By: Tim Hayes Financial Advisor - posted in: Investing - Last updated Nov 29, 2018

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Are We in Another Financial Bubble

by | Investing

In the movie All The Presidents Men, a source of reporter Bob Woodward nicknamed “Deep Throat” informs him that, to solve the mystery of Watergate, he needs to follow the money. To understand how the stock market can almost triple in value during a period of mediocre economic growth (2008-2017), we must do the same.

The Fed and Commercial Banks

The Federal Reserve System—a.k.a. the Federal Reserve and, informally, the Fed—is the central banking system of the United States. It is where banks deposit their money. Those deposits, called reserves, are how banks pay other banks. Say, for instance, that your bank is Wells Fargo, and you write a check for $2,500 to your car mechanic, who happens to bank at Citi. Wells deducts $2,500 from your checking account. Then they transfer $2,500 from their reserve account at the Fed to Citi’s reserve account. Citi then increases the mechanic’s checking account by $2,500. No actual cash moves—it is just a series of interlocking IOUs all handled electronically.

Before the 2008 financial crisis, banks did not keep a lot of reserves because, if some banks were short of reserves, they could always borrow them from other banks. But when the housing market crashed, some banks were afraid that other banks were insolvent. So the healthier ones stopped lending them their reserves, and the payment processing system described above was in jeopardy.

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Through its Troubled Asset Relief Program (TARP), the federal government authorized $700 billion to the financial system. By backstopping the banks in this way, the government prevented the reserve payment processing system from freezing. Had the Fed not acted, the economy would have ground to a standstill, and a depression would have most likely followed. The Fed also slashed the federal funds rate, that minimum interest rate at which the Fed hoped banks would borrow reserves from other banks. This rate eventually became zero, but the economy still languished.

Enter Quantitative Easing (QE)

Starting in late 2008, with a touch of a keyboard the Fed created trillions of dollars to buy bonds. The banks that sold the bonds ended up with reserves, but reserves are used only among banks, so very little of that money made it into the economy. To push new money into the economy, the Fed also bought bonds from such non-banks as pension plans and asset managers.

By “new money,” I mean money added to the economy without money being yanked from someone else’s account. Usually, when someone sells an asset, the buyer’s bank account is reduced by the price paid for that asset. For example, if I sell you a bond for $10,000, your bank account will drop by $10,000. But with QE, the Fed created the money, so the sellers received it without anyone’s bank account dropping. That means additional money, and purchasing power enters the economy. Some of the new money did bankroll the oil and gas shale boom, but a lot of it was used to buy existing stocks and high-yield bonds. Those purchases pushed up the prices of those financial assets, but buying existing financial assets does very little to help Main Street.I

Commercial Banks and Money

Commercial banks also create “new money” when lending. For example, say you go to your bank for a $100,000 home equity loan. The bank reviews your credit and decides to give you a loan, and with a click of a mouse, credits your account $100,000. No one’s bank account is reduced by $100,000. The $100,000 is new money, which creates new purchasing power for the economy.

Because banks create money out of thin air, they favor lending for the purchase of existing assets rather than lending to investment or the creation of new assets. That way, the existing assets can act as collateral, so if the borrower fails to pay the loan, the bank has an asset they can sell. Post-housing crisis, the one area in which bank lending is surging is to hedge funds and private equity. However, like QE, most of that new money goes to buy existing assets such as stocks and high-yield bonds.

Stock Buybacks

Companies spend on plants, equipment, products, buyouts of other companies, debt payment, or buybacks of their own stock. However, only spending on plants, equipment and products transmits directly into economic growth, because payment for goods helps their suppliers to prosper.

For the past ten to fifteen years, stock buybacks have been the preferred method of spending, as they reduce the amount of outstanding stock that boasts the earnings per share, making companies appear to be more profitable. Today, many executive salaries are paid in stock, and their level of stock compensation depends on earnings per share. In 2013, the companies in Standard & Poor’s 500 spent a total of $477 billion on stock buybacks. Moreover, they bought that stock after the stock market had increased over 100%. Companies don’t use “new money” for buybacks, but the money they do use is no longer available to fund plants, equipment, products, etc.

Money and Financial Bubbles

The Fed used to do what “Deep Throat” recommended. They followed the money, harnessing their powers as a regulator to get some of their “new money” into new investments—research, infrastructure, plant and equipment, etc.—and limit the amount of new money that went into existing financial assets.

But then the Fed began to focus less on where the money went and more on its cost—i.e., the interest rate—to try to control the new money. Commercial banks know best policy. And now much of the new money created by banks goes into buying existing assets. Corporations have also gotten into the act with their massive stock buyback programs. As a result, economic growth is generated only when assets rise, as the so-called “wealth effect,” i.e., house or stock price increases cause people to spend on other things. (The wealth effect is more pronounced with housing, because more people own homes than stocks.)

When most new money did go into the new investments mentioned above, housing and stock prices also went up—but they were the beneficiaries, not the drivers, of economic growth. More people benefited when new investment fueled economic growth. Plus, there are fewer financial bubbles.

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