The Lords of Easy Money: How the Federal Reserve Broke the American Economy by Christopher Leonard. Review by Guy Dauncey
Every healthy economy has a financial immune system to protect its people from panic. Before America’s immune system was established in 1913, panics happened regularly. In the years since then there have been numerous crises, but each time, except in 1930, the immune system kicked in to stop the panic before it infected the whole population.
That immune system is the central bank, the most important and least understood component of the economy in every country that prints its own currency. In The Lords of Easy Money, Christopher Leonard has done us a huge service by scattering ignorance and confusion to the winds in his narrative exposition of the inner workings of the US Federal Reserve in the critical years from 2007 to 2020.
Leonard believes that the Zero Interest Rate Policy and Quantitative Easing (ZIRP+QE) combination is the most important and least discussed economic policy of the decade. It created a tidal wave of cash in search of a high-yield home. The easier the supply of money, the greater the willingness of bankers and traders to take risks, in contrast to the dull-but-secure yields of government Treasury Bills. By the summer of 2011 the Fed’s account – the money it had pumped into the economy – had grown to $2.5tr, but this was nothing compared to what was to come.
A central bank creates money out of thin air, an attribute that is pretty useful when a crisis hits. To understand how this works, we need to understand the origin of money, which I believe dates back to our hunter-gathering days. Imagine you are in the Arctic sitting around in your igloo, conscious that you owe Akna for the robe she made for you, and Pamuk for his gift of seal fat.
They, in turn, are conscious of debts they owe to you. Digitise such thoughts, and you have the origin of money as reciprocal gifts, based in kindness. Today, the banks create it on our behalf, charging interest on every dollar. For every million they have in reserves, the Bank of International Settlements in Zurich might allow them to issue twenty million in loans.
Back in your igloo, Pamuk mentions that old Tuktu is struggling. “What can we do?”, he asks? Together, you decide to throw a feast for him without expectation of return. In so doing, you are acting as your clan’s central bank, drawing on your accumulated trust for the benefit of one who is in need. If too many such feasts were given you’d cause an inflation of expectations, leading people to act selfishly, knowing that the clan would come to their rescue.
A central bank creates money in much the same way, creating money to head off a financial crisis. Between our hunter-gathering ancestors and today’s pin-striped suits, however, something happened. With the coming of food surpluses the clans divided into dominators and dominated, haves and have-nots. The bankers stored the savings of the haves, and in modern times they created central banks to save themselves from financial panic. The money the central banks create comes out of thin air. It is a drawdown on society’s accumulated trust, which should never be abused, which brings us to Christopher Leonard’s book.
Leonard’s history is compelling, but he falls short when it comes to new ideas and constructive alternatives. I would like to have seen him explore the possibility that the newly-created money could have been used to bail out flooded homeowners; build enough affordable housing to end homelessness; install solar panels and wind turbines to tackle the climate crisis; or write off student debt. Each of these methods would have caused the money to trickle up into the economy through wages, restoring consumer demand.
Instead, it went to the banks, who didn’t want to invest in the nuts and bolts of manufacturing when they could invest in corporate debt and real estate. For anyone who owned housing, stocks or bonds, it was a golden age. Between 2008 and 2018 the Dow Jones doubled from 13,000 to 26,000 points.
When a chief financial officer can borrow at 0%, with the goal to maximise shareholder value, the most logical strategy is to buy back shares, creating a scarcity which increases their value and enriches everyone whose pay includes stock options. Between 2008 and 2018 American corporations spent $6tr on share buy-backs, with the excuse that they didn’t have anything else to invest in. Where did all that money come from? ZIRP + QE.
The recent era of financial history began in the 1970s, when Milton Friedman tossed old-fashioned values out of Wall Street’s 20th floor window and declared that a business’s only valid purpose was to maximise value for its shareholders.
Bankers ceased investing in actual companies and switched to financing leveraged buy-outs of the same companies by hedge funds, who piled the debts onto the beleaguered companies, all in the name of a 15% return, often forcing the workers to take a pay cut or to lose their pension fund to pay the interest on the debt. A deep weakness settled into the bones of America’s economy as companies were starved of research, training and innovation at the very time when Chinese workers were learning how to make things more cheaply.
The Fed responded to the growing weakness by a prolonged period of low interest rates, which encouraged riskier lending. There was the dot.com financial earthquake in 2000, and then the big one in 2008, caused by sub-prime mortgage recklessness, which wiped $8tr off the economy, pushed unemployment to 10% and threw 9m people out of their homes. Chair of the Fed, Ben Bernanke, believed that the Fed had not been fast or bold enough in its response to the Great Depression in the 1930s, so he reached into the Fed’s monetary toolkit and pulled out Quantitative Easing.
Between 1913 and 2008 the Fed added $847 billion to the US economy, using its power to create money very cautiously, relying on interest rate changes to encourage or discourage lending. The 2008 crash was so big that its zero-interest-rate policy (ZIRP) was insufficient to restore the animal spirits of businesses.
The Keynesian response would have been for the government to borrow and pour money into the economy, but Tea-Party Republicans in Congress wanted less government, not more, so it was left to the Fed to restore order. They did so by creating new money and buying $600bn in bonds off the banks, placing the money directly in their reserves, easing their quantitative shortage (hence QE). This was done through a handful of Wall Street dealers under an arrangement struck when the Fed was founded to reassure the banks that the Fed would not cut them out of their primary business, which was creating money and charging interest on it. In this way, a cozy relationship developed between Wall Street and the Fed. “Quite Easy,” they might chuckle, as they enjoy lunch at a Wall Street oyster bar.
Meanwhile, the hedge funds and private equity funds – shadow banks that are basically unregulated and carry no reserve requirements – had an infinite supply of money to lend, thanks to ZIRP. They found a new way to entice investors with promises of yield: corporate debt, bundled into Collateralised Loan Obligations that mix the good with the bad – junk bonds from zombie companies whose debt interest payments exceed their profits. And blessing upon blessing, they discovered that whatever foolish crisis they caused, the Fed would come to their rescue, giving them new money to ease whatever quantities they were short of. It was known as “the Fed put”, a confidence that the Fed would always be there to bail them out. The term “moral hazard”, which central banks were meant to protect us from, was entirely forgotten.
The economists at the Fed, who had PhDs in economics and wrote their reports in intimidating and obscure financial jargon, were happy to approve ZIRP + QE along with “forward guidance,” reassuring the bankers and investors that interest rates would stay low. Leonard recounts how the one central banker – Tom Hoenig – who consistently opposed this as being: dangerous in the long-term; highly allocative; and a cause of growing inequality, resentment and anger – was consistently outvoted, 11 to 1. In 2013 the Fed began to unwind QE, but the market had a “taper tantrum”, melting down until the Fed quickly reversed its policies.
By 2020, global corporate debt had risen to $13.5tr, 14% of global GDP, on which interest had to be paid every month to lenders on Wall Street and elsewhere. When the pandemic struck the bankers and chief executives saw a looming disaster, they rushed to convert their assets into cash to cover their debt obligations, or see them downgraded into junk bonds.
The Dow fell from 29,000 to 20,000 points in three weeks, revealing “the extraordinary weakness that record levels of debt had woven into the fabric of corporate America.” And then the Fed stepped in. Its governors pulled out another $4tr of QE, which they used to buy corporate bonds and junk bonds in “the largest, most far-reaching, and most consequential intervention in the history of the Fed.”
The Dow immediately ceased falling. By July it had recovered its losses and by January 2022 it had risen to 36,000 points, which the financially lazy media interpreted as a wonderful boom. The Fed continued to pour money in at $120bn a month, reaching a cumulative total of $9tr by 2022. Nobody outside the world of finance seemed to notice: the virus was monopolising the public’s attention. And yet, as Leonard wrote, “Fundamentally, we have socialised credit risk. We have forever changed the nature of how our economy functions.”
Where did all the new money go? Not to ordinary Americans, since the bottom 50% of earners only own 2% of the nation’s assets. It went to existing asset-holders, America’s richest 10%, who own 70% of the wealth and 84% of Wall Street’s assets.
Meanwhile, consumer debt rose to $15tr, eating up 9% of a typical family’s monthly income and transferring $62bn to the owners of the debt, if we assume an average 5% interest. The finance, insurance, and real estate (FIRE) sector increased its share of America’s GDP to 31%.
On the TV show Frontline, the investor, Jeremy Grantham said, “We’re like a giant bloodsucker. We have doubled in size, and we’re sucking more than twice the blood out of the rest of the economy.” The details differ for each country, but the world’s central bankers have been of one mind, pouring $28 trillion into the world economy.
How will this end? Leonard doesn’t say. Now we have 9-10% inflation. If the central banks raise interest rates further, an unknown amount of corporate debt will become unpayable, triggering a repeat rush for liquid assets. If they respond by lowering rates yet again and pouring in more QE, the Jenga tower of debt will continue to grow.
Have the central bankers walked themselves into a financial trap? The neo-classical economists say don’t worry: in the long run everything will return to equilibrium, and the rise in inequality won’t matter. The wealth of the billionaires will trickle down, pouring blessings on us all. They are slowly unwinding QE by letting bonds expire, withdrawing that much money from the economy, and so far, there has not been a repeat of the 2013 taper tantrum. Fingers crossed.
I await Christopher Leonard’s next book. This time I hope he will dare to tread where other economists don’t, and use his extraordinary grasp of what’s happening to explore these questions:
- What would it take for a central bank to cease being an insurance scheme for private bankers, and become instead an insurance scheme for society as a whole?
- What reasons are there for not using QE to finance climate solutions bonds or affordable housing bonds, instead of corporate bonds?
- What new system of governance could enable a central bank to respond to a society’s critical needs while avoiding the risk of abuse by a corrupt or neo-fascist government, which history tells us could be far worse than abuse by corrupt bankers?
- Could the world’s central banks combine forces to tackle the global climate and biodiversity emergencies? To use that $33tr for our collective benefit, instead of to build that Jenga tower of corporate debt?