The firemen are also the arsonists; irresponsible policy from the Federal Reserve made the coronavirus crisis worse than it had to be, writes James Grant. He continues in The Wall Street Journal:
It took a viral invasion to unmask the weakness of American finance. Distortion in the cost of credit is the not-so-remote cause of the raging fires at which the Federal Reserve continues to train its gushing liquidity hoses.
But the firemen are also the arsonists. It was the Fed’s suppression of borrowing costs, and its predictable willingness to cut short Wall Street’s occasional selling squalls, that compromised the U.S. economy’s financial integrity.
The coronavirus pandemic would have called forth a dramatic response from the central bank in any case. Not even the most conservatively financed economy could long endure an official order to cease and desist commercial activity. But frail corporate balance sheets and overextended markets go far to explain the immensity of the interventions.
Perhaps never before has corporate America carried more low-grade debt in relation to its earning power than it does today. And rarely have equity valuations topped the ones quoted only weeks ago.
“John Bull can stand many things, but he can’t stand 2%,” said Walter Bagehot, the Victorian-era editor of the Economist, concerning the negative side effects of a rock-bottom cost of capital. Needing income, investors will take imprudent risks to get it. And if 2% invites trouble, zero percent almost demands it.
Interest rates are the critical prices that measure investment risk and set the present value of estimated future cash flows. The lower the rates, other things being equal, the higher the prices of stocks, bonds and real estate—and the greater the risk of holding those richly priced assets.
In 2010 the Federal Reserve set out to lift market prices through a rate-suppression program called quantitative easing. Chairman Ben Bernanke was forthright about his intentions. “Easier financial conditions will promote economic growth,” he wrote at the time. Lower interest rates would make housing more affordable and business investment more desirable. Higher stock prices would “boost consumer wealth and help increase confidence, which can also spur spending.” The Fed commandeered investment values into the government’s service. It seeded bull markets in the public interest.
But investment valuations don’t exist to serve a public-policy agenda. Their purpose is to allocate capital. Distort those values and you waste not only money but also time—human heartbeats.
Like a shark, credit must keep moving. Loans fall due and must be repaid or rolled over (or, in extremis, defaulted on). When the economy stops, as the world’s has effectively done, lenders are likely to demand the cash that not every borrower can produce.
To resolve the devastating panic of 1825, the Bank of England rendered “every assistance in our power,” as a director of the bank testified, “and we were not upon some occasions over nice.”
In a still more radical vein, the Fed has set about buying (or supporting the purchase of) commercial paper, residential mortgage-backed securities, Treasurys, investment-grade corporate bonds, commercial mortgage-backed securities and asset-backed securities. It has abolished bank reserve requirements. Through a new direct-lending program, the Fed has become a kind of commercial bank.
If not for the buildup of the financial excesses of the past 10 years, fewer such monetary kitchen sinks would likely have had to be deployed. No pandemic explains the central bank’s massive infusions into the so-called repo market that followed this past September’s unscripted spike in borrowing costs. For still obscure reasons, a banking system that apparently is more than adequately capitalized was unable to meet a sudden demand for funds on behalf of the dealers who warehouse immense portfolios of government debt.
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