Although just about everyone is blissfully unaware, we are now living in an era of monetary insanity. So much credit and liquidity is being supplied by the world's central banks on a more or less permanent basis that the entire financial world has become distorted. It has also changed people's behaviour. The never ending supply of credit has encouraged risk taking, and consumption beyond normal boundaries.
Am I over dramatizing the situation? I don't believe so, but judge for your self. The chart below shows the extraordinary spending behaviour in the US in recent years. This chart, produced by Paul Kasriel of Northern Trust, shows personal disposable income minus the sum of expenditures on consumer goods and services, and residential investment.
Since the year 2000 Americans have gone into a massive deficit spending binge at an accelerating rate. For sure, residential investment can be regarded as an investment rather than consumption, but overall this chart shows highly unusual behaviour. Americans seem to be exhibiting supreme confidence in relation to their disposable income, at a time when employment and wage income growth have just experienced their worst post recession recovery since 1945.
So are they justifiably confident? Or is this extraordinary behaviour the result of highly unusual incentives and opportunity? Certainly we have seen remarkably low interest rates over this period. However, low borrowing costs are really only part of the explanation. In reality it has been a remarkable explosion in credit creation that has enabled or encouraged a highly unusual spending spree.
The table below shows what has been happening to key components of the US economy over the last 10 years.
The table shows us that even though the growth of disposable income has been falling, the savings rate has also fallen, now into negative territory. It also shows us that credit growth has been explosive in order to make up for the shortfall in spending power.
Unfortunately, we can also see that real GDP growth has been broadly stable over the 10 year period, despite explosive credit growth. Credit growth is having less impact in boosting the economy, but it has encouraged outsize spending that inevitably creates a widening current account deficit.
Policy Tightening Farce
The analysis above explains why the recent tightening cycle has been so confusing. True monetary tightening only occurs through slower credit expansion throughout the financial system. One sure way to enforce this is through curtailing bank reserves through selling government bonds. The other lever at its disposal is credit costs and short rates did rise from 1% to 5.25%, but long term rates have remained very stable throughout.
To equate rising short term rates automatically with tightening policy can be a great mistake. This time around the Federal Reserve never tightened bank reserves, and credit figures continued to show expansion. Higher short term rates have had some impact but the Federal Reserve's actions were exceptionally timid during this cycle, credit has not contracted at all and interest rates were only raised in small 25 basis point moves. Clearly the Federal Reserve is much less confident in the underlying strength of the economy than its statements would suggest.
Our policy makers hope that this bizarre state of affairs can continue indefinitely by continued monetary manipulation. The political imperative of avoiding a weak economy remains paramount. This state of affairs will no doubt be successful, at least for a while. However, ultimately, history tells us we will face enormous economic difficulties, one way or another. We just don't know when.
Whatever the end game, we can not afford to forget that a return to sound monetary policy has become extremely problematic. Once you have applied excessive monetary policy on this scale it is almost impossible to rein it all back in, as it would almost certainly produce a deep recession. It is far more likely that excessive money supply will have to be maintained to avoid a crash landing. This is the point at which we have entered "money madness". Excessive credit growth has to be sustained, adding distortions on top of distortions.
While the Federal Reserve's policies have helped to hold up the economy they are now left with a weaker hand to manage the economy. The relentless consumer spending of recent years has satiated consumer demand while weakening personal balance sheets. Credit expansion has, therefore, already been very extensive, and is already losing its impact.
Unfortunately, this is happening at an increasingly challenging time. The economy has already lost its main source of growth. In the housing market it will take a few years to rebalance supply with demand, with record levels of inventories and affordability still very low. Furthermore, with the economy to a large extent "asset driven", the recent weakness of both house prices and commodities could provide a challenge to the capability of monetary policy to provide sufficient demand to keep the economy going.
So far the consequences of sustained excessive credit creation have seemed to be entirely benign. The economy and markets seem to have been doing reasonably well and so the background of growing problems and instability are ignored. However, this has always been a highly dangerous departure from sound money policy. Just as in the USA in the 1920s and Japan in the 1980s, the US now finds itself increasingly at risk of having overused credit creation to the point at which monetary policy may no longer be able to sufficiently stimulate the economy, in a downturn. Even if we are not yet at that point, the costs of returning to a more balanced monetary policy are so high that excessive credit creation may well need to be continued. This approach continues to undermine the effectiveness of monetary policy over time, and weakens the economy's ability to avoid a major downturn.
Monetary policy has been used so excessively in recent years that it has now become increasingly ineffective. Remarkably, although interest rates rose over the last 2 years, the Federal Reserve continued to promote excessive credit expansion throughout. There never really was any credit restraint for the first time in any rising interest rate cycle.
The data clearly shows that since 2000 overall consumer expenditure added to residential investment has outgrown disposable income, for the first time ever and at an accelerating rate. So further credit growth looks increasingly limited given that consumer demand is saturated, personal balance sheets have deteriorated, and the savings rate has now gone negative.
The economy has therefore become acutely vulnerable to falling asset prices and the now more limited ability of short term interest rates to cushion any fall. We need to realize that once policy makers have embarked on a sustained period of excessive credit expansion, it is very hard to return to sound and stable monetary policy, as it involves imposing hardship. The usual course of events is to continue providing excessive credit for far too long. This is what occurred in the 1920s in the US, and the 1980s in Japan, with ultimately disastrous consequences.
We all need to understand that we are living in an era of "Money Madness". This creates huge distortions in the markets, the economy, and in society at large. It can continue for far longer than anyone can imagine, but do not be fooled into believing it can last forever.
For now, short term interest rates have significant room to fall from 5.25%, and could fall dramatically as we approach the next economic down cycle. Interest rates changes may need to become more aggressive as the effectiveness of monetary policy has been significantly weakened. This should provide a significant boost to equity markets, which are now very close to the most bullish phase of the 4 year election cycle, and a much more strategically bullish stance seems appropriate.