Editor’s Note: As we finally enter 2021 — goodbye forever, 2020! — the old Wall Street phrase “Don’t Fight the Fed” could be recast as “Don’t Fight the Fiscal.” With government spending set to dominate the investment look for years to come, the final installment of our “best of” series revisits the difference between monetary policy measures and fiscal ones. Happy New Year! –JCL
October 2020 was an ugly month for the U.S. stock market. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all declined more than 2%, registering their second down month in a row.
Some will attribute this market weakness to pre-election jitters. In our view, it is more a reflection of post-election jitters — that is to say, what happens in the months after the election, rather than what happens with the election itself.
For the stock market, the immediately relevant question is not “Who is going to win the election?” but rather, “When will we get more fiscal stimulus?”
The real U.S. economy — meaning Main Street, rather than Wall Street — needs help from the government to keep consumers and small businesses from going under, particularly with COVID-19 cases topping 100,000 per day and the threat of new evictions and shutdowns looming.
Wall Street craves fiscal action too because, when the government injects currency into the real economy, a good portion of that money winds up flowing into stocks. This is what happened earlier this year, with financial surveys indicating that “buying stocks” was a popular use of the $1,200 stimulus check.
The market weakness of the past two months can be traced to uncertainty over a deal. For months now, Republicans and Democrats have been debating the terms of a new relief bill, and nothing has happened.
The president has also been all over the map on this issue, first tweeting a desire to cancel all stimulus negotiations until after the election, then hinting at terms for a partial deal, then saying he wanted a larger stimulus than the Democrats (which Senate majority leader Mitch McConnell certainly does not).
The bottom line is that, if another round of multi-trillion-dollar fiscal stimulus comes through before Christmas, the U.S. economy will get a boost and markets will be happy.
But if it looks like the fighting will persist, with nothing on the table until February 2021, the U.S. economy could convulse in fear as the pandemic worsens, and the stock market could see a sharp drop.
Struggling consumers and small businesses need more help to keep from going under, and tech stocks with wildly inflated multiples need another wave of stimulus-funded retail support to stay sky-high. In the absence of such help as provided by Congress, look out below.
Given this state of affairs, it is worth discussing the crucial differences between monetary policy and fiscal policy. The two are very different, but many investors don’t know why or how. Let’s take a look.
The first thing to understand is that fiscal policy is far more powerful than monetary policy.
If monetary policy is like caffeine, then fiscal policy is a high-potency prescription drug.
A pot of coffee can help keep you awake, but if you are feeling incredibly tired, the coffee won’t help. Prescription drugs like amphetamines or methamphetamines, in contrast, can make you want to stay up for 72 hours straight, to paint your house, clean your basement, and organize the garage besides.
Monetary policy has a limited effect because it is wholly oriented to borrowing.
The interest rate at which one can borrow is like the price of money. When interest rates are high, the price of money is high (and borrowing is expensive). When interest rates are low, the price of money is low (and borrowing is cheap).
When a central bank uses monetary policy to boost the economy, they typically lower the short-term interest rate, which is like lowering the price of money. Cheaper money, in theory, makes it easier for consumers and businesses to borrow, which encourages lending and spending.
The problem is that, at a certain point, consumers and businesses lose their appetite for borrowing. In a deflationary environment, interest rates can fall to zero and yet the borrowing impulse is still weak.
When this happens, monetary policy is described as “pushing on a string,” because borrowing is made about as cheap as possible and yet nothing happens.
Another problem with monetary policy is that, as a general rule, it works through the banking system.
Most of the money and credit in circulation is not created by the central bank. It is created by the banking system itself.
When the central bank lowers interest rates, the idea is that consumers and businesses should go to the banks and borrow more, and the banks should lend willingly. This lending and spending then increases monetary velocity (the speed at which money changes hands) through the effects of fractional reserve banking and stepped-up consumer behavior.
But if the central bank lowers interest rates to zero, and engages in quantitative easing (QE) by purchasing hundreds of billions of dollars’ worth of assets, what is happening is that liquidity is piling up inside the banking system and isn’t getting lent or spent.
If, say, the banking system has a trillion dollars in liquidity just sitting in its vaults, stagnant, then that liquidity will not have an inflationary effect. This is why the dire predictions of inflation after the 2008 financial crisis were wrong: Most of the liquidity created by the Fed’s multi-trillion-dollar balance-sheet expansion stayed inside the banks. The funds didn’t venture out into the economy and speed the pace of borrowing and spending, so prices didn’t go up, and no inflation occurred.
The one place where inflation did occur after the 2008 financial crisis was in asset markets, and this is because a particular type of borrower benefited hugely from quantitative easing (QE).
While businesses in the real economy did not borrow much after 2008, blue chip corporations took advantage of near-zero interest rates to borrow money to buy back shares. So, QE was great for the stock market in the 2009-2019 period, but not for much else.
Here and now in 2020, monetary policy is believed to be maxed out in the sense that the Federal Reserve has done nearly all it can do.
There is only so much effort you can take to entice someone to borrow money, particularly if that person, or business, is already in debt.
Fiscal policy, however, is completely different, in ways that are much more powerful.
With fiscal policy, the government can simply hand out money, and let people spend it however they want. Alternatively, the government can use fiscal policy to buy things itself, injecting currency into the system through direct transactions with private-sector businesses.
Either way, the core of fiscal policy is not about lending or borrowing. It is about the “helicopter drop,” in the sense that the government goes out and drops money from helicopters on people.
With fiscal policy, there is an element of borrowing that takes place — but the debt is assumed by the government itself. So if, say, Congress decides to authorize $2 trillion in new pandemic relief, and then disperses that money to consumers and businesses, that is the U.S. government deciding to increase the national debt by $2 trillion for the sake of boosting the economy here and now.
When it comes to being a credible borrower, the U.S. government has powerful advantages.
- It is immortal, meaning the U.S. government does not have a lifespan and never retires.
- It is a military superpower (think aircraft carriers and control of two oceans), a technology superpower (Amazon, Apple, Google), an agricultural superpower (U.S. farm output), and an energy superpower (U.S. shale output).
- It has taxation rights, backed by the authorization of force, on U.S. economic output that represents about 24% of total world output.
- It maintains the world’s deepest and most liquid debt market (the U.S. government debt market).
- It issues the world’s reserve currency.
For all the above reasons, the U.S. government is the only entity in the world that could decide to borrow $2 trillion, based on an act of Congress, and more or less say “we’re good for it,” and have the world believe it (as evidenced by the U.S. bond market not collapsing).
This isn’t to say that emergency fiscal policy is always a good idea. It is only to point out that, when the U.S. government itself decides to pump currency into the economy by taking debt onto its own balance sheet, that is a very different proposition than asking consumers or businesses to borrow more, even at near-zero rates.
Just think about the difference between, say, a person or a business being offered a loan of $10,000 versus receiving an outright gift of $10,000.
With the loan offer, a decision has to be made by the borrower whether to take the loan or not, and that decision will hinge on factors like how much debt the person already has, and whether they have a responsible use for the funds that will result in the loan being paid back.
But if someone is given $10,000 in the form of a direct stimulus check, or unemployment top-ups, or small-business relief funds, there is no encumbrance. It is more like “here is some currency, go spend it however you want.” That money can then be spent on food or utilities or paying down other debts, or a down payment on a brand-new car, or even on near-dated call options on Tesla or Peloton or Netflix; there is no obligation to pay the money back, so the funds provided tend to slingshot back into the economy, or the stock market.
The incredible potency of fiscal policy is the thing that gets proponents of Modern Monetary Theory (MMT) so excited.
If the government can borrow trillions upon trillions with no ill effects, the MMT theory goes, then why not target that spending in specific ways and put the money to good use?
We are probably going to test the limits of the MMT theory in the coming years. In a very real sense, we don’t have to wait for MMT to arrive — thanks to the pandemic, it showed up without anyone noticing.
In a meaningful sense, mega-powerful fiscal policy is, in fact, MMT in action. The main difference is that advocates of MMT want to use the government borrowing and spending bazooka on a regular basis, and not just in the depths of an economic emergency as created by a 100-year pandemic.
The dangers of out-of-control fiscal policy revolve around undesirable inflation and, ultimately, the destruction of the currency.
If a government borrows too much relative to its balance sheet, or prints too much currency relative to the size of its economy, the result can be inflation that gets out of control, or a debt market that threatens to collapse, or a glut of currency that causes its value to freefall (which then leads to devaluation-fueled price inflation).
In laying out the risks of overactive fiscal policy and MMT, we come full circle to the metaphor of caffeine versus a powerful prescription drug.
You can drink a lot of coffee, maybe even too much coffee, and you will probably still be OK, other than feeling jittery and nauseated. If you overdose on amphetamines, on the other hand, the side effects can hospitalize you or kill you.
Those who fear a full-on embrace of MMT-style thinking, in using the government’s deep pockets and vast balance sheet strength to prop up the economy with trillions, and then trillions more, are looking down the road at the prospect of 1970s-style inflation but far worse, or a dying currency, or both.
In the short run, though, the announcement of a new multi-trillion-dollar stimulus package would likely be seen as a good thing for both the U.S. economy and the stock market alike — because the market would first focus on consumers and businesses being saved here and now, rather than what comes later, and would also anticipate a direct refueling of retail investor buying-power.