Mega Money, which is a large scale increase in the monetary base, creates unease — if not fear — among market participants. The fear is that it will lead to a cycling upward of prosperity and inflation, followed by an equally sharp downturn of both. Many have moved to the investing sidelines as a result of the uncertainty. They are alarmed at the prospects for a down-cycle because classroom theory or personal observations have taught them to expect it.
In academics, Mega Money creates an expectation for some version of “runaway inflation” whether based on neoclassicist, Austrian School, or monetarist thinking. Generally, it is taught that inflation is proportionate to the money surge.
But it should be understood that this version of the money-inflation linkage occurs when governments print money as a means to purchase goods. That is, the money is directly inserted into the economy’s spending stream, creating demand and higher prices as happened, for example, during the Civil War.
This is in contrast to today’s Mega Money, which has been inserted by central banks into financial asset markets as opposed to the direct route of inserting money into the goods market. So the effects of Mega Money, for better or worse, arise out of financial market purchases, which some might characterize as having inflated asset prices. The Mega Money process is that central banks purchase assets from private investors, and those investors, in turn, take the proceeds and purchase some other private sector financial claim that feeds some ventures with capital.
If the Mega Money is the result of central bank expansion, firms finance some activity, usually via credit market instruments (bonds or loans, etc.). So when credit-financed spending takes place, in things like plants and equipment, there is a short-term impact that generates spending, income, and jobs. The same can occur via the consumer sector where the credit funds investments in durables, such as autos or homes.
This is short term in nature and might generate some inflation if those goods are in short supply. This describes the classic Keynesian rationale and process of employing monetary policy to stimulate an economy.
However, the longer term impact of the money created depends crucially on whether the capital spending creates an income stream to retire the debt that was incurred in the process. If the debt-financed investments generate additional cash flows to retire the debt over time, and if it continues to generate additional cash flows, it become a gift that keeps on giving.
But if the use of the credit doesn’t generate cash flows to retire the debt, then its longer run influence is adverse because the debt is paid off from future income rather than from the underlying earnings of the investment undertaken.
To coin a term, this is Dead Weight Debt. It sounds bad, and it is. Dead Weight Debt compromises future income, and the usual cyclical responses are negative. That is to say, expect recessionary forces and all that goes with it: Less spending, lower income, less employment, lower market values of financial claims, deflation, and so on.
For example, consider the classic case of the housing boom (ending in 2007) and the subsequent bust: Easy money built houses which did not create its own income stream to retire the debt. It compromised future spending, creating The Great Recession and deflation instead of inflation.
This same issue arises today, post-election. The US government is contemplating major debt-financed infrastructure investments. Will the investment generate revenue streams to more than retire the debt incurred, or will it be Dead Weight debt that compromises future economic growth? This is the difference between a short-term positive lift vs. a longer term contribution to economic growth.
So the result of the central bank’s Mega Money depends on either the public or private investment returns it finances. If the returns are positive, taking into account the debt retirement, it can lead to sustainably higher growth rates — but if negative, it creates Dead Weight Debt, which is recessionary.
Take a look at how uncommon Mega Money episodes are in the US. The monetary base is shown from 1956 on forward. It reveals very steady growth with but a minor blip until 2009.
Then the monetary base rose, and it should be safe to say dramatically, as the increase over the following five-year period (2010 to 2014) was nearly 100 times the annual increases from the immediate prior years. That is to say, the Mega Money buy was the near equivalent of a century’s worth of buying.
So the question we have to ask today is, did the Mega Money-financed buy set up Dead Weight Debt that will become a burden on economic growth, or is the debt self-sustaining and will it contribute to future growth?
Since over that Great Recession time period it helped finance more than a doubling of US government debt outstanding, most of that debt must be argued to be Dead Weight as it didn’t create income streams.
The consumer sector did not participate in the temptation of cheap interest rates to add further debt and, in fact, continues to net pay down debt incurred in the housing boom.
But the corporate sector, it must be realized, participated heavily in borrowing from the Mega Money liquidity. Below shows the ramp up of Non-Financial Corporate Debt since just prior to the Great Recession.
The total amount of debt securities by the corporate sector rose from a base of $3.4 trillion, just prior to the Great Recession, to near $5.6 trillion. If you add in the growth of commercial and industrial bank loans of another $.7 trillion, the business sector debt gets above $6.3 trillion combined.
Much of this ramp-up of corporate borrowing was incurred at the extremely low interest rates that prevailed in the course of the Mega Money expansion. However, the funds were generally used by the borrowing businesses to repurchase its own equity shares off the secondary market. The purpose, then, of the transaction was to augment earnings on a per share basis rather than in total. Manipulating higher earnings on a per share basis by leveraging up the corporate balance sheets has to be the very essence of Dead Weight Debt. It contributes no income to retire the debt. Moreover, refinancing the debt at maturity means the interest carry costs will rise substantially at that time.
Interest rates have made their turn upward from all-time lows in July of this year. This means that debt service for the corporate sector will be rising, especially for those with junk ratings (as the default experience by junk rated firms is already moving up from 1.7% in the spring to north of 5.6% presently). Cash flow strains are hitting the business sector and will increase in the years to come when more debt is refinanced at higher interest rates. It will have adverse effects on corporate earnings and spending and market valuations.
So in evaluating the effects of Mega Money, the question to ask is, does the Mega Money finance productive investments that have led to increased income streams to retire the debt incurred? If not, Dead Weight dead is paid for with reduced future income.
This represents an important qualification from Keynesian thinking in which all monetary and credit expansion is thought of as always having a positive income payoff. This is a consideration that the Federal Reserve needs to grasp. Mega Money can lead to a depression if it creates enough Dead Weight Debt.
So far, almost nothing in this episode of Mega Money has been typical, certainly not as compared to the neo-classical outcomes of Mega Money turning into goods inflation. The stimulus phase of this episode of Mega Money financed energy and commodities investments at a cost to those who financed it. That is these investments didn’t create sufficient income streams. The gain was short term.
Mega Money has increased business leveraging and is starting to unwind. Will it be sufficient to take the specific companies down, and will it take the economy down along with them into a generalized recession? That remains to be seen.
To read more from Professor Lew Spellman, visit The Spellman Report.