The Semi-Permanent Stimulus

The American markets have been going up, up, up over the past few years. Some prognosticators are expecting the trend to reverse soon, but I’m not in that camp. I think the markets will continue moving upwards for awhile, but I also think that it’s not necessarily a positive development.

The question is whether the economy is truly recovering or whether it’s merely being inflated through a large and continuous stimulus. My view is that the latter is more likely.

Since around 1998, the United States has almost always had either a fiscal or monetary stimulus. While there have been a few brief breaks in the past 15 years (mostly from around 2005 – 2008), for the most part, this stimulus has been continuous. We might call it a semi-permanent stimulus and it’s gradually expanded over the years. Arguably, it’s creating malinvestment all over the economy and leading to suboptimal economic outcomes.

The housing boom was one example of malinvestment that resulted from this constant stimulus. By keeping interest rates artificially low, we stimulated demand for housing. This was further complicated by a significant fiscal stimulus under the Bush Administration that came from military expansion. As a result, the American public overinvested in housing and created significant inflation, so that the average American saw no gains at all.

We started tightening monetary policy around 2005, which led to a break in the stimulus. I also wouldn’t discount the fact that 2005 was also the year that China loosened its own currency peg, which alleviated its need to purchase US treasury securities. With less demand from China, the Federal Reserve had a more difficult time keeping interest rates artificially low. This shift may have very well been the impetus that helped turn the housing boom into bust.

Once things crashed, the Fed had to ease policy in order to prevent a liquidity trap. They mostly took the right steps during the crisis, but we got past the “crisis-stage” sometime around late 2009. We’ve never really reverted back to more normalized operations, as the Federal Reserve has continued to invent new reasons for quantitative easing. Admittedly, some of their experiments have not achieved their objectives, but that was ultimately only because the housing bust had so thoroughly obliterated demand for mortgage loans. Now that the housing market is starting to recover, this constant quantitative easing could become much more problematic.

Monetary policy may not even be the biggest danger at this point. The Federal government has continued to run fiscal deficits between 8% – 10% of GDP over the past four years and there seems to be no end in sight under the Obama Administration. Since the US is a sovereign issuer of its own currency, this essentially means that every time we run a fiscal deficit, new money is being created and pumped into the economy.

The Administration views this semi-permanent stimulus as beneficial because unemployment is still elevated, but unemployment is likely driven more by structural factors that the current Administration has introduced, including the so-called Affordable Care Act, and the Dodd-Frank financial reform bill.

We act as if it’s shocking that the market is recovering so dramatically, but this is exactly the result we should expect when the Federal government is creating a gigantic semi-permanent stimulus. But this stimulus is likely leading to malinvestment. It will likely soon result in significant inflation in asset prices and it will act as a stealth tax on lower and middle income individuals.

The stimulus is funded through money creation. Money creation benefits banks the most. While it doesn’t necessarily benefit “the wealthy," wealthier citizens do have more options on how to avoid the impact of inflation. Many wealth individuals will invest in hard assets (such as real estate) that protects their wealth. Lower and middle income individuals have fewer options. Buying a home is one option for middle income individuals, but the Obama Administration has become tightening rules for mortgages, pushing more middle class citizens into the rental market, where they are exposed to inflation.

I’m not trying to promote gloom-and-doom. My goal has always been to try to understand the reality before me, and the one I see is a large government creating a semi-permanent stimulus that is inflating asset prices and equity markets, but that is likely creating very little real wealth for the average American citizen.

The likely outcome: Expect interest rates to rise over the next few years and the Federal Reserve will eventually be forced to tighten the screws, in spite of proclamations to the contrary. It’s at that point that equity investing will become much riskier.

A less likely alternative: Call it a long-shot, but if Congress were to significant reduce the deficit, then you’ll see the economy slow down, as well. This will actually be a positive long-term development for the US economy, but could get ugly in the short-run, as the “semi-permanent stimulus” is destroyed.