How Fed Policy Is Wrecking the Economy

by James A. Bacon

Of all known government interventions in the U.S. economy, the most insidious and dangerous is regulation of the price of money (interest rates). Years of Federal Reserve Bank monetary stimulus and quantitative easing, promulgated for the purpose of easing or avoiding a recession, is wrecking the U.S. economy in ways that are only dimly understood. In the most important essay you can read this month — perhaps this year — Ruchir Sharma, chief global strategist for Morgan Stanley Investment Management, shines light on the problem in a Wall Street Journal op-ed, “The Rescues Ruining Capitalism.”

The op-ed is must reading for anyone who seeks to understand the direction of the national economy, and is vital even for readers with a Virginia-centric viewpoint because if the U.S. economy falls victim to declining productivity, slower economic growth, and aggravated income inequality, so, too, will Virginia’s. If economic growth stagnates, we must make commensurate adjustments to our budgetary and policy aspirations here in the Old Dominion — which our local political class shows no inclination to do.

Here follows a Reader’s Digest-like condensation of Sharma’s key points, with occasional interpolations.

A growing body of research shows that constant government stimulus has been a major contributor to many of modern capitalism’s most glaring ills. Easy money fuels the rise of giant firms and, along with crisis bailouts, keeps alive heavily indebted “zombie” firms at the expense of startups, which typically drive innovation. All of this leads to low productivity — the prime contributor to the slowdown in economic growth and a shrinking of the pie for everyone.

At the same time, easy money has juiced up the value of stocks, bonds and other financial assets, which benefits mainly the rich, inflaming social resentment over growing inequalities in income and wealth. … The rising culture of government dependence is, in fact, a form of socialism — for the rich and powerful. …

In 2008 the Treasury stepped in to save an entire sector — banks at the core of the mortgage crisis — with $200 billion. Unable to do much more to cut rates, which were already close to zero, the Fed launched its first experiments in “quantitative easing,” buying up tens of billions of dollars in assets each day, including mortgage-backed securities, to calm the credit markets. The rest of the world followed the Fed. …

In the 2010s, as easy money continued to flow from central banks, the global economy staged a recovery that was unusual for its length but also for its frustratingly slow pace of growth and for how few nations were allowed to suffer a moment’s pain. …

As governments stepped in to do whatever it took to eliminate recessions, downturns no longer purged the economy of inefficient companies, and recoveries have proven weaker and weaker, with lower productivity growth. …

After the global financial crisis of 2008, households and financial firms in many capitalist countries felt pressure to restrain their borrowing. Governments did not. The world’s total debt burden plateaued at a historic high of 320% of global GDP by the end of 2018, but within that total, government debt rose most rapidly. …

The idea of government as the balm for all crises is appealing the short term, but it ignores the unintended consequences. Without entrepreneurial risk and creative destruction, capitalism doesn’t work. (My emphasis. JAB) Disruption and regeneration, the heart of the system, grind to a halt. The deadwood never falls from the tree. The green shoots are nipped in the bud.

Low rates give big companies a strategic incentive to grow even bigger, in large part because securing a dominant position in the market promises outsize financial rewards.

Here I would interject to mention a book by French economist Thomas Philippon, “The Great Reversal: How America Gave Up on Free Markets,” which documents this very trend. His thesis is that over the past 20 years or so, American industries are increasingly dominated by fewer, larger corporations that exercise greater market power. Reduced competition leads to slower productivity growth, less innovation, and greater inequality of wealth. Now, back to our regularly scheduled programming…

As the large grew increasingly entrenched, they sucked up talent and resources, crowding out the little guys. Startups represent a declining share of all companies in the U.S. and many other industrialized economies.  Before the pandemic, the U.S. was generating startups — and shutting down established companies — at the slowest rates since at least the 1970s. The number of publicly traded U.S. companies had fallen by nearly half, to around 4,400, since the peak in 1996. And many of them started running up massive debts, in part as a desperate effort to grow in the shadow of the giants.

Today an astonishing number of the survivors are, quite literally, creatures of credit. In the 1980s, only 2% of publicly traded companies in the U.S. were considered “Zombies,” a term used by the Bank for International Settlements (BIS) for companies that, over the previous three years, had not earned enough profit to make even the interest payments on their debt. The zombie minority started to grow rapidly in the early 2000s, and by the eve of the pandemic accounted  for 19% of U.S.-listed companies. …

With every crisis, more of these creatures of debt survive. … Each new U.S. recession has been met with more bailouts and easy money, leading to a lower rate of corporate defaults. Over the last 20 years, the falling default rate has also closely mirrored the slowdown in U.S. productivity. … “Zombie congestion” in any industry lowers the productivity of rival companies — and blocks the entry of new companies — by raising labor costs and making it difficult to attract capital. …

The question is how much further capitalism will be deformed by government intervention on this scale. When government is willing to buy just about anything, it distorts market prices, which normally guide people to buy into profitable, promising companies. Now investors are simply buying what the Fed buys. The process of competitive capital allocation, which is critical to raising productivity, has broken down. …

Governments need to recognize that constant intervention to prop up the economy and financial markets is not achieving its intended purpose. After 2008, the Fed and the Treasury were praised to the moon for “saving the world,” but the Fed’s “experimental” forays into quantitative easy continued long after the crisis was over. … Its interventions are doing more to boost the stock market than the real economy. … Easy money is … inflating stock and bond prices, encouraging inefficient firms to take on more debt, and seeding financial instability.

Unless the Fed drastically shifts course — at the expense of considerable pain, analogous to the sharp “Volker recession” that broke the back of inflation in the 1970s and early ’80s — the United States can look forward to increasingly concentrated industries dominated by fewer big companies, more debt-ridden zombie companies, lower productivity growth, less innovation, slower wage growth, and a host of other ills. Sadly there is no sign that America’s political class — much less our president, who has agitated for more cheap, easy  money — is remotely aware of the damage that Fed policy is doing to the economy. Without such awareness, there is zero chance of that policy changing.

In the past, I’ve found consolation in the thought that, although federal fiscal and monetary policy was careening toward disaster, Virginia remained an oasis of economic stability and soundly managed government. As I look around me, I no longer find comfort in my Virginia citizenship. We are fast becoming New Jersey. We are sprinters in the race to the bottom.

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11 responses to “How Fed Policy Is Wrecking the Economy

  1. James Wyatt Whitehead V

    The Federal Reserve is the baby of Woodrow Wilson and Carter Glass, known segregationists. Should the Federal Reserve be cancelled? To what degree is the Federal Reserve subjected to 2020 election politics? I learned a lot from this post. It seems the Federal Reserve is much more now than the original purpose of managing employment, price stability, and careful control of interest rates.

  2. Equity market listings are a lagging indicator of innovation. See:

    https://www.nber.org/papers/w8081.pdf?utm_source=Investor+Amnesia&utm_campaign=4fa6262814-RSS_EMAIL_JFC&utm_medium=email&utm_term=0_7228441be9-4fa6262814-412891805

    So many things are wrong with the WSJ piece, but that’s a simple one. Also, bemoaning the listing of companies is quite comical (and shows a paucity of knowledge about today’s economy). The real money in America (and globally) has increasingly been private and doesn’t have any interest in listing (nor should it IMO). It shouldn’t shock anyone that more and more public companies are “zombies.” But…what about everyone who is simply staying private? Much more innovation and productivity is concentrated in private markets today than in 1999.

  3. Just a couple of things. The American auto industry would have gone under had it not been bailed out. Folks can argue about the wrong or right of it – but at least it should be acknowledged.

    We talk now about industry/business that may not come back but what would we have looked like if even more cars came from Asia than now?

    Second, few if any complained when we did tax cuts financed by borrowing. If you want to talk about the ills of quantitative easing , then at least talk also about do “stimulus” tax cuts by borrowing – when we
    re NOT in a recession.

    Finally – we still have a LOT of innovation and start-ups… but they don’t grow into companies like they used to. They get bought up and the folks that owned the start-ups become millionaires… not so bad.

    Look at how Elon Musk got his fortune.

    Here’s a list of unicorn startup companies:

    https://en.wikipedia.org/wiki/List_of_unicorn_startup_companies

    To the contrary – we do not have doom & gloom – we have a vibrant economy and it’s due to the Federal Reserve and monetary policy.

    Proof? We’re still the best economy, the most productive country on the face of the earth. We have to be doing something right… I’d not want us to be Brazil or China for all the tea in China…pun intended.

  4. Eric the Half a Troll

    “Governments need to recognize that constant intervention to prop up the economy and financial markets is not achieving its intended purpose.”

    There is a role for direct government stimulus (as in direct to the taxpayer) when the economy needs to be supported. The issue is that (as noted) the massive QE and interest rate manipulation props up the stock market and preferentially benefits the wealthy. It is not lost on the youth that billionaires made hundreds of billions during this last downturn while they got furloughed. The rich are just getting richer and the rest are falling farther behind. This is directly relevant to the protests we are experiencing in our inner city.

    • Like a lot of things – how the government intervenes (or not) in the economy is evolving and the naysayers are still stuck in the boogeyman era.

      I do not disparage the idea that government can (and does, especially in rd world and developing world) countries screw the pooch.

      But the Federal Reserve is a legitimate function of government.

      I say again – had the auto industry gone under in the US, really, really bad stuff would have happened… a LOT of our industry is tied up with vehicles… and I do not see everyone driving KIAs as good for our economy.

      Besides, the Asians don’t know jack S_it about making proper pickup trucks!

  5. Except for the last paragraph, Jim’s remarks and the arguments made by the WSJ op-ed writer represent legitimate worries. The Fed sees its role as keeping the economy stable. Interest rate policy is its primary tool. However, it had already reduced interest rates to really low levels and did not have much room to go further. So, it has been buying up notes, and not just Treasury notes, but other securitized instruments. It seems that these actions have not mitigated unemployment and there is a question as to how much they have helped the overall economy. (The stimulus checks and enhanced unemployment probably did more.) The biggest benefactors of the Fed’s actions have been the gamblers on the stock market.

    In addition to the access to cheap money, another factor in the growth of large corporations, with the result of stifling competition, has been the reluctance of the federal government to use the anti-trust laws to foster more competition.

    As for the big companies buying up the startups, as Larry posits, a lot of that activity is motivated by a desire to get rid of the competition. The owners of the start-ups benefit, but the general public usually doesn’t.

    • yes. But the big companies want the innovation that startups created and they pay a pretty penny for them.

      Google has bought over 200 start-ups.
      Facebook – over 80 start-ups

      the big difference is that big companies have the finances and the little companies do not but the point is – if you have an innovative idea – chances are you will be rewarded – but probably not in running your own company…like in times past… but the innovation itself has tremendous value… and the market wants that innovation…

      Our economy has changed dramatically from the 20th century and many of us keep judging as if it’s the 20th century and it’s not and monetary policy doesn’t work the way it used to either…

      If you look at the most significant companies in the world, they’re knowledge-based, not industrial.

      It’s not your fathers’ economy anymore.

      • I agree with this. I guess I’m not as alarmed that the goal of today’s entrepreneur is to get bought out rather than to run a business. Honestly, most of those guys would tell you that they have zero interest in managing a mature company. Google purchasing a startup and applying its managerial/financial expertise is probably better for overall productivity than someone who loves their idea being forced to manage a company.

    • It’s not just a lack of antitrust enforcement, which has, indeed, been largely dormant for decades. It’s also the ability to obtain and use regulation to protect market position and to stifle competition. Need we look beyond Dominion?

  6. When it comes to monetary policy, I have always pictured the government, starting with Greenspan, as a man with a screwdriver trying to synchronize the twin SUs on a 1960 Volvo.

    Eventually, you learn to brake with your left foot while keeping the rpm up with your right.

    Too much policy no police. Whatever happened to the SEC?

    • My mental image is of Icarus flying too close to the sun. I had hoped he would get burned in 2008 and fall back to earth, but instead we discovered he had a jet pack and heat shield hidden underneath those wings. But the sun will win in the end.

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