"You Just Pay For It": How Trump and Ocasio-Cortez Think Alike
“Obama had zero interest to worry about; we’re paying interest, a lot of interest.” – President Donald J. Trump, on the Fed’s interest-rate increases.
“You just pay for it.” – Alexandria Ocasio-Cortez, on how to finance Medicare for all.
Fed watchers were positively giddy last week when Chairman Jerome Powell alluded to the Fed being closer to “neutral” on the interest rate front. Supposedly this meant the rate hikes that have largely occurred amid surging stock markets would end sooner rather than later.
Not asked enough is what the Fed or Powell could possibly mean by “neutral.” Ok, Fed officials do have some idea, at least of what they imagine it to be. It seems the “neutral real interest rate” is the “rate at which monetary policy is neither accommodative nor restrictive.” The words in quotes are those of Kevin Warsh, former vice chairman at the Fed. Warsh expressed a mild skepticism about the notion of a “neutral real interest rate,” though it’s not unreasonable to suggest that he was merely being polite to former colleagues. The very notion of Fed officials happening upon the neutral rate (“r-star” in the parlance of central bankers) brings new meaning to ridiculous.
Lest readers forget, the cost of credit is a globalized number arrived at through the infinite decisions made by billions of individuals around the world every millisecond. Short of the dollar’s price, the price of credit is the most important one in the world. That’s the case because we borrow money for what it can be exchanged for. The interest rate is the price of accessing everything on offer anywhere in which there are people working.
To believe then, that the Fed has a way of setting the correct rate, or more laughably, the “neutral rate,” is just childish. More to the point, it doesn’t matter. If anyone doubts this, they need only consider the rate at which they could borrow from a bank versus what Bill Gates would pay to borrow. Or consider actual businesses. In July of this year, big banks (you know, the ones the Fed projects its long overstated influence through) rejected 75 percent of small business loan applications. Think about that for a minute. The Fed has fiddled with its funds rate at very low levels for years now, but credit for the typical business is still highly scarce.
Crucial here is that difficult credit conditions are the norm. More crucial is that this is a good thing. While the Fed aims to centrally plan the cost of credit (as is the norm for non-market creations), market actors operate as though the central bank doesn’t exist. For small businesses, credit conditions are always “recessionary” no matter where the Fed is in terms of “r-star.” For thriving businesses like Apple, credit is always abundant. For Jeff Bezos or Tom Brady, they could walk into most any bank in the world only to walk out minutes later with many millions. Just the same, Bernie Madoff would be escorted out of most any bank in the world, regardless of what the Fed does.
Simply put, the price of accessing the world’s resources cannot be altered by central planners. If it could, as in if the Fed’s rate machinations actually altered the flow of credit in substantial fashion, the U.S. – and realistically the global – economy would be endlessly weak. The previous point isn’t a speculation, it’s just a statement of the obvious. Does anyone remember the countries in the 20th century that tried central planning? It was an impoverishing, murderous failure. In the countries in which government planners allocated resources, the results were truly disastrous.
Taking it further, let’s also not forget what’s previously been alluded to: the Fed projects its vastly overstated influence through banks. About banks, there’s nothing wrong with them. They’re not inherently bad as some so naively attest. But as any banker will confirm, interest-bearing loans are not remotely the same as equity finance. Translated, well run banks must issue loans that will be paid back given the razor-thin margins they operate under. It’s a reminder that banks generally can’t take risks on the dynamic companies that drive big jumps in growth. Banks must lend to what’s known. That’s all well and good, but economic progress is to some degree driven by surprise; as in it’s driven by equity financing in companies that have rather high odds of failure. In short, what powers the economy is finance that has nothing to do with the Fed’s machinations.
Credit is once again difficult. Being turned down for it is the market rule, even in the United States. Applying this simple truth to now Representative Cortez, “You just pay for it” shows how divorced from reality politicians are. They can say “you just pay for it” precisely because they’re backed by the most productive people on earth. As for President Trump, his incoherent ramblings about the Fed reveal him as not much more grounded than the avowed socialist in Cortez. Trump laments that “Obama had zero interest to worry about” as though the Fed, for being the Fed, could merely decree zero cost borrowing for the U.S. Treasury, or businesses more broadly. With Treasuries, Trump is mistaking cause and effect. The Fed couldn’t decree easy borrowing any more than Mayor De Blasio could decree cheap apartment purchases and rentals in Trump Tower. Just as the cost of buying and renting at 725 5th Avenue is always going to reflect market realities, so is the cost of Treasury borrowing. It’s low because it’s backed by productive people, not because the Fed made it that way. With businesses, Facebook is always going to borrow at a much lower rate than the corner store; assuming the corner store can attain bank financing at all. The Fed is a rate follower, not a rate setter.
Bringing this all back to the market’s alleged excitement over Powell’s mention of a looming rate pause, it seems the Fed watchers have yet again gone overboard with their simplistic perception of equity markets, and the Fed’s ability to plan their direction through rate machinations. On its own, such a view is a non sequitur. Equity prices are a projection among investors about all the dollars a company will earn in the future. How the Fed’s fiddling with a rate could impact equity prices has never been properly explained, nor has it been explained how the lowering of a central bank’s artificial rate would boost prices. Goodness, very few companies took the markets up (think Microsoft, Apple, Amazon, Facebook, etc.), and those same companies took the markets down too. Does anyone seriously think the Fed could alter their access to finance in a material way? In an empirical sense, it’s worth pointing out that the Bank of Japan kept rates at zero for years, yet equities never rallied. The Fed aggressively cut rates in 2001 and 2008 (to name but two instances) with no resulting equity rally.
That there was no resulting equity boom was logical. Just as the Fed can’t control the cost of credit, it most certainly can’t dictate the cost of equities through its artificial rate mechanism. If it could, then stocks would routinely be depressed given the central bank’s ability to perpetually prop up the present to the detriment of the future during which the good and great of tomorrow replace the mediocre and bad of today. To be clear, the best, most vibrant equity markets are those in which the future is regularly replacing the past. More specifically, U.S. equity markets roar precisely because the leading U.S. companies when the 21st century began (names like GE, Tyco and Worldcom) are no longer on top today, to the extent that they're still around.
After that, stocks are rallying as yours truly types, and the buoyancy is said to be related to Trump blinking in his pursuit of what would be an equity-sapping trade war with China. Notable here is that the latest equity rally began last week, on a day in which the New York Times reported a “new willingness” on the part of Trump to achieve a trade truce with China.
So while the media consensus was that equities rallied in response to a telegraphed pause in the Fed’s rate fiddling, stocks had been rallying throughout 2018 despite persistent rate hikes from the central bank, and promises of more. With the Fed and equities, there’s not much there to it. Same with the economy more broadly. If the Fed were a fraction as powerful as its watchers assume, neither the U.S. economy nor its stock market would rate any of our attention to begin with.