On “Febezzlements”: Introspection (or lack thereof) and the Fed Put (or lack thereof)

“One should recognize reality even when one doesn’t like it, indeed especially when one doesn’t like it” – Charlie Munger?

“Febezzle” is just a word that Charlie Munger made up in the year 2000. Derived from John Kenneth Galbraith’s word “bezzle” which was a contraction of the word “embezzle”. Galbraith’s “bezzle” described the stimulating economic impact of undisclosed embezzlement. The embezzler of funds is richer and spends more, while the person whose funds were embezzled also spends more, as on paper they appear wealthier. Of course, this all crashes when fraud is exposed. Perhaps Bernie Madoff and FTX are modern day examples of “bezzle.” As for “febezzle,” Munger described what are the functional equivalents of “bezzle” which he attributed to “foolish investment management practices.” Munger believed “febezzle” could occur for much longer than outright frauds. Munger’s “febezzle” occurs when an investment manager earns compensation from the rising value of the assets under management during periods of rising asset prices. In his example, the asset manager receives the “wasted” asset management fees and other stock compensation from the investors as income, making them richer, and the investor, despite paying the asset management fees, also feels richer. Both parties believe they are “virtuously earning income” and can sustain spending from what they believe is income but is in reality spending from a “wealth effect,” which dissipates if asset prices decline. Munger went on to bemoan the impact “febezzle” can have on the misallocation of capital to unproductive projects and foolish spending which cannot support the continued increase in values, the fall of which led to real and long-lasting macroeconomic consequences once the “febezzle” starts to unwind. Munger’s advice: “when the financial scene starts reminding you of Sodom and Gomorrah, you should fear practical consequences even if you like to participate in what is going on.”?

Should we be concerned about this wealth effect in reverse? We know that low interest rates lead to higher valuations and encourage the buildup of debt in both the public and private sectors. With the Federal Reserve raising interest rates, it seems fair to wonder how much extra stimulus has already occurred through rising valuation in assets that won’t generate enough future cash flow to support their valuation.?

A topic of recent discussions has been whether the Federal Reserve is committing an error with their policy of setting a higher interest rate target. The discussion tends to go something like this: of course, there was a bout of inflation, but that is now ending, the consumer is tapped out, and the Fed, by raising rates, will cause firms to delay projects, lose money, lay-off workers, and harm the economy writ large. This might sound to some like a bit like fearmongering over the unwinding of a “febezzle,” and, in my opinion, there is a lot to agree with in the concern embedded in this line of narrative – and we’ll get to that.?

This fearmongering may very well prove correct. Nonetheless, it lacks any introspection. What were consumers spending so much money on? How might some investments go south? Could it be excessive leverage and an implicit bet that rates would stay low in perpetuity? Why have certain asset values increased so much? Could it have been a function of the low interest rates and negative real interest rates that allowed some asset classes to attract so much capital in the first place? Wouldn’t the prospect of earning a higher return lead to more supply, not less? Is the best public policy to keep inflation above target so that certain segments of the economy can continue to grow, and capital stays invested in certain asset classes??

I am all for a debate around Federal Reserve policy and a discussion of government dysfunction more broadly, but I think that we must be willing to ask whether the period of extremely low and negative real interest rates experienced for much of the period from 2009 through 2021 helped certain industries disproportionately. When engaging in the current Fed bashing, one should at least be willing to reflect on what has been a prolonged period where the Federal Reserve and the U.S. Treasury have explicitly and implicitly supported certain investors.?

I tend to believe that Jerome Powell knows that raising interest rates is not making him any new friends. In Chair Powell’s recent address at the Symposium on Central Bank Independence in Sweden, he stated that “…restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy.” In his defense, I think we all know that high and unstable inflation can be disastrous for an economy by making long-term planning nearly impossible. High inflation also redistributes income and wealth. Those borrowing large sums benefit at the expense of savers, forcing savers to reach for yield, often benefiting asset owners. By all measures real earnings of labor have not kept pace with returns on capital.?

Setting that aside, is the current Fed policy about to indiscriminately kill the economy???

Before attempting to answer that question, there are two topics that often get lost in the discussion that can help ground views on what the Fed should be doing at present: (1) Theories of inflation and (2) The role of the central bank.?

We can all debate where the current bout of inflation came from and how it will be resolved. As a “finance guy,” I tend to find John Cochrane’s Fiscal Theory of the Price Level very interesting. Cochrane’s theory values money (defined as cash, reserves [cash and reserves just being overnight government debt] and government debt [which are promises to pay money]) the way those in finance would value any other asset, as the present value of the expected future cash flows. Money is backed by a claim on future surpluses. In the case of government debt/money, that is the present value of current and future government surpluses discounted at the real interest rate. The consequence of Cochrane’s theory is that inflation occurs when investors believe the government has issued more debt than they can credibly pay back, such that the price level adjusts to inflate away some of the debt. In the context of inflation today, this sounds like a plausible model given the fiscal largesse of our government and the size of COVID-related stimulus, possible student loan forgiveness, etc. If there is too much money (Cochrane’s definition of money) chasing too few goods you get inflation. If the government issues $5 trillion of debt and we all expect we’ll be repaying this from future taxes, we won’t rush out to spend this newfound wealth as we’ll know we need to repay it in the future and it won’t be as inflationary (this is a true debt issuance, like a company issuing stock that investors believe will be accretive to earnings). While this theory sounds simple and intuitive, the nuances of this are so complicated that Cochrane wrote something like 600 pages to explain this theory. I’m not stating here that Cochrane theory is correct; you are welcome to look at monetarism, Keynesian and New Keynesian theories, or other theories.?

Cochrane’s theory would say that the Fed can change the timing of when the inflation is experienced, smoothing it over time, but it would take a credible commitment by the government to raise taxes, create growth through policy, or a change in the real discount rate to bring inflation down. Cochrane likes to state that the interest rate target sets expected inflation; fiscal policy determines unexpected inflation. With interest rate targets now above 4%, this statement would imply that expected inflation would be 4%, barring any other shocks. This may make some intuitive sense if you consider that higher interest paid on government debt ultimately requires more money.?

“The broader perspective is important because the new Keynesian/old monetarist view implicitly embeds a dirty little secret: for monetary policy to successfully control inflation, fiscal policy must behave in a particular, circumscribed manner.” – Eric Leeper?

One other detour: if we are discounting cash flows at a real rate, or the neutral rate, what exactly is that rate? Edward Chancellor’s excellent book, “The Price of Time,” has a detailed account of the history and debate over whether interest is moral, determinants of the level of interest, and the consequences of low interest rates. As it relates to the connection of interest rates to the real economy, Chancellor makes reference to French economist Anne-Roberts Jacques Turgot’s statement that “Every capital in the form of money…is the equivalent of a piece of land producing a revenue equal to a particular fraction of this sum.” As Chancellor provides: “For Turgot, the world of finance was a mirror held up to the world, with real and financial assets exchangeable for each other. Since land, buildings and factories produce income, so money must yield interest.” Chancellor further states that interest exists because loans are productive, and even when not productive, still have value. It exists because those in possession of capital need to be induced to lend, and because lending is a risky business. It exists because production takes place over time and human beings are naturally impatient. Invoking Englishman Thomas Wilson, Chancellor provides that interest is summarily the price of time.?

As for the natural, or neutral rate of interest, this is the rate of interest that would prevail in an economy even if there was no money. The natural rate of interest was “money neutral”, it was a function of “real” factors. Swedish economist Knut Wicksell is the best known for positing the concept of the “natural rate” which today is accepted as something unobserved but tied to factors like population growth and productivity as opposed to monetary factors. Wicksell believed that while you could not see the natural rate, you could see the impact of policies that kept rates above or below this rate by looking at trend growth rates. Today, our central bankers discuss their interest rate policy relative to this neutral rate or “R-Star” to determine if their policy is restrictive or not.?

“Nature’s productivity has a strong tendency to keep up the rate of interest” – Irving Fisher?

As for the Federal Reserve targeting interest rates, Lev Menand’s “The Fed Unbound” provides a succinct history of the Federal Reserve. For Menand, the challenges at the forefront of the establishment of the Federal Reserve System were those of “(1) deflation, (2) maldistribution and (3) insufficient political legitimacy.” We take for granted that we live in a monetary system whereby much of our day-to-day money is “inside money,” IOUs from banks or other institutions (i.e., checking accounts). Throughout history, runs on these IOUs have cascaded into crisis (i.e., bank runs) and one of the Fed’s primary missions was to keep deposits from shrinking and ensuring a lack of money created by the banking system doesn’t cause the economy to fail to achieve its longer run growth potential by maintaining stable growth in price level and maximum employment. To do so, money claims issued by regulated banks would trade at par with government money.?

It’s worth keeping in mind that throughout much of Fed history, such as during the Volcker Fed, the Fed didn’t target interest rates, it targeted the supply of bank reserves, letting the interest rate fall where it may in the Fed Funds market. Today’s Fed doesn’t even operate with a reserve requirement for member banks, and in effect will supply as much money as desired to member banks at the interest rate it sets. This isn’t the only way the Fed interacts with the economy, but it’s the primary tool being focused on by market participants at present.?

One other tool the Fed has used over the last decade both in the GFC and the pandemic were their emergency powers to lend to non-chartered banks under what is referred to as their 13(3) authority under the Federal Reserve Act, which requires blessing from the U.S. Treasury. Through these programs, the Fed allowed what were otherwise “money claims” (IOUs) backed by all kinds of assets to be money good. In other words, certain non-bank IOUs traded at par with government cash. During the COVID-19 pandemic, the Fed administered several programs under the CARES Act to promote credit and liquidity in the economy, aiding some sectors more than others. We commonly refer to situations where the government and central bank support certain industries as “bailouts.”?

Now back to Cochrane’s theory of inflation. If inflation is related to government liabilities, and the government is willing to bring what were previously private obligations (inside money) onto its balance sheet while also increasing deficits, then Cochrane’s equation would likely say that, all else equal, that would increase government obligations with no corresponding increase in future real surpluses and therefore cause inflation. Why inflation may not occur at once in this scenario would likely be due to a decline in the real interest rate, driven by uncertainty over the future of real growth, thereby increasing the present value of the expected long run future surpluses. However, as we’ve come out of the pandemic, with government seemingly lacking a credible plan to cut spending or otherwise increase revenue and real interest rates increasing with the real resources coming back online, the inflation cost would eventually have to be paid. Setting aside the moral hazard of bailouts, in fairness there is also some nuance around whether certain initiatives were indeed bailouts or could cause inflation, especially if these programs ultimately were backed by future revenue generated by the assets acquired by the central bank and government.?

With some of these factors in mind, you would think criticism of the Fed might be a little more nuanced, no??

Aside from obvious economic support during the pandemic, for most of history some economists have been warning about the impact of interest rate targets being set below the natural rate of interest, and the resultant misallocation of capital, credit driven booms and bubbles. Recent examples include the work of William White and Claudio Borio during time together at the BIS. White’s 2012 paper “Ultra Easy Monetary Policy and the Law of Unintended Consequences” warned that ultra-low rates ultimately lead to misallocation of real resources with consequences for the real economy. One area that economists such as Borio and White cite as a source of concern during period of low interest rates is excessive capital allocation to ?low-productivity” sectors like housing.?

Pre-dating White and Borio, in “The Wealth of Nations,” Adam Smith devoted much ink to the share of income that should be paid in rent. Smith was careful to distinguish between housing and what he called “profitable buildings which are the means of procuring revenue not only to the proprietor who lets them from rent, but to the person who possesses them and pays that rent for them; such as shops, warehouses…These are very different from dwelling-houses.” “A dwelling-house, as such, contributes nothing to the revenue of the inhabitant; and though it is, no doubt, extremely useful to him, it is as his clothes and household furniture are useful to him, which, however, make a part of his expense not of his revenue. If it is to be let to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue, which he derives, either from labour, or stock, or land. Though a house therefore, may yield a revenue to its proprietor, and thereby serve in the function of a capital to him, it cannot yield any to the public, nor serve in the function of a capital to it, and the revenue of the whole body of the people can never be to the smallest degree increased by it.”?

To me, Smith’s description of “dwelling houses,” or what we would call residential housing, is most concisely summed up by comedian George Carlin’s famous “A Place for My Stuff” routine, in which Carlin provides: “That’s all your house is — a place to keep your stuff…A house is just a pile of stuff with a cover on it.” In today’s economy, Smith’s distinction appears to have lost its meaning as “dwelling-houses” have become just as much an investable asset class as “profitable buildings.” Maybe work-from-home has made that distinction blurrier, but we should at least wonder if so much capital being attracted to investments that Smith saw as effectively unproductive has been a worthy endeavor. Whether you agree with this thinking or not, it still leaves open questions about why we might be under-supplied in housing??

Nevertheless, I agree with the concern surrounding the possibility of the Fed committing a policy error by continuing to raise interest rates and by leaving interest rates at their current level, as there does appear to be a financial stability risk insomuch as rising interest rates may cause some highly indebted investments in unproductive sectors to unwind and cause what equates to a debt deflation or alternatively a hyperinflation. The debt deflation outcome occurs if the febezzle unwinds such that IOUs thought to be “money” turn out to be worth less than expected, leading to a classic debt deflation spiral. The possibility of hyperinflation could occur if those same IOUs end up on the balance sheet of the government with no associated, credible means of repayment. Perhaps the current conundrum is driven by a failure of policy on many fronts, from wasteful government spending, costly regulations, to interest rate policies that were destabilizing.?

So, what’s the Fed to do? I turn back to Cochrane’s theory of inflation. Cochrane’s theory would provide that the current inflation environment will go away even if the Fed does nothing. Setting aside whether that theory is correct, if the Fed were to stop raising interest rates, they may seemingly further allow the unproductive buildup of unbacked commitments and inflation. In Cochrane’s theory, the role of an independent central bank is to help ensure that a government pays back its debt with future surpluses. Arguably, higher rates at present would help reign in government spending, encourage policies that will lead to reforms in healthcare, education, research, and entitlements that can lead to real productive economic growth in the long run.?

“I define central bank independence in one sentence, it's the ability to raise interest rates when the Treasury doesn't want you to. And the Treasury almost never wants you to, because of the cost of the debt.” – Peter Stella?

?The alternative seems to be for the Fed to stand pat, cut rates, and increase the level of reserves in the banking system through restarting quantitative easing (QE). Taking it a step further, if the value of stocks or real estate fall, the Fed can turn to programs to backstop these values. Let the febezzle continue, why not? None of us wants to see people lose their jobs. However, I believe this policy choice is not free. ?Allowing economic actors to reap private rewards with no public benefits while remaining protected from risk is “moral hazard.” ??

“A riskless society is 'unattainable and infinitely expensive’” – Edwin Goldwasser?

While the wealth effect in reverse is painful, ending febezzles enabled by the “Fed Put,” returning to a reasonable interest rate regime, encouraging more equity to reduce the risk of sudden blow-ups, seem like a reasonable policy stance.?

As Chancellor states: “Without interest, future income streams are impossible to value. Capital can’t be properly allocated and too little is saved. If this situation continues for long, then the state investment would have to replace private investment and central banks would have to replace commercial banks as the major providers of credit.” Holding onto a system where most gains are privatized and losses socialized is likely not the long run solution we’re looking for to ensure future generations can meet the challenges they’re likely to face.?

Let’s get back to a system where risk is rewarded, failure allowed and supported by the appropriate safety nets and trampolines (see Michael Falk), such that true innovation can flourish and society as a whole benefit. Interest rates are one of the most meaningful price signals in our economy and we need accurate risk pricing to ensure our capitalist system allocates capital to the most worthwhile endeavors. To me, that means time should have an appropriate cost which leads to the need to finance investment with appropriate capital structures and acknowledging and transferring risk when appropriate.?

“As a rule, panics do not destroy capital, they merely reveal the extent to which it has previously been destroyed by a betrayal into hopelessly unproductive works.” – John Mills?