Economic Damage Created by the Fed

With a turbulent flow of easy money having flooded into the banking system, the Federal Reserve System has inflicted great wounds on our economy. In previous posts we have shown that the Federal Reserve has failed to stimulate the American economy by means of the easy money policies of ZIRP and QE. See the posts Current Economic Effects of the Federal Reserve, Quantitative Easing and Its Effects, and Division in the Fed. We then speculated on some of the mechanisms that may have caused the failure in Why Have ZIRP and QE Failed?, none of which were  mutually exclusive and all of which may have contributed to the disaster. We have even discussed one of the main ways in which the Fed contributed to the smoking ruin of the American economy in the 2007-2008 financial crisis by financing the inflation of the real-estate bubble. Yet those narratives do not complete the tale of destruction the Fed has wreaked on the Economy.  

Besides inflating financial bubbles, the Federal Reserve kept the real interest rates for both short-term and long-term loans at “the zero lower bound“, as they liked to say, for six long years. Of course this is precisely what the Keynesians on the Fed desired. By holding real rates at zero, they said they would give incentive to companies to borrow and invest in productive capacity, thereby stimulating more economic production and creating more jobs. Unfortunately for the Fed and the nation, as we and many others have noted, it did not work. In addition, holding interest rates down for such a long period did its own damage apart from the easily available money for blowing bubbles.

The source of all new capital for investment is the national savings of the country, which comes from the savings of  households (which includes both individuals and families), companies, and government. The savings of companies are their retained earnings not yet invested. Government savings is defined as the difference between taxes (including fees) and government expenditures. Clearly in our era government savings has been negative and a drag on the system. Even with households, savings is not what it should be. Below is graphed the personal savings rate of household savings from January 1959 to July 2015 as the blue curve.

In July 2015 the personal savings rate was 4.9%, far less than the 10% to 31% people, who begin saving before age 40, are advised to save just to prepare for retirement. From the chart we can see the American people were minimally achieving this goal from 1959 to sometime in the mid 1970s. Then there was a slow secular decline until we hit the 2007-2008 financial crisis and the great recession. That traumatic event inspired Americans to raise their savings rate from 2.5% in November 2007 to 11% for one month in December 2012, after which the personal savings rate began to decay again.

Why has the savings rate been so low? Why should anyone save, or buy CDs and bonds when interest rates are effectively zero? This can be seen by comparing the yield of long-term treasury bonds in the red curve with the savings rate. Notice the long-term interest rate had to increase rapidly during the 1970s in order to keep the savings rate in the range between 10 and 13 percent, because of high inflation reducing the real interest rate. The slight dip in the savings rate in the latter half of the 1970s coincides with the advent of stagflation. Finally, the increasing long-term rates rose fast enough to raise the savings rate to healthy levels in 1981. After 1981 until the start of the Great Recession in 2007, the savings rate and long-term interest rates were tightly correlated and almost equivalent. The tremendous shock of the Great Recession temporarily broke this correlation. It caused people to increase savings levels as they tried to recover, while QE drove down the long-term interest rates. In early 2013 the correlation was recovered as the falling real long-term interest rates removed incentives to save. Currently, the real interest rates are in the neighborhood of the zero lower bound, and we can also expect the savings rate to fall to zero if nothing changes.

Why would not corporate investment take up the slack created by low savings rates? After all, with such low interest rates, both short and long-term, the borrowing of money from the banks should be essentially free! In fact, large corporations have been borrowing money in great amounts, but they have not been investing it in productive capacity. Instead, they have been buying back their own stock to increase the earnings per share by reducing the number of shares, and they have been using it to pay out dividends to the stockholders. As a side note, this corporate buy-back activity is part of the ultimately destructive stock market inflation enabled by the Fed. So why have corporations not borrowed to increase wealth producing capacity and hire more employees?

The answer to the last question is the hostile business environment companies currently have to endure within the United States. It used to be that the United States always ranked high up in the annually published economic freedom index produced by the Heritage Foundation. Now it can do no better than rank 12th. In the last seven years businesses have been hit with a vast new array of profit-sapping government regulations, including from the Dodd-Frank Act, Obamacare, EPA regulations designed to eliminate fossil fuel consumption and to gain control over land use through water regulation, and many others. In addition, U.S. corporate taxes are no longer globally competitive, as we noted in the posts Beware BEPS! and Economic Effects of Current Tax Policy. If it has become progressively more difficult to earn profits in the United States than in other parts of the world, one should not be surprised if companies would rather invest overseas than in the United States.

Many of our economic wounds have been inflicted by the executive and legislative branches of the federal government, although many of those culpabilities have been enabled by the Federal Reserve’s loose money policies. The progressive destruction of U.S. savings, however, belongs totally to the Federal Reserve.

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