What’s Happening with the Economy? The Great Wealth Transfer

The economy clearly isn’t reacting in the usual way to the Fed’s tightening; it is much stronger than normal and stronger than expected. Why is that? The answer is in the data that I will paint for you in this post’s charts. Before I do that, I will summarize.

There was a big government-engineered shift in wealth from 1) the public sector (the central government and central bank) and 2) holders of government bonds to 3) the private sector (i.e., households and businesses). This made the private sector relatively insensitive to the Fed’s very rapid tightening to a more normal monetary policy. As a result of this coordinated government maneuver, the household sector’s balance sheets and income statements are in good shape, while the government’s are in bad shape. In the US and globally, the central governments’ balance sheets and income statements are bad and getting worse because the governments ran and are still running large deficits. They also have big losses on the government bonds they bought to fund the government debts and, with their balance sheets where they are, are losing money where interest rates are.?Said more simply, central governments took on a lot more debt (so their balance sheets deteriorated) and central banks printed a lot more money (which caused inflation to rise) and bought a lot of the debt to get money into the hands of the private sector which, as a result, is now in relatively good shape financially.???

This took place in 2020 and 2021 when there were huge budget deficits (e.g., 10-14% of GDP in the US) and huge central bank purchases of bonds (e.g., Fed bond holdings jumped from 18% to 35% of GDP), holding rates down to zero or lower. You will recall the period of free money and nil or negative interest rates.?The question I often got then was how one could make money owning bonds with negative interest rates. The answer was by borrowing at even more negative interest rates than the central banks were offering. Imagine that! That’s when cash was trash, so it was good to borrow and bad to own. That’s what a lot of banks did with the central banks’ encouragement. Also, when people and businesses got big piles of money from the governments, lots of money was deposited in banks, which had low loan demand, so they bought “safe” government bonds at that favorable interest rate spread.

Then in 2022, with inflation roaring and unemployment low, there was a move toward less insanely easy fiscal policies (e.g., a reduction in the US budget deficit from an enormous 12% of GDP to very large 5-6% of GDP), and there were rapid moves from central banks away from insanely easy monetary policies?(e.g., -1.5% real bond rates?with a huge balance sheet expansion to a more normal level of tightness with +1.5% real bond yields and a gradual shrinking of the balance sheet in the US). While this tightening sent bonds and stocks down and squeezed some areas of the capital markets and the economy (e.g., venture capital, private equity, and commercial real estate), the private sector’s net worth rose to high levels, unemployment rates fell to low levels, and compensation increased a lot, so the private sector was much better off while central governments got a lot more in debt and central banks and other government bond holders lost lots of money on those bonds.

Does it matter that the central governments and central banks have such bad balance sheets and income statements if the real economy is in pretty good shape? Of course it does! As with people and companies, governments that borrow have debt service payments and eventually have to pay back principal, which is painful. The only differences in their finances are that governments can confiscate wealth through taxes and print money via the central bank (so that’s what we should expect to happen). Will this be a big problem? The answer is probably not much over the near term but probably a lot later. That is for reasons I will explain briefly here and more comprehensively in a later writing.?

Before I give you my brief synopsis, I want to point out that long-term history is a good guide. Though this big government maneuver hasn’t happened before in our lifetimes, it happened many times in history. In fact, I described this typical maneuver used at this stage in the long-term debt cycle in my book Principles for Navigating Big Debt Crises, which I published back in 2018. The book looks at the biggest debt crises over the last 100 years and explains how the classic big debt cycle works, including how big debt burdens get reduced, which is commonly through the approach governments are now using.?

In the book, I called this approach Monetary Policy 3 (MP3) because, in the long-term debt cycle, it typically occurs after?MP1, which is monetary policy via interest rate changes without big central bank balance sheet changes (i.e., without the “printing of money” and buying of financial assets), and after MP2, which is the central bank’s “printing of money” and buying of financial assets (also known as “quantitative easing,” or QE), which is done when the free market demand for the debt falls short of the free market supply of the debt and the central bank would like to stimulate the economy but can’t do it through interest rate cuts. The problem with MP2 that leads to MP3 is that while buying financial assets helps the holders of financial assets, it doesn’t help get the money and credit into the hands of the people who need it the most. Targeting getting the money to those who need it most can only be done by central governments because they have the authority to send money to those they want to send it to, so the symbiotic relationship that I described as MP3 occurs. Though I won’t delve into an explanation of this classic cycle and these types of monetary policy here, if you’re interested, you can read about them in this free PDF version of Principles for Navigating Big Debt Crises.

By the way, despite my seeing this dynamic happening and studying those cases, I failed to fully appreciate how much the improved financial condition of the private sector would soften the impact of the Fed’s tightening because I was too focused on how the last 12 tightening cycles (since 1945, when the new world and currency order began) worked. Now, I will give some brief thoughts about what my lessons from history and my projections tell me about the possible future.?Then I will paint the picture with charts.?

Briefly Looking Ahead?

Over the near term, if there isn’t a big supply/demand imbalance in which the amount of government debt sold overwhelms the amount of demand for these debt assets, it appears that a period of tolerably slow growth and tolerably high inflation (a mild stagflation) is most likely. Of course, there is a significant range of uncertainty around that because what we don’t know is greater than what we do know about a lot of influences (e.g., politics, geopolitics, the environment, and technology’s impact). However, over the long term, from looking at history and penciling out what is likely, it is virtually certain that central governments’ deficits will be large, and it is highly probable that they will grow at an increasing rate as the increasing debt service costs plus increasing other budget costs compound upward, and, as they increase, governments will need to sell more debt, so there will be a self-reinforcing debt spiral that will lead to market-imposed debt limits while central banks will be forced to print more money and buy more debt as they experience losses and deteriorating balance sheets. While central banks have had significant losses, they are not yet at the point of these losses affecting monetary policy, but it is not inconceivable that they will follow the classic late big cycle dynamic, which is also consistent with not unreasonable projections that are deeply concerning as to what might happen. The concerning scenario that could occur if deficits compound so that there is more supply of government bonds than there is demand is that either interest rates will rise or central banks will have to buy more to try to hold them down, but in either case central banks’ losses and their negative net worths reach magnitudes that could have adverse effects on monetary policies directly (because they have to monetize their own and the central governments’ losses) and/or indirectly (because such losses could become political issues). Germany—which experienced this late debt cycle dynamic that destroyed the value of its money in the 1920s and the 1940s and so is wary of this dynamic and as a result?is inclined to be more conservative monetarily—is now considering whether its central bank’s losses (i.e., Bundesbank losses) and its negative net worth positions should be handled in the classically proper way of having the central bank get capital from the central government, which hits the central bank’s budget and thus raises the budget deficit. In the UK, where central bank losses are handled this way, the Treasury will need to borrow another ~2% of UK GDP to cover the Bank of England’s negative equity position. A number of central banks are now considering what to do under this type of scenario. One could even imagine in the US that large central bank losses and negative central bank net worth could cause political reactions that would threaten the central bank’s independence and lead to more political controls over it.

To be clear, I’m not saying this will happen; I’m not sure about anything, and I’m getting ahead of where I intend to go in this report, so I will get back to painting the picture of what happened in charts.?

Painting the Picture of What Happened in Charts

I will now show you a bunch of measures of the forces I described for the US. There are different versions of these that are broadly similar in most countries. These charts will come in pairs, with the one on top showing the measure(s) since 2018 so you can see it closely and the one below showing it since 1970 to help you put it into a longer-term perspective.?

This first pair of charts shown on the left below shows the total income (which includes the money handed out via the government), employment income, and total spending. The second chart pair (on the right) shows the savings rate. As you can see from the one on the upper left,?the amount of income from employment plunged but the total?amount of income soared by a lot more, in two big waves, because of the big government handouts. The first big handout was under Trump, which was in response to COVID and was?about?$2.2 trillion, and?the second was under Biden and amounted to $1.9 trillion to provide added social, financial, and infrastructure support. As you can also see in the top-left chart, spending plunged at first during COVID and then surged and recovered steadily. As has always proven to be the case, when you give people money and credit with incentives to spend it, they will find a way to spend it.?The chart on the top right shows how there were two big surges in the savings rate as the money poured in and how it declined to new low levels as spending picked up. A lot of those savings were deposited into banks, which bought government bonds because loan demand was weak. Remember that the savings rate is the savings relative to the income and is not a reflection of the incomes and balance sheets of the household sector, so its current low level shouldn’t be misconstrued to mean that the household sector is in a cash-strapped position. It’s not, as we will soon see.??

The next pair of charts on the left shows real household wealth along with the real asset and liability levels that make that up. As you can see, real debts were flat and real assets went up so net worths soared. They soared to new highs in response to the fiscal and monetary stimulations and declined a bit due to the Fed’s tightening but remain very high by historical measures.?The charts on the right show the household sector’s borrowings, which, as you can see, picked up during the easings and declined during the tightenings.??

The next two pairs of charts show the unemployment rate and the growth rate of compensation. As you can see, while the unemployment rate surged during COVID, it has now plunged to the lowest level since the late ‘60s. At the same time, compensation increases soared. As reflected in both the previous two pairs of charts and these two pairs, the balance sheets and the income statements have been strong.?

The next two pairs of charts show the US budget deficit (on the left) and the Federal Reserve’s bond holdings (on the right). In them, you can see the massive deficits and the massive Fed bond purchases to fund these deficits in 2020 and 2021. In the ones on the left, you can see that these deficits are still large and tending toward worsening, and in the ones on the right you can see that, since the beginning of MP2 in 2008, the Fed accumulating bonds has been the norm, with two occasional and modest exceptions. I am watching this number closely because I believe the next significant increase in monetization will probably signal the last and probably biggest leg of the long-term debt cycle’s reduction in the values and burdens of debts.??

The next two pairs of charts show nominal government interest rates (on the left) and real interest rates (on the right). As shown, they went to all-time low levels in 2020-21 and then were raised to more normal levels.?

The next two pairs of charts show commercial bank bond holdings (on the left) and mark-to-market gains and losses of commercial banks and the Fed (on the right). As shown on the left, commercial banks made huge purchases of government bonds and, while they sold some, they still have near record levels of them. As shown in the pair of charts on the right, commercial bank and Fed losses in these bonds came fast and are big.??

The next two pairs of charts show inflation and breakeven inflation as reflected in the bond markets. I won’t get into the different types of inflation and the different time frames to measure them over because I’m just trying to convey the big pictures that are in these charts. You can see the big surge and the coming off of that, but not to prior levels or central-bank-targeted levels (on the left) and the relatively modest rise in breakeven inflation (on the right). In fact, if you were to believe the breakeven inflation numbers (which I don’t), the future inflation rates will go to the targeted inflation rates.??

While I can show you many more interesting charts that paint a much more detailed picture of how the economic machine has been working, I’m testing your patience, so I will instead just point out a few more interesting and important facts:

• The disparities in the developments and circumstances of different countries, different sectors, and different businesses are much greater than normal, so it is virtually impossible to understand and talk about the aggregates (e.g., the stock market, the economy, etc.) sensibly.?We have to understand them at the granular detail level and add them up to make sense of the whole.?I wish I could show and discuss these big differences, but that’s too much for me to do right now.?
• There are other big structural changes that I haven’t touched on that are changing everything that we have gotten used to. You know what I think about the five big forces: 1) the financial economic force that we just explored; 2) the domestic conflict force that will be extraordinarily forceful over the next two to five years, especially via the upcoming US elections; 3) the international conflict force that will also be extraordinarily forceful over the next two to five years; 4) the acts of nature force, most importantly the enormous climate costs that are certain over the next several years in the form of abandoning brown energy for green energy, rebuilding infrastructure to better withstand the changes, and the costs of the changes themselves; and 5) the force of technologies, which will certainly be very disruptive in both good and bad ways.?
• These will affect each other and add up to huge differences relative to the recent past. For example, the financial costs of “onshoring” and “friendshoring” and military spending in preparation for war (let alone the cost of war) and climate will affect the markets and the economy, which will affect the attitudes of stressed people who are on the brink of fighting each other, and this will affect politics and geopolitics. ??

Maybe I will write a piece about these big structural changes—including the good things and the good places—at another time, but I’m done for now.?

I hope this was of some use. Please give me feedback because at my stage in life I’m passing this stuff along?to be helpful and not as a job, so I’d like to know if my doing this is worthwhile for you.??

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