologies and a reasonable tax hike as a cushioning mechanism against exorbitant inequalities resonate well with moderate free marketeers and the entrepreneurial class.
If the radical US fiscal expansion is justified, then why not protract monetary activism – at least for the foreseeable future? There are a host of arguments in favour of a perpetual ‘‘Fed put’’ (the implicit floor under asset prices due to interest rate cuts after a credit crunch or other shocks). Some of them are systemic, whereas some others give heed to the phenomenon of mass financialization. It is worth addressing the latter because they are less conspicuous in the intellectual discourse.
Some scholars contend that the democratisation of leverage – that is, the diffuse of credit among the middle class – led to the extensive interventions of the Federal Reserve during and after the financial crisis as a response to public expectations. In today’s context, the retail investing boom, fuelled by low-cost trading platforms, stimulus cheques and lockdowns, raises the stakes for financialised individuals, who have gotten accustomed to the Fed put and, therefore, expect its continuity.
Public Opinion
I cannot see, however, how public expectations – existing or not – can decisively shape monetary policy. Conventional wisdom says it is central banks that shape the expectations of the public and not vice versa; this is how long-term inflation is anchored. After all, the two linchpins of modern central banking, namely institutional independence and inflation-targeting, emerged through the ashes of stagflation to cushion bottom-up pressure, not to accommodate it. Central bank independence is not a majoritarian institutional arrangement. And what determines Jay Powell’s persistence on a supportive monetary policy is not the wishes of the retail crowd or middle-class mortgage borrowers. Yes, he is accountable to Congress for the Fed’s dual mandate, but he does not need the voters’ permission to decide on the appropriate policy mix. It is an irresistible nostalgia for the great moderation era that drives Mr Powell’s overtly risky bet on a robust recovery that will be accompanied by only temporary inflation.
The Facts
Interpretations aside, the facts speak louder than words: Whilst the post-dotcom easing aimed at slashing interest rates and the 2008 balance-sheet expansion targeted mortgage-backed securities, the Fed now backstops the entire financial system. To head off a cascade effect of defaults due to Covid, the Fed accepted an unprecedented range of collateral, this time including blue-chip corporate debt and ETFs tracking junk corporate bonds.
Moral hazard, in other words, the extraordinary de-coupling of risk-taking from macro-fundamentals and the market environment, has dire consequences. Corporate leverage has skyrocketed since the onset of the coronavirus crisis. Leverage levels among high-yield corporate issuers are reaching the alarming levels of the dotcom era, while investment-grade leverage hit a record in the pandemic year 2020. According to a Financial Times analysis, the past year saw borrowing in corporate bond markets soaring to roughly $2,5tn, reaching thereby a historic high. Meanwhile, the recent Archegos debacle demonstrated the risks posed by the last year’s boom in margin debt.
The Fed has now scaled back its corporate debt facilities, but investors are well aware that the institutional innovations during previous crises have a path-dependency effect. They know that, if necessary, the Fed will do it again. The Fed put remains thus in place, albeit more implicitly, feeding a never-ending Minskian doom loop: crisis, lower spreads between riskless and riskier rates, monetary easing that lead to breathtaking equity rallies, excessive leverage and cavalier yield-seeking strategies. In turn, this sows the seeds of the next crisis, which will inevitably culminate in even more sweeping bailouts and ballooning central bank balance sheets.
Thinking Long-term
One could argue that unlocking credit to let it circulate throughout the arteries of the real economy more than offsets the risks associated with asset price inflation and ever-larger gearing ratios. In my view, this thesis is dangerously simplistic. Ample post-crisis liquidity was not accompanied by elevated investment ratios in the advanced world. The ultra-low interest rate environment is among the factors that incite market concentration, especially in the US. Monetary easing also tends to favour growth companies in the tech sector that depends on human capital rather than fixed capital formation. Plus, cheap money and stimulus-enabled liquidity hoarding create incentives for more buy-backs to the detriment of long-term investment.
Therefore, there shouldn’t be complacency around the causal links between the Fed put and inadequate investment ratios. To be sure, I do not think that Keynesianist demand-side management is a panacea, even though it is absolutely necessary at critical junctures to the likes of today’s post-pandemic momentum. Market-driven entrepreneurial innovation through Schumpeterian creative destruction is the driving force of technological advance and economic growth. This process relies on credit provided by financial institutions, to which Schumpeter assigns a special responsibility within capitalism. Boundless monetary easing distorts this vital role of banks and deprives the real economy of the merits of free markets.
Crises almost always mark the beginning of long-term institutional arrangements. This is why, sooner than later, policymakers need to send the appropriate signals to the public and plan a transition to a monetary regime that will set market forces free again. This must be done in a stepwise manner; sustainable government debt service costs have the priority now and rightfully so. But the policy orientation must be unequivocal. It is time to dismantle the Fed put.
