LEDC Update

We have been making leaps and bounds in recovering from the storm that struck Linden a little over a week ago and our local businesses are now closely following the state’s “limited re-opening” orders as well. I have to say, it was quite nice to be able to go out to eat on Friday night, and I’m certainly glad that we can start taking real steps to mitigate the economic damage we’ve experienced over the past few weeks.

I want to return to the topic of fiscal policy that I left off on two weeks ago. As a brief recap, on March 15, the Federal Reserve System (FED) reduced the federal funds target rate to near zero in response to the COVID-19 pandemic’s effects on the economy. This was done to reduce lending rates across domestic and international markets to improve access to capital and attempt to keep financial markets “afloat.” Keep in mind that attempting to spur economic growth through capital access alone does not constitute real growth and ultimately leads to an overall devaluing of said capital (i.e. heightened inflation). The FED also committed to implementing a form of monetary policy known as quantitative easing (QE). Both of these practices were hallmarks of the aftermath of the last major financial crisis seen in the United States in 2007 and 2008.

I’ve already gone into detail on why the sudden reduction to lending rates is problematic, so with this article I want to take a closer look at QE. QE is a practice in which the central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. By increasing the money supply, QE has a similar effect to reducing lending rates, but it also has an impact on the actual investing ethos that is seen within the market.

By buying up long-term securities (typically government bonds and other financially “stable” securities) the FED is altering the componential make-up of financial markets. With the FED’s decision to buy up $1.5 trillion in assets as an emergency measure to increase liquidity, that leaves 1.5 trillion fewer investment opportunities in the long-term, low-risk sector of the financial markets. This forces investors into relatively riskier investments in order to find stronger returns.

At the same time, lower lending rates can incentivize publicly traded companies to begin borrowing and expanding operations—even if they aren’t financially viable to do so. Expanded operations are a major signal to investors to purchase stock in a company which causes stock prices to raise and the market to appear healthier. However, these “false flag” expansions that aren’t backed by actual growth in a company can ultimately lead to a catastrophic downfall once the other shoe drops and inflation sets in. At which point, the investors that poured money into the riskier investments see losses and we’re right back where we started (if not at a worse place).

QE is not a new practice by any means and also isn’t solely used by economic decision makers in the U.S.A. It was used by the Bank of Japan following a financial crisis in the 90s, the Swiss National Bank following the economic crisis in 2008, and as recently as 2016 by the Bank of England to attempt to stabilize markets to address the ramifications of Brexit. In all of these cases, the practice has either fallen short of the expectations of those who implemented it or caused far more damage to the value of the nation’s currency and GDP following its implementation.

Now that we’ve taken time to discuss exactly what steps (or missteps) have been taken in regards to recent fiscal and monetary policy, we can look at alternatives to these practices that have had historically more beneficial effects in next week’s article.