By Greg Hartz, CPA, CFA
Greg Hartz, CPA, CFA, is the founding partner of Foundation Resource Management, an independent, value-based investment advisory firm in Little Rock.
Only 18 months ago, we had just begun to learn of Modern Monetary Theory (MMT), a concept that was beginning to attract attention in academic circles. As we understand it, MMT espouses the idea that the government should create all of the money it “needs,” and the amount of the federal deficit and debt doesn’t really matter as long as the currency remains sound (soundness, no doubt, being a relative term).
It was probably no coincidence that this construct was the topic of increasing discussion as government deficits around the globe became more irreconcilable. Fast forward to today. It turns out, the amount of money the government “needs” is quite a lot! MMT seems to have been adopted wholeheartedly by governments and central banks around the world, though most would not admit to it. Heightened government demand for credit of the current magnitude would have raised interest rates back in the good old days of, say, 15 years ago. No longer.
Central banks, with the U.S. Federal Reserve leading the way, are buying this debt in order to suppress interest rates, thus monetizing the debt (using money creation as a permanent source of financing for government spending). By doing just this, the U.S. Fed doubled the size of its balance sheet in 2020 (see chart 1 in which periods of economic recession are shaded). No small portion of the debt that was financed by the Fed this past year was used to facilitate the direct stimulus payments in an amount never contemplated before ($1,200 per single adult, $2,400 for a married couple).
With the Payroll Protection Program (PPP), an enhanced $600/week federal unemployment supplement, and other stimulus, the bill for the Coronavirus Aid, Relief and Economic Security Act (CARES Act) came to $2.2 trillion (this on top of a projected $1 trillion annual budget deficit before the pandemic was even a thing). This money, for the most part, was put directly into the hands of the American people, as witnessed by the vertical rise in the M1 definition of money (coin, currency and checking deposits in circulation) as shown in chart 2.
This was a much faster and more direct method of getting money into consumers’ hands than was used during the Great Financial Crisis when a lot of the money ended up sitting idly in bank reserves. More COVID-19 relief money, the Fed’s Epochal Credit Expansion, is on the way at this writing, much needed by those whose income stream has been interrupted by the pandemic.
Evolving modern money has never grown more rapidly or been as potentially bewildering. From the charts, one can see that monetary practice is evolving rapidly. Also, it is easily seen that for more than a decade, the quantity of money has been inflating at an unprecedented pace. It is the lack of apparent consequences of Fed policy that has most folks bewildered. Many money-savvy and suspicious observers tend to express this bewilderment that can be summed up in three questions. Our short answers follow.
Q: Why are inflation and interest rates so low?
Cost-of-living inflation is impossible to measure precisely. We do know that it is in the federal government’s interest to have low inflation statistics because that reduces the statutory increases in cost-of-living adjustments on transfer payments.
However, many major household expenses have been inflating at a high rate (e.g. meat and other food products). To this point, the lack of recognition of inflation has helped keep money velocity low. That could change very quickly, in our opinion. Interest rates are so low because much of the lending in the economy is not done from a finite source of savings as in the past but from a seemingly infinite source of debt monetization by the Fed (refer back to the first chart).
Q: Where does all of this money come from?
The U.S. Treasury issues the debt through contracts with its primary dealer banks throughout the country, which currently number 24. These banks must sell the Treasury’s debt. The Federal Reserve has been out-bidding other potential buyers, thus pushing down interest rates.
The Fed cannot buy directly from the Treasury, because the Federal Reserve Act states that the Fed can only buy and sell Treasury securities in the “open market.” Take out the middlemen (the primary dealers), and in effect, direct buying has been taking place.
Q: How long can this go on and will the government’s debt ever be paid back?
No one knows how long the Fed and the federal government can continue this practice without having long-term negative effects on the U.S. dollar’s value vis-à-vis other currencies.
We have now accumulated a level of federal debt that will almost certainly be repudiated by the government or paid back with seriously inflated dollars. A form of repudiation is already taking place at the expense of savers with the intentional artificial suppression of interest rates by the Fed. Due to the policy actions described above, so many forms of traditional investing for current income have now been made unattractive. Cash yields are practically zero, and government and investment grade corporate bonds yield zero or below after inflation.
This environment seductively beckons those with capital to rush to equity investing, regardless of valuation, in the hope of generating total returns from dividends and stock-price appreciation. This is referred to as the “TINA” approach, or “There Is No Alternative.”
This acquiescence ignores the fact that investors with shorter time horizons cannot prudently invest in equities. We strongly believe that one cannot rely on liquidity in the stock market always being maintained by monetary machinations at the critical time when cash is needed. The TINA approach has fostered an emphasis on potential growth that has driven growth stocks to absolute valuation levels and valuations relative to value stocks that are at all-time highs.
The short-term performance mania that has infected modern investing is currently producing tremendous pressure on professional managers to lower their margin of safety and go with the flow. It is also encouraging retail investors to dive into speculation in a way that has not been seen since the technology bubble of the late 1990s. That “flow” is being aided and abetted by the Fed’s policy actions in response to the pandemic. As in every crisis and potential crisis of the last 30 years, the Fed’s answer has been… “more money.”
In spite of a deep worldwide recession caused by the pandemic, broad stock-market indices had a huge year in 2020. The more speculatively one was positioned, the better was the result. Chart 3 shows one aspect of how the Fed’s money printing has bled over into the stock market. The FANG+ Index contains many of the most popular and speculatively valued stocks. The concurrent rise of this index with the expansion of money and credit was almost totally the result of stock market-valuation expansion, not improved fundamentals.
We see the current margin of safety in the broad market as very narrow. We have never experienced a more important time to be positioned in companies representing strong fundamental values, good balance sheets and attractive margins of safety.