Before we continue our foray into the systemic risks and consequences of profit-free business practices, we need to make a quick stop over in Europe and look at some recent monetary data. It is relevant for our analysis of the monetization consequences of profit-free corporations (consequences that we will be discussing in a coming article).
Monetization is a phenomenon where central banks pump cash out in the economy without an equivalent value being created in the real sector of the economy. The real sector, in turn, is where businesses and individuals exchange money for a good or a service; every transaction of money is reciprocated with a transaction of a product. The money is simply a means of payment, where the money is the carrier of the underlying value of the product sold.
This is the traditional, sound and sustainable function of money. The stock of cash and other forms of money (bank deposits, etc.) is there to facilitate the transfer of product value and the storage of accrued value from transactions in the real sector. At any given time, the money stock has to stand in a sound relationship to the activity in the real sector; we know this relationship as the velocity of money. If the velocity gets too high, the price of money – the interest rate – increases; when the velocity drops, interest rates drop, of course, but there is also an inflation risk associated with low velocity.
A low monetary velocity means that less money is being used for the transfer and storage of real-sector value. The more money that is not being used for those purposes, the greater the risk that this idle cash finds its way into places where it can do inflationary damage. Idle cash first finds its way into asset prices, then to product prices.
It is this inflation scenario that we are concerned with here. We are going to discuss the relationship between money printing and profit-free corporations in Part 2 of Zero Profits and Market Instability, but, again, we need some context in terms of monetization as a monetary-policy phenomenon.
The term at the center of all this is, of course, risk. Without delving into the details, the new practice of Initial Public Offerings of businesses that don’t make a profit, means that the stock market and its investors are setting themselves up for very large, hitherto unaccounted for, systemic risk. Profit-free corporations (Uber, DoorDash, Tesla) cannot underpin their stock market value with current or even prospective dividends. The only way a shareholder in a profit-free corporation can expect to make money is by selling the stock to someone else and cash in the capital gain.
It is here, at this point, that the need for central-bank monetization comes in. It is a way to funnel cheap liquidity into a stock market that otherwise would become highly unstable. Without, again, going into the details of this process, let us just notice that it will require the active involvement of the banking system.
To be part of this process, our banks will have to expose themselves to high risk. That is acceptable – even possible – if and only if banks have a risk anchor in their portfolios. Traditionally, there has been no better anchor than treasury bonds; the more solid an investment portfolio stands on the grounds of treasury bonds, the more acceptable it is for the investor to take on high-risk assets.
The problem with banks both in America and in Europe is that they can no longer rely on treasury bonds with the same confidence as before. In the past decade, governments on both sides of the Atlantic Ocean have seen their credit downgraded. Even the U.S. government took a hit (two, actually) during the Obama administration. Generally, these downgrades have not substantially weakened the treasury bond as a risk anchor, but it has narrowed the span of bonds acceptable for that purpose.
Bluntly: the only reason why treasury bonds are still as acceptable as they are, is that both the ECB and the Federal Reserve have engaged in purchase-guarantee programs for holders of treasury bonds. In the American case it has been an indirect guarantee: the Fed has engaged in Quantitative Easing, holding up the market value of Treasurys while the sovereign-debt market is being flooded by U.S. debt.
In Europe, the practice has been more direct. In the midst of multiple euro-zone governments being on the brink of a debt collapse (and an actual, partial default in Greece) the ECB started a program where they would use newly minted cash to buy any euro-denoted treasury bond, anywhere, at any time. This prevented an otherwise unavoidable implosion of euro-zone sovereign debt, and by consequence the euro itself.
Central bank intervention may have saved the day in terms of avoiding a domino-effect debt default, but it certainly did not save the day in terms of the underlying risk problem. A treasury, namely, works in the same way as shares in a corporation: its value to an investor is based on a regular stream of income, i.e., interest or dividend. In lieu of either, the only way to motivate anyone to buy treasurys and profit-free stock is that there will be some buyer out there at some point, who will have the cash and the desire to purchase those assets.
The treasury bond used to be a source of reliable income for investors. In our modern zero-interest environment, that is no longer the case; investors have to rely on the willingness of someone to buy those bonds at some future date, or else he has no reasonable expectation of a return on his money.
We already know that the U.S. government is using the Federal Reserve as a permanent source of cash to pay for out-of-control spending. The same is happening in Europe.
Interestingly, the constitution of the European Union – the Maastricht Treaty which later became the Lisbon Treaty – explicitly forbids the ECB from monetizing debt. Yet over the past ten years that has been its main focus. As I explain in my upcoming ebook Tax Cuts Don’t Work, you cannot have a welfare state and at the same time expect to keep government debt under control. The Europeans have therefore abandoned their prudent position on government debt – just like we have – and allowed their central-bank system to become a de facto permanent source of funding for euro-zone welfare states.
Once this happens, the central-bank involvement becomes as permanent as your ties are to the Sicilian mafia: once you are in, you can never get out. Quantitative Easing depresses interest rates, scaring away investors who are in the sovereign-debt market for income; as income-minded investors leave, only those are left who are willing to speculate in bonds, or park cash there as a safety for the future. Since the bonds are income-free, you rely on someone else of the same mindset to buy your bond at a future date in time.
When interest rates are at zero or – absurdly but actually – negative, the prospect of finding those investors is dimming over time. That leaves only one reliable buyer: the central bank. The problem is that in order to remain the buyer of last resort, the central bank has to print even more money. This, in turn, perpetuates the zero-to-negative interest rate that scares away income-minded investors.
The central bank is pulled further down into the sinkhole it created.
With interest rates virtually wiped out, the entire banking system has to alter its investment policy. Every commercial bank that buys treasury bonds has to rely on the central bank as its buyer of last resort. When those banks directly or indirectly become more exposed to an unperforming stock market, their dependence on the central bank as a risk-anchor guarantee (buyer of last resort of their treasury bonds) eventually becomes unsustainable. When high-risk stocks of profit-free corporations are no longer marketable, investors with credit lines in the commercial banking system will default to an increasing degree. This, in turn, causes the banks to cash in on their treasurys to fill the cash gap, forcing the central bank to pump out even more new cash.
This is a systemic-risk situation that central banks are well aware of. Therefore, they will take preventative measures to avoid a “run on the treasurys” situation. They will pump out liquidity into the economy to maintain credit lines that feed into the high-risk end of the stock market.
Again, more on the details of this later. For now, let us take a look at what Quantitative Easing has done to the ownership of government bonds in the banking system.
This phenomenon has now become statistically visible, both in Europe and in America. We start with Europe, which is used here mostly for reference on the destructive role of government debt; the prevalence of the profit-free corporation culture in Europe is yet to be established. However, in addition to helping us explain the erosion of treasury reliability, the European case also shows that international investors who invest in stocks in America cannot rely on European treasurys as a risk anchor (at least not generally).
Figure 1 reports the share of government debt in the euro zone that is owned by monetary financial institutions. These include commercial banks and the branches of the ECB:
Starting in 2010, the ECB got involved in the sovereign-debt market, directly as a buyer and indirectly by supplying commercial banks with cheap loans in exchange for pledges to purchase treasuries from governments with troubled credit and runaway deficits. The rise of the share of sovereign debt owned by MFIs is a direct result of this active policy to monetize deficits (and thereby to monetize debt). In the wake of the Covid-19 artificial economic shutdown, this share has now climbed well over 40 percent.
The long-term trend in the United States is not much better. Figure 2 reports treasurys in commercial-bank balance sheets. To be clear, the numbers are reported with a distinction between mortgage-backed securities and those that are not backed by mortgages; the latter category is traditional government debt. This is a different statistic than in Figure 1, insofar as it focuses on the portfolio composition of commercial banks, but it does tell us how they are drifting into an increased dependency on the Federal Reserve for their portfolio risk anchor:
It remains to be seen to what extent this upward drift in Treasurys is the result of cheap loans from the Federal Reserve; anecdotal evidence suggests that a sizable portion of it actually comes from that source. But, again, the statistical analysis will have to wait.
Last but not least, the Federal Reserve’s own, direct involvement in buying Treasury debt. Figure 3 reports data comparable to that in Figure 1, but it is concentrated exclusively on the central-bank share of government debt:
The first episode in Figure 3 was a perfect storm of debt and debt monetization. The new, socialist welfare state, rolled out by the Lyndon Johnson administration, opened up a structural deficit in the federal budget. This was also the peak of the Vietnam War, which only added more borrowing (but contrary to what some pundits have suggested, it was not the main cause of the deficit); the gold standard ended and the Bretton-Woods exchange-rate system broke down. All these factors led the Federal Reserve to go deep into the market for Treasurys.
The second episode is the bulk of the Ben Bernanke QE period. It depressed interest rates, which in turn had negative consequences that serve as a learning lesson today (though we don’t have time for its details today…). Episode 3, in turn, is the aftermath of the Great Recession and the Gargantuan debt accumulation that followed.
In short: we already have central banks on both sides of the Atlantic Ocean that have gotten themselves and their banking systems irrevocably involved in the sovereign debt market. When we add a new profit-free corporate culture on top of this, we exacerbate the systemic imbalances that are already built into our economy. The common denominator is money printing.
Stay tuned for details. In the meantime, make sure to click the Follow button up to the right, and get updates as soon as they come in. Blog subscribers will get a special offer on my new book, Democracy or Socialism (Palgrave McMillan) which will be released on March 18, 2021.