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Welcome back. No bitcoin today! That may be more of a relief to me than to you. Bitcoin is hard work to write about. But then, so is today’s first topic: where money comes from. Email me at robert.armstrong
Krugman on monetising the debt
The Federal Reserve is buying a lot of US government debt. This can look a lot like the government funding itself by creating new money, or, as they say on the internet, “money printer go brrr”. New York Times columnist Paul Krugman puts the point more historically: “Some point to the rapid growth in the money supply and say that we’re on the verge of becoming Venezuela.”
Krugman argues the US is not becoming Venezuela, but I can’t follow his argument. Here is his chart of deposits at banks, bank reserves held at the Fed and Fed ownership of securities. They are all going up!
At the same time the stock of money is going up, too:
These four make up what Krugman calls the “monetary daisy chain”. The question is, which is linked to which, and in what order?
In Krugman’s view, if I understand him correctly, the order is this:
Households put savings in a bank. The bank now has a liability, a deposit;
The bank’s corresponding asset is bank reserves, deposited with the Fed;
The Fed uses those reserves to buy Treasuries;
The proceeds from the Treasury sales finance federal deficit spending;
Government deficit spending creates new money by transforming reserves (which are the flip side of the savings/deposits in step 1) into dollars spent writing stimulus cheques, building aircraft carriers, and so on.
Unlike steps 1-4, Krugman doesn’t state step 5 explicitly, but he has to think the new money comes from somewhere, and I’m guessing that’s it. Anyway, he writes:
“Households are financing the deficit: the funds being borrowed by the government are coming out of the huge savings undertaken by families saving much of their income in an environment where much of their usual consumption hasn’t felt safe . . . The Fed isn’t the Venezuelan government printing bolívars to pay its soldiers; it’s basically acting as a financial intermediary for investors who want to park their money somewhere safe.”
But aren’t a lot of the extra household savings coming not from lower consumption, but from stimulus cheques? Or the fact that the breadwinner in the family works building aircraft carriers? In other words, isn’t the government deficit spending (Krugman’s fourth step) causally before households can have more savings (his first)?
I do not enjoy getting into economic arguments with Nobel laureates. What I know about economics could be written on the back of an envelope. So in the long and honourable tradition of small boys picking fights and then running to their big older brothers, I called my colleague Martin Wolf, the FT’s chief economics commentator.
He made the point that the excess savings are just the flip side of the deficits. They must emerge together. But savings cannot and do not create money. So the question of where the money came from remains, and the most likely answer is that it comes from government deficit spending. Here’s Martin:
“The government is running a deficit, and the Fed — which is the government’s bank, after all — has to honour the government’s cheques. The government usually helps the Fed by selling debt, which mops up the money. In this case, though, the Fed buys the debt, so the money is not mopped up. That makes the reserves the Fed created when it honoured the government’s cheques permanent.”
Krugman’s argument, in other words, is the wrong way round. And to my mind (if not Wolf’s) this suggests that the money printer is, indeed, going “brrr”.
What does this have to do with financial markets? All those household savings (the flip side of the government deficits being funded with new money) are not just going straight into banks. Sometimes they pass through the stock market on the way, which supports share prices. Another place government deficits often reappear as surpluses is in the corporate sector as profits. Higher profits support stock prices, too.
So if you think it is not sustainable for the money printer to go “brrr” (I myself am unsure) then maybe you ought to wonder about the sustainability of stock prices.
A better way to think about valuations?
Last week I wrote about the strong historical correlation between high valuations (which we have now) and low long-term stock market returns. The standard response to this point is that all the past instances of high valuations occurred when interest rates were higher than they are now. In today’s lower rate environment, the argument goes, valuations will remain high, and investors will do fine. This might be true.
There is, however, another way to think about valuation: in cash. Credit Suisse’s HOLT team has a way of doing this. They calculate what they call a “discount rate” for the stock market, by taking the price of stocks, company earnings estimates, converting the estimates into free cash flow, and then calculating what cash flow yield investors can expect on their investment. It is the investors’ return, at a given price, calculated in terms of the distributable cash companies generate.
Here is a long-term chart of that expected cash yield, for the US market, ex-financials:
This looks a lot like a chart of price/earnings valuations turned upside down, and it tells you mostly the same thing. But it tells it to you in real cash yield terms. At the current price and if current earnings expectations are right, a 2 per cent cash yield is what investors will get. It’s the second lowest in history.
This does not imply that stock prices must go down. They could keep going up, for one of two reasons:
We might just live in a low-yield world now, so prices don’t have to fall in order to restore historically normal yields. Real government bond yields are much lower than 2 per cent, after all. Keep owning stocks, you’ll be fine;
Earnings are going to be much better than expected, so yields are going to be higher, pushing stocks up.
A brief comment on each possibility.
A low-yield world really stinks, especially for young people, because buying assets through which wealth can be compounded is very expensive. It is a world tilted in favour of people who have assets already. We should all hope we are not living in this world. But we might be.
On earning expectations, according to Howard Silverblatt of S&P Dow Jones Indices, the consensus 2022 earnings per share estimate for the S&P 500 is $209. That implies earnings growth since 2019, before the pandemic, of 10 per cent a year. That’s roughly the average rate for the 10 years leading up to 2019. With the money printer going “brrr”, couldn’t earnings per share come in higher? It makes sense that it might.
I had promised to write something more cheerful this week. I guess that was it.