Order Before Peace
Kissinger’s Middle East Diplomacy and Its Lessons for Today
Raphaële Chappe and Mark Blyth
The COVID-19 recession has prompted states to offer vast amounts of financial support to firms and households. When combined with steps that central banks have taken in response to the financial crisis of 2008, the bailout is so large that it has ushered in what Sebastian Mallaby, writing in the July/August 2020 issue of Foreign Affairs, calls “the age of magic money.” The combination of negative interest rates and low inflation, Mallaby writes, has created a world in which “don’t tax, just spend” makes for a surprisingly sustainable fiscal policy.
The thrust of that description is accurate. But the world Mallaby describes is not a direct result of responses to the financial crisis and the pandemic, as he contends. Nor should it come as much of a surprise.
The roots of the current moment lie in the late 1990s, when the U.S. Federal Reserve responded to the collapse of a major hedge fund by cutting interest rates in an effort to help financial markets avoid more widespread losses. The practice of cutting rates whenever the economy hit a bump became widely known in the following decade as “the Greenspan put.” (In finance, a put option is a kind of contract that gives an investor the right to sell a stock at a predetermined price regardless of market conditions; it is a form of insurance against losses.) The Greenspan put served as an implicit guarantee to financial markets that the Fed would cut rates to accommodate shocks. The Fed made good on that pledge during the 2008 financial crisis, when large-scale asset purchases and quantitative easing expanded the central bank’s balance sheet to over $4 trillion—a move that might be termed “the Bernanke put,” after the Fed chair at the time, Ben Bernanke. This year’s COVID-19 recession has prompted yet another put, this time with the Fed buying (or at least promising to buy) almost any debt security.
The age of magic money has been more than two decades in the making.
These interventions, each larger than the previous one, have transformed the structure of the U.S. economy in profound but barely recognized ways. They have created a substantial moral hazard by allowing holders of protected securities and debt issuers to take enormous risks without much fear of the consequences. In doing so, they have trapped the Fed in a cycle of responding to shocks, buying assets, cutting interest rates, and then buying more assets, driving up overall leverage and debt across the financial system with each intervention. Considering that history, the age of magic money does not seem new or extraordinary at all—it is a direct extension of the Fed’s past policy record.
Under normal conditions, conventional monetary policy involves the Fed (and other central banks) directly influencing short-term interest rates by buying and selling short-term government securities through open-market operations. But in its efforts to contain the 2008 financial crisis and the present COVID-19 recession, the Fed has departed from that model. In 2008, the policy of quantitative easing extended these purchases to long-term government debt and toxic assets such as mortgage-backed securities. This past March, in response to the pandemic, the Fed publicly pledged to buy a much wider range of assets from a much wider range of sellers, including corporate bonds rated below investment grade. The idea behind the move was that investors would trade the securities on the Fed’s “buy list” with the assumption that they were insulated from overall market conditions. This helped restore market confidence, prompting a stock market rally in spite of widespread economic devastation and massive unemployment.
Whereas the Greenspan and Bernanke puts targeted interest rates to deal with shocks, this time around, the Fed has effectively put a floor under the price of a wide range of high-risk assets. Their valuations are now based on that floor rather than on the actual state of the economy. Investors that hold such assets can use them as collateral, secure in the knowledge that the Fed will eventually buy them to safeguard financial stability. As a result, investors have an incentive to take on more debt at the first hint of a new Fed put.
This is moral hazard as a business model—and its logic is familiar. Consider the aftermath of the 2008 crisis, which resulted in part from innovations that allowed the so-called shadow banking system to extend private credit outside the formal banking system. When the credit bubble burst, those private liabilities threatened to derail the financial system unless states could absorb them by creating outside money—that is, money not generated by the assets that were now failing. The Fed stepped in and did exactly that. The Fed’s put, however, fueled massive inflation in the price of financial assets, especially high-risk corporate debt products. The resulting borrowing spree, which companies used mostly to fund dividend payments and share buybacks, left corporate balance sheets increasingly fragile before the pandemic hit.
The age of magic money is a direct extension of the Fed’s past policy record.
Now, the Fed has stepped in once again to exorcize financial demons that its own past rescue operations helped create. Its intervention may have saved the corporate bond market for the time being, but it has done so by engineering an even bigger debt bubble around the same assets that left companies vulnerable in the first place. In the months that followed the Fed’s move in March, U.S. companies issued bonds at a dizzying speed, flooding the market with corporate debt priced well below the firms’ risk profiles. Amazon, for example, raised $10 billion in June in an offering that included a three-year bond with a 0.4 percent interest rate—what the Financial Times reported to be the lowest rate for any bond in U.S. corporate history.
The Fed’s lending practices may even end up benefiting private equity firms, which can access Fed support even as they use their large cash pools to buy up distressed assets. The net result—aside from turbocharged market concentration and increased economic inequality—is more debt, perpetuating the systemic fragility and overleveraging that will force the Fed to pick up the pieces when the next crisis inevitably hits.
In severing any remaining ties between financial markets and the real economy, policymakers seem to believe that the rising value of stocks and bonds will trickle down enough to produce GDP growth. But the belief that increased wealth can replace wage growth as the driving force in lifting aggregate demand ignores the fact that the vast majority of U.S. households are not able to build wealth in the first place. According to recent research by Goldman Sachs, the bottom 90 percent of Americans hold a mere 12 percent of the value of stocks owned by U.S. households. The U.S. economy has failed to deliver inclusive growth for decades, as real wages for many workers have been stagnant since the mid-1970s. The Fed itself determined last year that the majority of American adults would not be able to cover a hypothetical unexpected expense of $400—a scenario that for millions of Americans became a reality when the pandemic forced the country to shut down. The only remaining recourse for typical consumers struggling to maintain their standard of living is to rely on ever more expensive credit.
In short, the United States seems to have stumbled into a monetary policy regime that has untethered the fate of economic elites, who derive most of their income from state-protected financial assets, from that of ordinary people, who rely on low and precarious wages. Such a regime offers permanent protections to those with high incomes from financial assets; everyone else gets little more than temporary help in times of crisis. In a world of high inequality and intense polarization, this is a dangerous policy mix.
The numbers speak for themselves. By this past June, some 45.5 million Americans had filed for unemployment, and more than $6.5 trillion in household wealth had vanished. Meanwhile, between March 18 and August 5, according to data from Forbes, the net worth of U.S. billionaires surged by over 20 percent, reaching a total of $3.6 trillion. But this soaring wealth is so poorly distributed, it cannot increase aggregate demand enough to stimulate wage growth. As such, the gulf between those who live in the precarious real economy and those who live in the insured financial economy widens with each iteration of the game.
The Fed has stepped in to exorcize financial demons that its own past rescue operations helped create.
Curbing this inequality would require yet more quantitative easing and rock-bottom interest rates, particularly given the increased debt loads that U.S. states have taken on over the course of the pandemic. Pursuing those policies, as Philip Aldrick of The Times of London has noted, would only exacerbate “the rule of the markets, the rise of asset prices, the enrichment of the plutocratic elite and a growing sense of injustice that comes with widening inequality even if everyone is getting richer.” In other words, it would mean another round of puts, with the same payoffs and risk buildups as before.
One could argue that during the current crisis, the Fed’s promises have been more effective than its purchases, and so the effect of the Fed put this time has been limited. The Fed has thus far used only $100 billion of the $2.6 trillion it said it would deploy; it still has plenty of firepower at its disposal. Yet since the start of the pandemic, the Fed’s balance sheet has nonetheless increased dramatically, from $4 trillion to $7 trillion, and many on Wall Street anticipate that it could soon hit $10 trillion. But this is a part of the problem, not the solution. Every time the Fed acts, more debt gets added to the system, which increases the size of the future shocks it will need to address. The cure feeds the disease. The only real question is how many more rounds the global economy can endure before it finally breaks.
The United States had an opportunity to break this cycle last spring. It could have done what many other countries have done, which was to bail out the labor market by giving direct payments to workers and by providing liquidity to solvent firms that could not access the public markets. Instead, Washington bailed out insolvent firms and, for the most part, let the labor market crash, spinning the wheel of moral hazard once again.
Washington can do better. But to do so, policymakers need to remember that in capitalism, firms are supposed to fail, and in a democracy, the state is supposed to protect its citizens. Twenty years of misguided Fed policy have upended those basic rules. It is time to put them back in place.
I am glad that Raphaële Chappe and Mark Blyth agree that this is the age of magic money. But in seeking the roots of today’s sorcery in 1998, they underplay both the novelty of the present and the relevance of more distant history. A different understanding of the long arc of monetary policy points to a more optimistic take on today’s challenges.
Consider, first, the distinction between past responses to financial blowups and today’s magic money. In 1998, when the U.S. Federal Reserve faced the failure of the hedge fund Long-Term Capital Management, its actions were both modest and temporary. The fire sale of LTCM's hugely leveraged portfolio created a danger that other financial institutions might collapse. The Fed delivered three small, quarter-point interest-rate cuts to protect the economy from the fallout.
In contrast to this year, in 1998, there was no expectation that the Fed would keep short-term interest rates low indefinitely. There was no thought of the Fed driving down long-term rates by buying bonds—the term “quantitative easing” had yet to be invented. Nor did the Fed effectively print money to finance a large federal budget deficit. In fact, Alan Greenspan, the Fed chair, was known then as a deficit hawk.
In 1998, the Fed still assumed that inflation was lurking over the horizon and therefore that easy-money firefighting would have to be limited. What is different, and extraordinary, about the situation today is that this trepidation about inflation has all but vanished. In consequence, money can be conjured on a nearly open-ended basis, without fear of penalty or cost. Easy money has become magic money.
In capitalism, firms are supposed to fail, and in a democracy, the state is supposed to protect its citizens.
Now look further back in history. Chappe and Blyth are correct that the emergency interest-rate cuts of 1998 propped up financial markets, enriching the fortunate minority who own most of the country’s financial assets. But long before this “Greenspan put” there was a “Volcker put,” even if it wasn’t called that. Paul Volcker, Greenspan’s predecessor as Fed chair, was an austere public servant who frowned on extravagant bankers. Yet in 1982, he propped up those same bankers by abandoning the Fed’s monetary targets to cushion the shock of a debt crisis in Latin American economies. In 1984, he rescued the eighth-largest U.S. lender, the Continental Illinois National Bank and Trust Company, setting the “too big to fail” precedent that came back with a vengeance in the 2008 financial crisis.
The lesson from the Volcker put is that financial rescues are not really a choice. Even a Fed chair who resembled an Old Testament scourge saw no good alternative to them. To allow financial institutions to go under is to court a repeat of the early 1930s, when contagious bank failures dragged the economy into the Great Depression. During the late nineteenth century, the United States had no central bank and therefore no central bank puts. For the rich, it was the Gilded Age; for the rest, there was a bruising run of boom-bust cycles.
Today’s commentators should acknowledge that there is still no desirable substitute for central bank activism. One can quibble, to be sure: if Greenspan had undone those post-LTCM rate cuts faster in 1999, he might have dampened the destabilizing bubble in technology stocks. Equally, the post-2008 stimulus would have been more equitable if it had relied less on quantitative easing, which necessarily enriches holders of financial assets, and more on a budget stimulus, which can be targeted at the less fortunate. But the larger point is that we have reached the age of magic money not because of perverse choices by central bankers—“the Greenspan put,” “the “Bernanke put,” and so on. Rather, we are where we are because central bank activism is preferable to Depression-style passivity.
Nevertheless, Chappe and Blyth are right that there are risks in today’s predicament. If magic money favors the rich and does nothing for the rest, it will be politically untenable. If it involves ever-larger financial backstops, encouraging investors to take ever-greater risks, it will become economically unstable. Although such outcomes are plausible, however, they are not preordained. They come down to political choices.
If magic money favors the rich and does nothing for the rest, it will be politically untenable.
The policy response to COVID-19 points to the possibility of equitable magic money. The CARES Act, passed in March, extended unemployment benefits to almost 11 million American workers who would not otherwise have been eligible. A further 19 million received unusually generous benefits. As of May, families in the poorest quartile had 40 percent more liquid wealth than they had a year before, according to the JPMorgan Chase Institute. There is more to be done: at least nine million American children live in households that cannot afford adequate food, and Chappe and Blyth are correct to conclude that “Washington can do better.” But in principle, by freeing governments to spend more, magic money opens the door to a reduction in inequality.
The same is true of the doom loop linking Fed activism to financial adventurism. Near-zero interest rates and quantitative easing encourage investors to invite risk, and if those risks turn sour, the Fed may have to provide even more easy money. But this danger can be mitigated by tough financial regulation. The striking sequel to the LTCM episode is that 22 years later, no other hedge fund has threatened financial stability: banks learned their lesson after 1998 and lent to hedge funds more cautiously. In the same vein, the post-2008 financial regulation has curtailed risks. Over the past decade, the Fed has grappled with chronically low inflation, and now there’s a pandemic that has consigned chunks of the economy to the deep freeze. It has not had to respond to a blowup on Wall Street.
Rather than criticizing the Greenspan put, commentators should make their peace with central bank activism and call for policies that contain its side effects. The age of magic money demands more redistributive budgets, since falling interest rates boost the wealth of the minority. The age of magic money demands regulatory vigilance, because when capital is cheap, it tends to be allocated carelessly. The age of magic money provides an opening, moreover, for public investments in education, climate policy, and basic science. It need not be a grim time. It could be an era of opportunity.