With vacation time hanging heavy on my hands here on Isle au Haut off the coast of Maine, the solitude invited a plunge into the new book by Mohamed A. El-Erian. Mr. El-Erian, was the CEO of PIMCO, the bond trading behemoth, to list just one of his major accomplishments. His book is “The Only Game in Town --- Central Banks, Instability, and Avoiding the Next Collapse.” To this I add, “Oh, my!”
The central premise of the book is that our central bank, the Federal Reserve, has been the only effective bulwark against economic malaise. But as it fills a void, it finds itself in uncharted territory.
In the face of past financial challenges, a combination of both private and public sector participants used to step up and initiate a turnaround. This time, thanks to a dysfunctional government, their fiscal programs have been comparatively non-existent while a traumatized private sector has elected to avoid risk and hoard cash.
The Federal Reserve, therefore, has been hit with the sole responsibility of stimulating the economy by keeping interest rates low --- a policy that helps businesses and consumers while “taxing” lenders. This fills the vacuum created by the government that might otherwise have created programs to increase employment and economic growth. Mr. El-Erian reminds us that Congress has not crafted a budget in over five years while it has shut down the government for three weeks and brought us to a technical default thanks to debt ceilings on several occasions.
In the private sector, where we all invest our 401(k) money, there has been a decoupling of financial risk from economic risk. Financial risk is associated with stocks and bonds that reflect the perceived values of companies. Economic risk is the risk associated with actually operating companies and making decisions about hiring personnel and investing in more capital equipment. Financial risk exhibits short-term volatility, while economic risk has long pay-back periods before success or failure becomes apparent. Normally, there has been a correlation between the two types of risk, but today, the gap between them has never been wider.
While the Federal Reserve may be in uncharted waters, their actions as the only game in town have contributed to record high corporate profits, so this is not all bad --- just unsettling, because we don’t fully understand what might come next. In the meantime, our Treasury Department collects over $100 billion a year in interest on those bonds the Fed has purchased from the banks --- in return for the cash we gave them. At least that’s a plus.
Now, activist investors have successfully pressured companies to pay out those profits in the form of higher dividends or stock buy-backs --- both of which lead to increased (some would say inflated) stock prices. Corporate managers, who benefit personally from rising stock prices see little reason to spend that cash on growth that would employ more people. If they spend it on anything it would be to buy other companies to increase the size of what they get to manage --- a zero-sum game from an overall growth standpoint.
Finally, Mr. El-Erian explains why wealthy hedge fund managers, Steve Forbes and the politicians they support want to dump the Federal Reserve and return to the gold standard. It’s because they can’t trade against an investor (effectively the American Public) that has unlimited resources and the ability to make the rules.
If there has to be only one game left in town, it’s reassuring to know that the lone source of adult supervision lies with the Federal Reserve. Of the available options, they would be my choice for steering us through uncharted waters.