In my April 08 piece in the Financial Express "Wall Street and the American Economy", I noted that skewed risk taking and over leveraged bets primarily contributed to the meltdown in mortgage-backed securities in 2007-08 and the Great Recession. That brought forth the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, targeting the financial sectors' (banks, mortgage lenders, and credit rating agencies) aggressive risky behaviour. In this context, an inspiring reader (Humayun Kabir, a former UN executive) underscored that one of the Act's major provisions, separating commercial banking from investment banking has worked well as intended. Consumer confidence in the financial sector was reinforced that helped the Wall Street, and the economy grew steadily. Unfortunately, those overly risky behaviour by Wall Streeters like Goldman Sachs returned after the Trump administration's removal of some of the consumer-friendly provisions (CFP) of the Act.
Indubitably, removal of CFP coupled with years of low interest rate, and the "untimely" trillion-dollar 2017 tax cut to big businesses, millionaires and billionaires steered the pre-Covid-19 stock market bubble. Unemployment bottomed 60 years low at 3.5 per cent even though the economy was growing at a lacklustre pace. Tempering with the Act did not cause the last month's market freefall to stampede, but the unsustainable bubble was boiling to its stretch - waiting for a trigger to burst. It was a fait accompli with or without the Covid-19 pandemic. The dilemma for the policy makers now is to rescue the Wall Street and the economy from plunging into a Depression - given the economy is already in a recession.
The Federal Reserve's (the Fed) policy objectives are mandated by the US Congress - maintaining maximum employment (full employment estimated between 4.0-4.5 per cent) and price stability (low inflation). With its discretionary power, the Fed set the inflation target at 2.0 per cent. Since the 2008 Great Recession, inflation remained tamed under 2.0 per cent and that allowed the Fed to keep its benchmark interest rate below 2.5 per cent for most of the time before 2018. That helped the recovery of the stock market and employment and hence the economy in general.
The estimated US labour force (16 years and older) was 164.6 million in February 2020 (unemployment rate or UR at 3.6 per cent). The unprecedented loss of lives in about a month or so and lockdown of economic activities inflicted by the Covid-19 pandemic has already, as of April 09, resulted in unemployment benefits claim of 17 million and counting with unemployment rate UR reaching 13 per cent - the highest since the Great Depression of the 1930s (UR=25 per cent). Some estimate indicates that the UR could reach as high as 30 per cent. If that were to happen, the number of unemployed Americans would reach close to about 50 million (4.0 million more than the entire population of Spain or 5.0 million short that of UK). Therefore, with doomsday prospects, if not now when would the Fed resort to policies that are deemed unchartered - nuclear, if you will?
Among the arsenal of emergency relief measures to rescue Wall Street and the economy, the Fed already lowered this benchmark interest rate to near zero and committed to open ended quantitative easing (QE) to rescue debt and liquidity distressed financial institutions. Should conditions on Wall Street worsen more ominously, the next step for the Fed could be going "nuclear" - pursuing policies into unchartered territory, which it has never ventured before: passively intervening in the stock market for the first time ever. The Fed's March 23 announcement of buying corporate bond-based ETFs -- an example of a nuclear option -- raised eyebrows in all quarters. What is ETF?
An exchange-traded fund (ETF), like a mutual fund, is a basket of securities (stocks, commodities, or bonds etc) that trade all day (buy and sell) on an exchange, just like a stock. Example -- SPDR S & P ETF (SPY) which tracks S & P 500 Index. This is unlike mutual funds, which are not traded on an exchange, and trade only once per day after the markets close.
Under a programme called "Secondary Market Corporate Credit Facility", it introduced on March 23, the Fed can buy up to 20 per cent of the assets of any ETF, having broad exposure to the investment-grade bond market. One intriguing question is: Why ETFs?
The Fed is eying on a class of ETF that seeks to track investment results of an index composed of US dollar-denominated, investment-grade corporate bonds. Nearly 26 per cent of these ETFs are banks' debt. So, Fed's buying these ETFs will provide liquidity to debt distressed banks. With the injection of additional liquidity to the banks, the Fed expects banks to extend loans to provide solvency to businesses, keep them running and keep workers employed.
Although the Fed's intention to buy ETFs may appear nuclear, it is not without precedence. Indeed, the Bank of Japan's (BOJ) move into equity ETFs would be something of a template for the Fed. The BOJ has already accumulated ETFs to the tune of around $256 billion in the fourth quarter and kept ramping up its purchases, which will now equal more than $110 billion annually.
On April 09, the Fed divulged a range of programmes to disburse $2.3 trillion in loans to small and midsize businesses and US states and cities. The Fed also announced that its corporate lending operations would include some classes riskier but investment-grade. These operations are well beyond its lender of last resort activism, which were not in the menu during the Great Recession. Should market conditions keep deteriorating portentously, the Fed could venture into buying company stocks but that would require Congressional approval. The problem would be which company stocks to buy?
No one should make a false equivalence between Fed's going nuclear with policy options to stabilise the financial market with Donald Trump and partisan Republican's 2017 untimely over a trillion tax cut to corporations and wealthy Americans. The tax cut was enacted nonsensically when the economy was operating at full employment. Had that tax cut not wasted, the economy could have benefitted the most now while saving the country from ever piling up debt burden.
As argued in my April 08 piece, the nexus between Wall Street and the economy is one of symbiotic -- interdependence. During good times one steers the other with a positive feedback in a merry-go-round loop. At other times, but not always, a big nosedive of the stock market creates uncertainty in investors' behaviour, exerting a negative effect on the economy. For example, the Wall Street crash of 1929 culminated in the Great Depression of the 1930s, while the 1987 crash did not trigger a recession.
Nearly 70 per cent of the US economy is consumer driven. Here people's spending patterns are not dictated by their paychecks alone. Their personal consumption is also linked to their expectation of wealth invested in stocks and bonds. Employees' retirement funds are also invested in stocks, bonds, and mutual funds (market value $ 33 trillion as of December 31, 2019). Therefore, any eye-popping drop in the stock prices becomes a nerve breaking concern to policy makers.
Higher stock prices arouse investors' confidence through wealth effects, which drives them to spending more and in turn, raises business confidence, leading to new capita spending, economic growth, and employment. That is precisely what the Fed is trying to do - taking preemptive actions to avert further gloomy decline of the market and the economy and avert an economic depression, reminiscent of the Great Depression of the 1930s.
Wall Street at different times has been looked up as a bellwether for the global economy. Both the 2000-02 and 2008 global recessions had their triggers in Wall Street -- the bursting of the dot.com (technology) bubble and sub-prime housing debacle, respectively. On the positive side, Wall Street has been discredited for spearheading the 2003-07 global economic expansion by sustained and buoyant Wall Street rally in March 2003. A massive bull market drive in March 2009 had resuscitated the global markets and the economy back to life after the Great Recession. Given nearly 33 per cent of international trade activities (exports + imports) are attributed to U.S. economy, rescuing the Wall Street would help the global economy which in turn adds to faster revival of the U.S. economy through feedback loop.
Dr. Abdullah A Dewan, formerly a physicist and a nuclear engineer at Bangladesh Atomic Energy Commission (BAEC), is professor of Economics at Eastern Michigan University, USA. [email protected].
Caption:
A man crosses a nearly deserted Nassau Street in front of the New York Stock Exchange (NYSE) in the financial district of lower Manhattan during the outbreak of the coronavirus disease (Covid-19) in New York City, New York, US on April 03, 2020. -—Photo: Reuters
