The Federal Reserve purchased 61 percent of the nation’s debt issuance last year.
Let that factoid sink in for a second.
It’s a dangerous development because it means that the Federal Reserve created electronically — that is, out of thin air — the cash needed to buy the debt from the Treasury Department.
Lawrence Goodman, a former Treasury official and current president of the Center for Financial Stability, blew the whistle on the economic frat party Ben Bernanke threw last year.
Writing in a recent Wall Street Journal Op-Ed, Goodman noted that the Fed intervention was “negligible” before the 2008 financial crisis, but due to massive quantitative easing, U.S. markets are “at risk for a sharp correction” if conditions aren’t “normalized.”
"This not only creates the false appearance of limitless demand for U.S. debt but also blunts any sense of urgency to reduce supersized budget deficits," he wrote.
If the Fed had not intervened, would the U.S. have been able to issue over $1.3 trillion in new debt securities last year?
The probable answer is yes, but at significantly higher rates. Last year the 10-year Treasury sold at around 2.43 percent.
Considering the precarious state of the economy and gargantuan budget deficits, without the Fed intervention, investors may have wanted 4.5 percent or more to take the risk in buying U.S. bonds. This would have increased interest payments paid by the federal government by over 100 percent, if not more.
Why won’t the Fed allow market forces set the price for Treasury debt?
There are two key reasons, in my opinion.
First, the economic recovery has been extremely shaky. Despite an $800 billion stimulus President Obama pushed through, and the artificially low interest rates effectuated by the Fed, GDP is currently growing at just over 2 percent, 50 percent less than the typical 4 percent GDP rates have witnessed in previous recoveries.
Second, Bernanke’s meddling with the nation’s cash flow no doubt has been encouraged by the Obama White House, especially with the election fast approaching this year.
Some time ago George Soros, the billionaire financier, revealed that the Obama economic team had developed a strategy dubbed “the wealth effect.”
The idea has been that if the stock market increased in value, and people felt wealthier, especially the rich, they would tend to spend money. Alan Greenspan, the former Fed chairman, also has advocated this strategy, arguing that a rising stock market is more stimulative to the economy than tax cuts or even government spending.
Back in 2010, Greenspan appeared on "Meet the Press," and explained the phenomenon: “As I've always believed, we underestimate the impact of stock prices on economic activity. Asset prices are having a profoundly important effect.
“What created the extent of the contraction globally was the loss of $37 trillion in market value. It collapsed the value of collateral in the system and it disabled finance. We've come all the way back — maybe a little more than halfway, and it's had a very positive effect. I don't know where the stock market is going, but I will say this, that if [the stock market] continues higher, this will do more to stimulate the economy than anything we've been talking about today or anything anybody else was talking about.”
The Fed, by keeping rates low, and by its unprecedented intervention in the long-term bond markets, has influenced the stock market.
Low rates mean that public and private debt offers little income, forcing investors in search of yield and return to buy riskier equity investments.
This, then, is the key reason why the Dow, which hit a low of 6,626 in March of 2009, falling some 53 percent from its high of 14,093 in October of 2007, had by 2012 completely retraced the entire loss it suffered.
Still, the Fed’s decision to artificially lower rates is no cure-all and has created other serious problems.
For example, banks are not lending as they should be, because they have little incentive to do so. Today, they borrow money from the Federal Reserve at zero or near zero rates, and re-invest a multiple of their depositors’ money into higher-yielding government bonds with practically no risk.
This scheme helped bank balance sheets as profits have soared. But banks aren’t operating as they should, and Joe and Jane can’t get a small business loan to expand their business.
Major corporations also are playing the balance sheet game. Highly credit worthy companies are borrowing huge amounts at little interest and can leverage the loans in the bonds and equity markets. There is a reason why corporations are sitting on over $2 trillion in cash on their books and not investing it in their own businesses.
Clearly, the wealth effect in corporate America has disproportionally affected large, financially stable firms as well. The big public companies that make up the Dow and S&P 500 are hitting new highs, but medium- and small-sized businesses have found little or no relief.
Just look at the Nasdaq, which better represents a cross section of business in America. It’s still down 40 percent from its tech-bubble high of 5,049, which it hit over 12 years ago.
Several years into the game now, it is clear that the “wealth effect” hasn’t worked so well, especially for those in middle- and lower-income brackets.
It is ironic that the Obama administration, so hostile to the wealthy, would implement an economic policy based on rising stock prices that benefit the wealthiest persons and corporations. The practical effects of this policy are evident in high-end neighborhoods where housing prices have held up quite well despite the housing collapse.
Globally, governments have poured some $15 trillion into the world economy. We still have no resilient recovery. And the current U.S. gimmick of creating money out of thin air to keep rates low is completely unsustainable.
My guess is that the Federal Reserve will ease up on intervention in the U.S. debt auctions soon, knowing its actions will be felt after the election.
Interest rates will eventually rise. They have to. This will create new mayhem, as markets fall again, growth stalls, and consumer spending slows.
Still, allowing market forces to work is still the best medicine and will pave the way for a strong recovery, which has been delayed because of undo meddling by our central bank.
© 2013 Moneynews. All rights reserved.