In the wake of the Federal Reserves’s decision to once again not raise interest rates, the big question facing investors and policymakers is whether global economic growth is slowing and why. The short answer to the first question is yes: growth is starting to slow after several years of expansion in jobs and spending on consumer and capital goods. But don’t blame this on trade tensions or tariffs.
The source of the slowdown lies in a conflict between the world of monetary policy, on the one hand, and efforts to protect the global financial system, on the other. Regulators think, wrongly, that by limiting liquidity in global markets, they’re protecting our banks and markets. The Fed found out the hard way in December that such a volatile conflict can lead to very bad outcomes. Look at how the 10-year Treasury note has fallen three quarters of a percentage point in yield since Thanksgiving. That’s why the Fed recently relented and indicated that there may be no changes in policy for the rest of 2019.
Some observers blame the rise of trade protectionism for the slowdown in global growth, but in fact the major factors are fiscal spending, regulation, and monetary policy. The visible level of growth is slowing because of a contradictory mix of policies coming from the world’s major nations that limit credit in the private sector. In the U.S., for example, a period of artificially low interest rates—care of the Federal Open Market Committee—is ending, putting pressure on nearly every sector of the economy. The shift in income from savers to debtors engineered by the FOMC did temporarily boost debt creation and bank earnings, but these radical policies have left a legacy of potential risk to the financial system.
Perhaps the single most important issue is that monetary policy has become a drag on global growth. Negative interest rates are not a form of “stimulus.” There is a vast amount of public sector debt around the world—over $10 trillion in face amount—that now has a negative yield. When central banks deliberately pursue policies that force the cost of debt into negative territory, they are not stimulating economic growth. They are instead retarding job creation and consumer spending by confiscating private capital.
For some reason, many economists think that appropriating the capital of private companies and individual savers to benefit debtor nations through negative interest rates is somehow helpful. But clearly less private equity capital in the financial system means less leverage in the economy to promote new growth and jobs. Simply stated, the neoliberal view of economics that has dominated public policy for half a century puts the emphasis on subsidizing debtors at the expense of savers, a disastrous policy that has led to the present dead end in economic thinking.
The second reason that global growth is slowing, especially in places like Europe and China, is that governments in these regions have reached the effective limit of their abilities to artificially boost economic activity through spending. Most of the major nations of the world now have debt levels that suggest they will eventually default. Even in the face of clear evidence that each dollar of additional public debt generates less and less positive impact in terms of short-term job creation and consumer spending, policymakers persist in thinking that we need more spending and therefore more public debt.
Even more worrisome is the trend among global central banks towards officially embracing inflation as an affirmative policy objective. Agencies such as the Federal Reserve have abandoned their legal obligations to seek “price stability” and have instead decided that a 2 percent inflation rate is consistent with their legal mandate from Congress. The Humphrey-Hawkins law passed by Congress in 1978 commands the FOMC to seek zero inflation after “full employment” is achieved. There is even mention of stable interest rates. But no matter.
Chairman Jay Powell has apparently accepted the nonsense embraced by his predecessors, former Fed chairs Janet Yellen and Ben Bernanke, that 2 percent inflation equals zero. As David Kotok, chairman of Cumberland Advisors, told me in a recent interview, “Two percent inflation means that the real value of your wealth will be cut in half in 40 years. A person born today under the current Fed 2 percent policy who inherits $1 million at birth will have a quarter million worth of buying power remaining when they die.”
A third reason for the ebbing economic growth is that the negative, distortionary impact of low interest rates on the real economy is starting to become more evident. In the U.S. housing sector, for example, low interest rates have attracted financial investors into the markets for residential homes, mortgage loans, and mortgage servicing, which historically have not been attractive to institutional investors. The result of this effort by the FOMC to artificially shift the risk appetite of investors has been enormous damage to the real economy. It is now impossible for many families to buy a home.
There has been a diminution of profitability for mortgage lenders, leading to falling lending volumes, corporate failures, and literally thousands of job losses in one of the most important sectors of the U.S. economy. How is this helpful? Lending volumes for residential mortgages in the United States this year are at the lowest levels in a decade.
Finally, the decelerating growth is the result of a conflict between the expansive monetary policies being followed by the Fed and other major central banks and the restrictive rules imposed upon banks following the 2008 financial crisis. Limits on lending and efforts to artificially increase the liquidity of large banks have had the effect of reducing the supply of credit to business and individual customers. The volatility seen in the global financial markets in December 2018, for example, is a clear example of the conflict between monetary policy and financial regulation when it comes to economic growth.
You need only to look at the fact that market interest rates in the U.S. are falling—this even as the Fed has signaled a desire to see interest rates move higher—to understand that the current policy mix is not helping create jobs or growth in terms of investments in productive endeavors. As Jim Glassman of JPMorgan Chase wrote last year, “According to popular theory, Treasury yields should be much higher than they are, given the current rate of GDP growth.” Indeed. The 10-year Treasury note, the benchmark for the housing sector, was at 3.25 percent around Thanksgiving. It is now at 2.5 percent and heading lower.
The supervisory guidance to banks from financial regulators has been to avoid risk taking and maintain levels of capital that are frankly too high. Hard ceilings have been placed on all manner of bank lending, from commercial and industrial loans to construction finance and multifamily and residential real estate. As with the increased capital levels, the guidance from U.S. regulators makes it effectively impossible for banks to maintain levels of credit needed to fuel higher economic growth.
So what is to be done? In simple terms, we need to moderate the oppressive regulatory environment to allow banks to lend on reasonable terms to creditworthy borrowers. At the same time, the FOMC needs to realize that pushing short-term rates much above current levels in the near term is going to be counterproductive and could lead the U.S. down the path to a recession. The American economy simply cannot tolerate higher interest rates in the near term. Moreover, the levels of bad debt floated in the debt markets since 2008, much of it used to finance speculation, have made the system more fragile rather than less.
Until we can somehow harmonize the regulation of private credit provided by the banking system with public monetary policy, this conflict of visions between the worlds of monetary policy, fiscal policy, and financial regulation poses a serious risk to the U.S. economy. We need a more carefully thought out approach that balances the need for credit to fuel job growth and investment with the clear public desire to keep our financial system safe and sound. Until then, the conflicts that exist will continue to act as a drag on economic growth.
Christopher Whalen is an investment banker and chairman of Whalen Global Advisors LLC. He is the author of three books, including Ford Men: From Inspiration to Enterprise (2017) and Inflated: How Money and Debt Built the American Dream (2010). He edits The Institutional Risk Analyst, and appears regularly on such media outlets as CNBC, Bloomberg, Fox News, and Business News Network. Follow him on Twitter @rcwhalen.