The Investment Scientist

The Negative Consequences of the Fed’s Money Creation

Posted on: July 3, 2020

1000x-1.jpgIn my last article, I wrote that the Fed’s actions were necessary to backstop the economy from sliding into another Great Depression. Now let’s talk about a few of the negative long-term consequences.

With so much liquidity sloshing around in the economy that is only half-opened, the only outlet is the financial market. That’s why we’ve seen a divergence of the financial market and the real economy. These two will have to converge at some point. When this happens, will we see hyperinflation? That is, the prices of goods and services are rising fast like they do for assets. In its communication, the Fed has signaled to the world that they don’t foresee any inflation in the next two years. If you read between the lines, it appears that the Fed does not see the economy returning to normal in the next two years, and during this time, they may print still more money.

If and when hyperinflation does come, the Fed, in fact, has a tool to tame it. It’s called balance sheet reduction. That is, it can “unprint” the money.  This is done by selling assets on its balance sheet to recycle money and destroy it. However, unprinting money will necessarily cause a slowdown in the economy and a higher unemployment rate. There may not be the political will to do that. (Here I am assuming the Fed is not independent of politics.) Thus the hyperinflation risk, though small, is not trivial. 

Averse incentive, asset bubbles and social instability
With the Fed seemingly able to create any amount of money to bail out the economy, investors may be lured to ignore risk in investing. There is already chatter about it: if we have a V-shaped recovery, then the recent stock market rally is justified; but if we get hit by the second wave of Pandemic, then the Fed will print more money, which also justifies the recent stock market rally. That is, for people who have the capital to invest, head they win, tail they also win. When this becomes the prevalent mindset, investors will take on excessive risk, leading to the formation of asset bubbles. But fear not, when bubbles burst, the Fed will come to the rescue – right?

The Fed actions can also exacerbate the gap between the rich (who own the capital) and the poor. Come to think of it, it’s almost socialism for investors: wins are privatized, but losses are socialized. Already there are folks who feel a strong sense of injustice when Jeff Bezos’s wealth is up $400 billion while 40mm Americans lost their jobs.

Dollar depreciation
I find it helpful to use this analogy when we talk about the dollar relative to other major world currencies:  the dollar is the new gold, the euro the new silver, the pound, and the yen are like the new copper and the rest are close to scrap metals. All these countries have a strong incentive to use money creation to solve their domestic problems, but the US has the strongest incentive since the dollar is in the strongest position and the US can reap the largest reward from “minting the new gold”. Therefore, in the long run, money creation will likely happen at a larger scale in the US than in other parts of the world, quite possibly leading to dollar devaluation.

Analogy aside, in reality, the Fed is the only central bank that has signaled “unlimited” money creation. Once the market begins to fully digest the implication of this, the dollar will slide. 

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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