There is a trend running through the West that threatens to destroy our economies from within. Our institutions for managing risk are slowly being hollowed out from the inside.
The centerpiece, of course, is government. More on that later; first, let us take a closer look at the problem itself.
To manage risk is the quintessential component of capital formation. Investing in our economic future – which is the plain meaning of capital formation – is the economic activity that separates us from universal poverty. Where resources are committed for an extended period of time, prosperity happens – all the institutions necessary for a free and peaceful society are clustered around investment activities.
Property rights emerge to protect the commitment that the investor makes. If he cannot rely on his investment to be his when it comes time to reap the profits of his investment, he won’t make the commitment. The legal and moral practice of honoring contracts is necessary for those who commit to build and operate the capital. Without a reasonable expectation of being paid, nobody will go to work on a long-term project. Financial institutions develop the credit products by means of which businesses can bankroll their investments, pay their bills as they go and pay back their loans on reasonable terms.
These institutions have synergy effects on all forms of economic activity, effects that have elevated capitalism to the supreme socio-economic organization of human civilization, one that is unmatched by any other economic system. It has defeated its arch enemy, socialism, time and time again.
Only one thing can bring capitalism to its knees.
Government. For the past half century, government has been blood-letting capitalism into a state of glacial ailment. Slowly expanding welfare states have infringed on the room where otherwise prosperity will form, grow and proliferate. Deficits, having become permanent funding arms for over-extended welfare states, have slowly built government debt burdens of ominous proportions.
It is in that pile of debt the story begins of how government is destroying the institutions of risk management.
There are two components to the destruction process, the first of which is, of course, government debt itself. The second component is private debt and the new practice where government intervenes in that market.
Motivated by the artificial economic shutdown, the Federal Reserve has created a “special purpose vehicle”, in other words an outfit within its organization that doles out money on things the central bank was not created to dole out money on. In this case the money is being spent on corporate bonds. Explains the Fed:
The PMCCF [Primary Market Corporate Credit Facility] provides companies access to credit by (i) purchasing qualifying bonds as the sole investor in a bond issuance, or (ii) purchasing portions of syndicated loans or bonds at issuance. The SMCCF [Secondary Market Corporate Credit Facility] may purchase in the secondary market (i) corporate bonds issued by investment-grade U.S. companies; (ii) corporate bonds issued by companies that were investment-grade rated as of March 22, 2020, and that remain rated at least BB-/Ba3 at the time of purchase
after which they add two more, essentially technical conditions for investing in corporate credit. The big message, of course, is that the Federal Reserve will be the “sole investor” in some instances, and that they will purchase both investment-grade and junk-rated bonds.
It is here that the central bank begins its unintended but nevertheless dangerous erosion of the institutional structure for risk management. The Federal Reserve is making these investments as an extension of the CARES Act, under Section 4003(b) of which Congress has appropriated
$454 billion for the Treasury to backstop Federal Reserve (Fed) lending programs aimed at supporting credit flows to businesses, states, or municipalities in the midst of the coronavirus pandemic.
In other words, our federal government is using our central bank to buy up debt that would otherwise be priced and traded on the private debt market.
There are two aspects to this corporate-credit investment program that erode the risk-management institutions. The first is the intervention of government itself: since government is not spending its own money, and since government can theoretically use force to get its hands on whatever money it needs, it is a more formidable investor on any market than any private competitor could ever be. Therefore, it does not have to care about the risk associated with its investments: those who lose the money are taxpayers – in today’s fiscal environment that would be the taxpayers of the future – whose ability to affect these investment decisions is comparable to their ability to affect gravity.
By not having any money to lose, government weakens price signals as transmitters of risk. When private creditors review the market segments where the Federal Reserve is active, the information they can gather through the market is increasingly limited. This in turn puts them in the undesirable situation of having to choose between investing with higher risk at any given set of information, or abstaining entirely.
Either path for the market would weaken access to financing for investors. Therefore, the Federal Reserve has to de facto become the default buyer of credit. It has to compensate the market for the weakened price-risk ties, and essentially establish itself as the guarantor for increasingly impactful segments of the corporate bond market.
In short, the Federal Reserve eliminates the risk tiers that otherwise help investors balance low and high risk.
There are already signs that this is happening. On September 29 the Wall Street Journal reported (p. B1, print edition):
In April, the Federal Reserve extended its corporate-bond purchase programs to issuers that lose their investment-grade ratings after the onset of the pandemic in late March. The Fed’s move signaled that companies wouldn’t lose access to debt markets if their ratings were slashed to junk.
At this point, the Federal Reserve cannot back out of the market. If they do, the real price signals will return with full force and turn a great deal of junk-bond companies into liquidity deserts. Their only choice is to stay in the market, and in doing so to make a long-term commitment to the elimination of the credit downgrade as a deterrent for investors.
By effectively eliminating the punitive component of the junk-bond status, the Federal Reserve and their backers in Congress have de facto socialized the supply of credit to corporations. This is dangerous, as it leads to misallocation of investment capital: over time this will lead to a slow but inevitable decline in the efficiency of the aggregate capital stock in our economy. Entrepreneurs will have to worry less and less about making a solid profit on their operations; if they struggle they can always sell debt on a market where government guarantees everyone access to financing.
While the impact of the weaker price-risk signal is still to be felt, we can see its forbearer in the sovereign-debt market. There, government has already destroyed the price signal associated with government credit ratings. As I have pointed out earlier, the Federal Reserve has engaged in a veritable debt monetization campaign with money printing at levels unheard of in our recorded monetary history. This has allowed Congress to keep spending, far beyond what taxpayers can afford, and with no regard for the risks associated with excessive indebtedness.
Since the Federal Reserve can print whatever money it needs, de facto for whatever purpose it wants to, its involvement in the sovereign-debt market has now completely severed the tie between price and risk. In short: the Fed’s QE-on-steroids money printing binge has turned the market for U.S. debt into a technical procedure for funneling money into the American welfare state.
The same destruction of the price-risk signal is now at work in the private bond market, but the involvement of government is bigger than what it seems to be on the surface. The Federal Reserve runs the corporate-bond buying program, but the money comes from the Treasury. That money, in turn, comes from the Federal Reserve, whose purchases of new U.S. debt provides the cash that is then used to fund the CARES Act appropriations. Among those appropriations we find – yes – the aforementioned program that authorizes the purchases of private bonds.
Plainly, what we have here is yet another channel through which our economy is being subjected to MMT, officially known as “Modern Monetary Theory”. In short: gobs of money printing. The long-term effects of MMT are totally destructive, as we have seen in Venezuela with its hyperinflation experience. However, a less-noticed consequence is that credit markets fall apart: when government – really the central bank – can provide whatever liquidity anyone needs simply by virtue of its monetary printing presses, no one will need to present its risk profile to tentative investors anymore. All you need to do is talk to the right bureaucrat at the right government office and you will get the cash you want.
Again, we are not at that point yet; we still have largely functional markets for private debt. The problem is that Congress and the Federal Reserve have opened a pathway to the destruction of those markets, and there are no stop blocks down the road. Congress allowed the CARES Act to open a continuum the far end of which is the elimination of the concept of risk. Since it has already happened on the sovereign-debt market, under the present circumstances it would be foolish to believe it can’t happen on the private-debt market as well.
Capitalism stands and falls with its free markets. Those free markets operate in all directions, in both space and time. For every price signal that government destroys, it weakens the institutional structure that keeps capitalism sound, strong and resilient. Congress needs to get out of its habit of tampering with all things economic, and get back to its real function: the protection of life, liberty and property.
Leave capitalism alone.