A Stimulating Conversation of the Economy and Stock Market
- The stock market soars on stimulus announcements because – hey, free money – but where’s the money tree?
- The US is broke and getting more broke. There is no political will to address the problem. In fact, it is just the opposite.
- The US stock market is poised for a loss worse than 50%, correcting excesses of the past decade.
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It all started in 2008 when the gears of the US economy were grinding to a halt, creating panic and desperation. Then a new radical idea entered the scene. As Senator Fred Thompson explains in this video, we would solve the problem of profligate spending by spending even more, much more, and we would give it the name “Quantitative Easing” (QE). Miraculously QE saved the day, and the US stock market had the longest recovery on record while the economy enjoyed modest growth rather than a recession.
QE is an experiment based on the “Modern Monetary Theory” (MMT) that advises the creation of money to solve economic problems. The answer to the concern about governments going broke is simple: they can’t go broke because they can simply print money. This experiment has never been conducted before, especially not in the magnitude of the US. although Japan comes close.
But just as we thought QE might be ending the pandemic struck and created a humanitarian need for more stimulus. At the time the pandemic struck, QE totaled $5 trillion. Then $3 trillion in COVID relief was quickly spent, and another $2 trillion appears likely. The government has spent $10 trillion in an economy with a $23 trillion gross domestic product (GDP). But that’s just a dent in the all-in debt of $100+ trillion. In this article we discuss the consequences of this enormous debt, sharing the warnings of leading thinkers on the topic.
QE and Inflation
The expected increase in inflation has not occurred, creating a sigh of relief: the problem solved with no repercussions. What has actually happened is called the Cantillion Effect postulated by French economist Ricard Cantillion in the early 1700s who said the following about increases in the money supply:
…more resources are allocated to long-term capital goods such as shares since they are spent by the most time-sensitive actors such as investors by buying stocks and profiting when prices are low. The sudden increased demand for stocks in the financial market bids up asset prices.
This results in deadweight loss due to new investments that may not be as well suited to the economy. This may result in large losses and possible bankruptcies by the owners of these stocks.
Ironically, it is those that aim to help the common man who advocates for disastrous spending policies that hurt us all. Politically this may seem like a monetary sleight of hand, ensuring the flexibility of the labor market and gaining voters, but in practice, inflation is a regressive tax, often under the pretense of egalitarian stability which exacerbates the inequalities it attempts to mitigate.
In other words, much of the $5 trillion in QE ended up in the hands of the wealthy who used it to buy stocks. This generated inflation in stock prices and created a huge divide between the rich and not-so-rich, which in turn has made Socialism more attractive because the bottom 80% are now poor relative to the rich. The consumer price index (CPI) did not increase because all of the inflation has been in stock prices. Cantillion foresees large investment losses ahead in this situation. More on this topic in the section below on the stock market.
More Stimulus for COVID Relief
As a result of the pandemic, 22 million people lost their jobs and many others were reduced to working fewer hours, so the government responded with a $3 trillion humanitarian relief stimulus. It is widely believed at the time of this writing that there will be at least another $2 trillion added to this aid, even though job losses have been reduced by half to 11 million. The difference between this stimulus and the 2008-induced stimulus is that much of this new money is going to people who are using it to buy groceries and pay bills. This new stimulus should move the CPI needle because it’s being used to buy consumer goods, as shown in the following picture.
The Global Debt Crisis
The US is not alone in incurring unprecedented debt as I describe in Per Capita World Debt Has Surged To More Than $200,000. In that article, I use the research of Professor Lawrence Kotlikoff on US debt . The consequences of this debt crisis can be seen in many places summarized in the following.
Lance Roberts, partner at RIA Advisors in Houston, quotes cowboy logic on the subject
At some point, you have to realize that you can’t get out of a “debt hole” by piling on more debt. Eventually, you have to stop digging.
Much of this newly printed money has inflated stock and bond prices. The problem is glaringly obvious in bond prices, where yields are near zero and even below zero in some countries. But many would quarrel with the view that there is a bubble in stock prices, arguing that low-interest rates justify high stock prices because future earnings are discounted at low rates. The truth is that reducing rates from 5% in 2008 to 0.5% today increases present values by 50%, but stock prices have increased by more than 250%. There’s something more than low-interest rates in play here. Plus it blames the stock market bubble on the bond market bubble.
Bursting the Stock Market Bubble
A “Bubble” exists when prices far exceed value, but there is rarely agreement before the bubble bursts on the meaning of “value.” In the case of stock market prices, there are a host of value measures including price/earnings ratio and Warren Buffet’s ratio of stock market value to GDP. These and several other measures are at historic highs. Consequently, Lance Roberts predicts a correction of at least 50% and I agree with him in my article.
The next correction will result from the excesses of the decade of the 2010s much like the 1929 Crash resulted from the excesses of the Roaring Twenties (1920s).
We all wish the best for $10 trillion in new money, but we should be prepared for trouble. Some see deflation on the horizon, and this may happen in the short run, but inflation is much more likely in the long run because a lot more money is chasing the same amount of goods.
Similarly, stock and bond prices have been inflated by new money, creating bubbles. Most bubbles burst with a catalyst that few can accurately predict. My guess is that interest rates will rise, falling out of the Fed’s control, and the dominoes will tumble.
No one can predict when these bubbles will burst so it’s best to protect for the eventuality. Baby boomers are particularly vulnerable because they are in the Risk Zone spanning the 5-10 years before and after retirement. Safety today comes with a high opportunity cost because safe assets have pitifully low returns. It’s a shame.