I saw a “scary” chart at the weekend which I thought I’d share with you this morning. (Don’t say I’m not good to you.)
It’s yet more evidence that the US Federal Reserve’s monetary policy is doing nothing but harm. That’s nothing new.
What’s scary is that it also suggests that the chickens will be coming home to roost before too long…
This scary chart highlights the damage being done by monetary policy
Dr Daniel Thornton, formerly of the Federal Reserve Bank of St Louis, posted an article at Hedgeye the other day. It contained a rather interesting chart, which we’ve reproduced below.
It shows net household worth in the US as a percentage of disposable income. When the chart is rising, then a family’s wealth – property, shares, etc – is growing compared to its disposable income. (Of course, it could also mean that disposable income is falling while wealth is static.)
The scary thing about the chart is pretty obvious. The last time it was at this level, was during the house price bubble in 2006 – which was of course, the factor pushing up net wealth. When that popped, it nearly destroyed the global financial system (and, of course, it may still do – that process isn’t over yet).
The other “scary” data point is the peak around the time of the dotcom bubble in 1999/2000, which also preceded a massive crash. In this case, the factor pushing up net wealth was stock prices, and the tech-heavy Nasdaq in particular.
So what are we looking at today? And does it mean that there’s going to be a massive “pop” anytime soon?
Clearly, what’s driving up household wealth today is rising share and property prices. As for how significant the peak is – well, we don’t have many data points to go on, not on that particular chart. Perhaps it could go even higher – after all, the housing bubble peak was greater than the dotcom peak.
So maybe it’s not warning of an imminent crash. But is it warning that something is out of whack? Most definitely.
You see, elsewhere in his blog, Thornton takes a look back at the trend for household net worth, and concludes that around the mid-1990s, something weird happened: household net worth started to rise a lot more rapidly than you’d have expected, given the trend of the preceding 40 years.
It also became more volatile – more ups and downs. Put simply, it “does not appear to be supported by economic fundamentals – it appears to be unsustainable”.
What could be the cause? Well, what else would result in wealth – asset prices, basically – becoming detached from the underlying economy, but monetary policy?
The Federal Reserve is really not helping matters
The Federal Reserve presumably thinks that it’s helping the “real” economy by keeping interest rates low, as has been policy since former Fed boss Alan Greenspan’s day.
Cutting interest rates makes it easier to borrow money, which boosts demand. Entrepreneurs respond to both the demand and the cheap money, and set up businesses and employ people to meet that demand. More people in jobs means more spending and even more demand and so on in a virtuous cycle.
Of course, when you get something like 2008 and it turns out that everyone’s too scared to set up a new business or to lend to one, the story changes. Then the Fed relies on the “wealth” effect.
The idea here is that if both banks and consumers feel that their balance sheets are in good order – their homes are rising in value, and that the loans they’ve written are nicely covered – then they’ll consume and lend more.
It’s a “build it, and they will come” approach. Get money circulating, get people doing stuff, and all will be well.
This is all very well, but it pays no attention to the quality of the businesses being funded or the assets being bought.
Look at it this way. If “real” (after-inflation) interest rates are high and you can get a decent return by putting your money into something safe like a bank account or a government bond, it’s going to take an impressive business plan or company to get you to part with your funds. Not only will you want good returns, you’ll also demand security – why take the risk otherwise?
When real rates are low, but positive, you’ll be keen to invest some of your money in carefully chosen projects that offer a better return than you can get in the bank, and you’ll be willing to take some more risk to get that.
But when real rates are flat or negative, you feel panicked. There’s no way that you can save enough for the long run to fund the quality of life that you were hoping for in retirement. So what do you do?
Different people will deal with this particular dilemma in different ways. But I suspect the way it shakes out en masse is as follows.
On the one hand, you force some people into over-conservatism – they save even harder, and into “safer” assets to compensate for the low returns. On the other, you encourage those who feel they have nothing to lose – because they will never be able to save enough – into pure gambling. (Think of all those fabled Japanese housewives and their forex trading accounts.)
The other big problem with today’s policies is that you also lose any benefit of the wealth effect when people can’t rely on that paper wealth.
Today’s investors have been through two epic crashes within spitting distance of each other. How much faith can they have in their balance sheets given the volatility involved, and therefore, what boost to confidence can the wealth effect possibly give them?
Hollowing out the “real” economy
The outcome is that you end up hollowing out the “real” economy. Instability breeds short-termism and defensive behaviour on the part of quality businesses, while cheap money and desperation breeds scam merchants and spivs at the other end of the spectrum.
Unfortunately, this is a hole that the Fed shows no signs of stopping digging. So when that household wealth chart next crashes – which probably won’t be that long in coming – expect a lot more of the same.