How the Fed Created a Stock Market Bubble of Epic Proportions
The U.S. Federal Reserve will soon trigger a financial crisis that threatens democracy itself
How did we get here?
Since the Great Depression, American politicians — mostly Democrats — have voted to construct an ever-larger “social safety net” to support the poor, elderly, minorities, and those not able to care for themselves. We now have Welfare, Social Security, Medicare/Medicaid insurance, and direct cash payments to the poor through food stamps and reverse taxes (so-called “earned income tax credits”). It’s compassionate, but very expensive.
Democrats believe that wealth should be redistributed from rich to poor, lucky to unlucky, advantaged to disadvantaged. In their view, the Federal government should collect money from the 50% who pay income taxes and redistribute it to those in need, in the form of social programs.
Republicans disagree. They believe in personal responsibility: those with talent who make large sums of money should be allowed to keep it; being poor is simply a lack of willpower; and the government’s social programs should be limited. Yet even as Republicans claim to hate government programs, they consume them all the same.
Republicans are also big spenders, favoring high levels of Defense spending — $0.7 trillion/year or 10% of the total $7 trillion federal budget. A strong defense makes sense, given the constant attacks against our democracy in an ever more authoritarian world. But these programs are also ruinously expensive.
As an Independent, I’m somewhat sympathetic to the Democrats’ point of view. Income inequality is getting worse. Success often has an element of luck (being born to wealthy parents, having certain character traits or mental capabilities linked to business success, being in the right place at the right time, winning the lottery, and not having health issues, disabilities or injuries, etc.) And if success has an element of luck, you clearly don’t deserve to keep all the money you make — and the poor don’t deserve to be poor either.
In short, both income redistribution and military spending can be justified. But at what cost?
To make matters worse, Republicans in Congress have consistently voted to lower taxes — as a way to protest the same big government programs that both they and the Democrats voted into law. Lower tax revenue has the effect of ballooning our yearly budget deficit, currently running at $3 trillion per year. The cumulative U.S. debt now stands at $30 trillion, including $5 trillion spent on programs to offset the impact of the Covid pandemic. Our debt to GDP (gross domestic product, or total economic output) ratio is now 128%, which is frightening and ruinous by any historical measure.
Because our government doesn’t collect enough taxes to pay for its programs, the Treasury Department funds the government by borrowing the rest. It issues IOU’s called Treasury Bonds to pay for the cumulative $30 trillion debt the U.S. government now owes. Interest rates are currently low, so we “only” pay $0.4 trillion per year in interest on that debt. Until interest rates go up — then we’ll be paying a lot more.
And who wants to loan an additional $3 trillion every year to a country that’s deeply politically divided and already indebted up to its eyeballs?
Enter the Fed
The Federal Reserve is the U.S.’s Central Bank. It has the power to print money to boost the economy and raise or lower interest rates. So, over the past few years, the Fed has been printing money to purchase U.S. Treasury Bonds (and mortgage-based securities, and even corporate bonds) through a program called Quantitative Easing (QE). The Fed’s balance sheet is currently $9 trillion and climbing.
This cozy arrangement bears repeating. The U.S. Treasury Department runs a deficit of $3 trillion a year, and the U.S. Federal Reserve prints money out of thin air to buy that debt (in the form of Treasury Bonds).
What could go wrong?
First, interest rates are rising because the Fed is printing so much money (risking third-world-style hyperinflation). Food and gas prices are skyrocketing, and the inflation rate has already reached 7.5%. Home prices are rising by 18% a year. The stock market rose 27% in 2021. All this contributes to inequality because the wealthiest 10% of Americans — who hold 89% of stocks, worth $35.87 trillion — made huge gains, while the other 90% struggled to pay their bills.
Second, a dirty little secret is that U.S. economic growth has been anemic and slow for many years. It’s been artificially propped up by high-levels of deficit government spending and reckless money-printing. The Fed purposely bought up the supply of “safe” assets like Treasury Bonds to drive down interest rates, making those investments less palatable to investors, which forced investors to turn to riskier assets like corporate junk bonds to “seek yield higher on the risk curve”. (And when that didn’t boost the economy, the Fed started to directly purchase corporate debt as well.) The net effect is that many “zombie companies” survive only because the Fed is now propping them up by buying their worthless debt that will never be repaid.
More subversively, the Fed deliberately stoked asset inflation to create a “wealth effect” to incentivize the super-rich to take more investment risk, leading to ever-worsening inequality, asset bubbles, and threat of social unrest.
The Fed is now in a box — they must raise interest rates now
However, with inflation now starting to rise, the Fed is in a box. Their mandate requires them to reverse course and bring down inflation to a reasonable level. So they’re forced to raise interest rates, stop the QE buying of U.S. Treasury Bonds, and wind down their $9 trillion balance sheet, even as higher interest payments will limit the Federal Government’s ability to continue its high levels of deficit spending.
The last time the Fed tried to unwind QE in 2013, the stock market reacted with a “taper tantrum” and the Fed backed down. But, with looming inflation, backing down is no longer an option.
The risks are substantially greater now than they were in 2013 because: 1) the Fed has kept interest rates so low for so long, and 2) the Fed has encouraged investors to speculate in riskier and risker assets (corporate junk bonds, bitcoin, unicorns, electric vehicle companies, meme stocks, NFTs, etc.) that will immediately deflate once the Fed reverses course.
It’s all about to come crashing down
All this money printing and deficit spending has created a speculative stock market and housing bubble of epic proportions. Once the Fed reverses direction, expect to see a 40–50% correction in the stock market and housing prices, high levels of unemployment and social unrest, and collapses in emerging markets which depend on American stability. Expect also the rise of new Putin-style autocratic rulers who promise “strong leadership” in return for absolute loyalty (competence being optional) and restrictions in personal liberty, freedom and rights — as democracy erodes.
In short, our weak political leaders have failed to address the many challenges facing our country. They abdicated their fiscal responsibility and handed power to a small group of unelected officials — the U.S. Federal Reserve — to forestall the inevitable. A reckoning is near.