EC The Echo Boom, Part 2

<< Read: The Echo Boom, Part 1

Boom-Bust Mechanics

We want to focus on a specific aspect of the current money supply expansion in this part. The topics of “price inflation”, as well as investment and production will be discussed in a follow-up post shortly.

Let us consider the mechanics of past boom-bust cycles in the US. In “normal” booms, banks expand credit to companies and households, with the former employing the funds mainly for investment and the latter for consumption. Banks that don’t have sufficient reserves will borrow them in the interbank market (Federal Funds market), where the Fed stands ready to satisfy any excess demand for reserves that threatens to push the overnight Federal Funds rate above its administered target rate. In short, monetary inflation is driven by bank credit expansion and accommodated by the central bank. To the extent that the Fed-administered target rate manipulates market interest rates below the natural rate dictated by society-wide time preferences, this seemingly “harmonious” inflationary process will promote ever more malinvestment of scarce capital as well as overconsumption. Eventually the central bank becomes worried that the credit expansion may push consumer prices above its arbitrary target for CPI and begins to hike rates – then the artificial boom falters with a lag and a bust ensues. The central bank thereupon lowers rates again. Lather, rinse, repeat. 

Image credit: mevans

As a rule, the impoverishment caused by this boom-bust cycle doesn’t leave society worse off at the end of the bust than it was on the eve of the boom. Instead, the outcome is simply a lot less satisfactory than it would have been without central bank intervention. During the boom, the stock market will attract a lot of investment as well. Stocks are titles to capital, and capital tends to become mispriced when interest rates are artificially lowered. These price distortions are then rectified during the bust. Falling stock prices don’t “cause” economic depressions. They merely mirror and/or anticipate changing economic and monetary conditions.

A Modified Boom

Since the 2008 crisis, the above described boom progression has been modified. After 2008, banks no longer lent money to companies and consumers and then went looking for the necessary reserves to back their lending up. Instead, the Fed actively pushed reserves and deposit money into the banking system in an attempt to motivate the banks to increase their lending. This was of course not the only motivation; as noted in Part 1, the big banks needed to be insulated against a burgeoning bank run, as they were de facto insolvent by late 2008/early 2009. Also, as Mr. Bernanke pointed out in a press conference in early 2011, pushing up asset prices was an explicit goal of the Fed’s QE policy.

The main difference between the post 2008 echo boom and previous booms is that normally, newly created money first reaches companies and consumers, while since 2008, it has first reached the accounts of the primary dealers and those of a few selected financial services behemoths like Fidelity and Blackrock.

It is quite similar in the euro area and Japan: Instead of commercial banks creating new money by lending to the non-financial private sector, central banks are pushing newly created money into the financial sector. We mentioned in Part 1 that some changes seem to be afoot recently (especially in the US), but by and large this is what has happened over recent years.

When all is said and done, the history books are likely to record this as one of the biggest, if not the biggest, asset bubble ever

We suspect that as a result, asset price inflation has been especially pronounced. Financial companies are likely to reinvest money they receive from selling assets to the central bank in other financial assets, as well as lending money to speculators. At the same time, many listed companies have been reluctant to engage in capital expenditures. They have instead used the strong decline in credit costs to borrow money for financial engineering purposes, as evidenced by the huge surge in stock buybacks in recent years. These buybacks have increasingly expanded the higher stock prices have risen (they were very low when stocks were actually cheap). This is probably not the best use of retained earnings or borrowed funds; it seems likely many of these buybacks will eventually look just as misguided as the record buybacks of 2007 looked about a year later.

Forecasting Difficulties

The above suggests that the current boom will continue to evolve and eventually end in a slightly different manner from its predecessors. Unfortunately there is little experience with similar historical contingent circumstances. These circumstances are always unique, but the combination of characteristics of the current era is quite unusual. For instance, in spite of a large expansion in the money supply, inflation expectations have moved lower rather noticeably. We will have a little more to say about this in the follow-up article on inflation and production. Our main point is though that for a number of reasons, forecasting has become more difficult than it used to be.