The exponential growth of the global COVID-19 pandemic steamrolled the path for a new era of unprecedented state intervention in the world’s economies and its financial markets. From its bird’s-eye perspective, the International Monetary Fund recently predicted that rich countries will borrow 17% of their combined GDP to fund a total of $4.2 trillion in spending and tax cuts, designed to keep the world’s economies afloat. The IMF, however, is woefully behind the frenetically changing news-cycle curve.
First, in the U.S. alone, federal legislators are deadlocked on another infusion totaling between $1 trillion (Republicans) and $3.4 trillion (Democrats). Added to the $2 trillion of CARES Act relief already enacted, it could total 27.8% of the $19.4 trillion in estimated GDP at the end of Q2 2020. Second, U.S., British, Eurozone and Japanese central banks have created new reserves for $3.7 trillion in 2020 to buy government debt. The Fed accounts for the lion’s share. Collectively, they are tacitly financing the stimulus.
Financial repression, at the cost of savers earning less than the rate of inflation, is intended to keep interest rates low even as public-debt issuance soars. As we wrote in our “Forgotten Man” essay, the passive saver, through the loss of potential income, has been picking up a grossly disproportionate share of the tab since 2008.
In the U.S., the government’s growing role as capital allocator-in-chief of this New Age is head-spinning. Together the Fed and Treasury are now backstopping 11% of America’s entire stock of business debt. Although the trade-weighted dollar index has declined 9.2% since the late March S&P lows, the recession-induced output gap—the 7% difference between the growth in actual real GDP and potential real GDP—has played a dominant role in keeping a lid on inflation, allowing a freewheeling macro policy thus far largely untethered from potential long-term consequences.
Our central bank’s growing role in financial markets was not by design but by default, reflecting the stagnation of banks as financial intermediaries. If ever there was a fitting financial example of nature abhorring a vacuum, it’s in the emergence of a hodgepodge of shadow banks. Commercial banks, still under the regulatory thumb following the Financial Crisis of 2008–09, have been back on their heels. Regulation-lite, tech-savvy non-bank intermediaries emerged out of the shadows and into a pivotal role in the capital markets. Call it regulatory arbitrage at work.
In times past, commercial banks ruled the roost, while central banks acted as lender of last resort to them. Once burned, twice shy, the erstwhile mainstays have lost their once heralded dominance in the credit markets. Corporate lending as a share of GDP, for example, has stagnated at about 12%. Banks have ostensibly shored up their capital while America has indulged in a borrowing boom (see Figure 1). Effectively neutered, domestic commercial banks have nearly $2 trillion worth of core capital on their balance sheets, almost double the amount they had in 2007. That capital is a significant 12% of risk-adjusted assets.
With no oversight or control over the shadow banks, central bankers increasingly have to get their hands dirty on Wall Street and elsewhere. Earlier this year, however, banks went relatively unscathed as capital markets seized up. Shedding its role as a lender of last resort to banks, the Fed became market maker of last resort, intervening in credit markets that total about $23.5 trillion in size. The scale of the Fed’s intervention makes 2008–09 pale by comparison.
One can gauge this by looking at how the status of lending by banks and non-banks has slowly changed. The U.S. has deleveraged since the Financial Crisis (see Figure 2), which was almost wholly driven by the decline in mortgage debt, held by both banks and non-banks. Corporate debt, though, has reached an all-time high, and the bulk of activity has still been facilitated by shadow banks. Of the mountains of debt that companies have incurred since 2012, funds lent by banks have increased by just 2 percentage points of GDP, whereas the portion the non-bank sector holds has risen by 6 percentage points. While banks are now flush with capital and liquidity, it is the capital markets that have financed the bulk of the increase in corporate debt.
Where Do the Systemic Skeletons Lie?
The role banks play in maturity transformation means they’re always exposed to runs, jeopardizing the provision of credit to businesses and households. Whether the evolution of the financial system is risky depends on how “bank-like” shadow banking is. The FSB (Financial Stability Board) has tried to identify the financial firms most susceptible to sudden, bank-like liquidity or solvency panics, and which pose a systemic risk to the economy. Pension funds and insurance firms are excluded as they match their long-term liabilities with long-term assets. The Economist reports that, globally, $51 trillion (or 59% of global GDP) in “narrow” shadow investments have been identified, almost three-quarters of which are held in instruments “with features that make them susceptible to runs.” This slice has grown rapidly, from $28 trillion in 2010 (or 42% of GDP). At the end of 2018, the U.S. share of the risky bucket stood at $15.3 trillion. U.S. commercial banks, with assets of $15.6 trillion, were only slightly larger.
The riskiest types of shadow banks, says the FSB, include the gargantuan U.S. fixed-income funds and money-market funds; companies that make loans and might be dependent on short-term funding, including retail-mortgage or consumer-credit providers; broker/dealers that trade securities; and entities that do securitization-based credit intermediation, such as creating CLOs (collateralized-loan obligations) that bundle corporate loans, which in turn are sold to investors. Tellingly, it was many of these same markets that seized up in March and April, as well as tipped the dominoes during the Financial Crisis.
Separating the activities of the “real” banks from shadow firms is more difficult. Some non-banks, such as private-credit lending arms, make loans the same as banks do. And just as they did before the financial crisis, banks issue shadow instruments that are allocated in capital markets, such as mortgage-backed securities or bundled corporate loans. Banks also lend to shadow banks. This has been one area where bank lending has grown relative to GDP, and it now makes up 5% of loan books, though a large portion of risk-adjusted capital.
Our own research doesn’t permit us to give commercial banks a bye. In a June 19, 2020, post, “Financial Stability at Risk: Déjà Vu 2007,” we dug deeper into “The Looming Threat to Bank Solvency.” According to the FSB, 30 “‘global systemically important banks’ had an average exposure to leveraged loans and CLOs equal to 60% of capital.” And the CLO risk may simply be the tip of the iceberg.
In what would give F. A. Hayek and other Austrian School economists apoplexy were they alive today, policymakers now seek to manage the business cycle and fight financial crises, presumably without a politicized takeover of the economy. Is this a utopian free lunch where no one picks up the tab—or the perfect storm where all hell breaks loose?
In our post on April 5, 2019, we referenced Hayek’s Nobel acceptance speech on “The Pretense of Knowledge” with his self-deprecating aside: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
Today the tab for the free lunch has expanded well beyond the saver. The action of central banks committing to bail out capital markets on such a scale has stemmed market dysfunction but at the consequence of artificially shoring up asset prices, usurping the role of markets in pricing risk. New Age thinking of the sort currently proposed is on the cusp of a political takeover of the economy.
As Thomas Friedman poignantly warns in the Aug. 9 New York Times, “… when everything is politics, it means that everything is just about power. There is no center, there are only sides; there’s no truth, there are only versions; there are no facts, there’s only a contest of wills.” Buttressing his practicality with a philosophical foundation, Friedman turns to Hebrew University religious philosopher Moshe Halbertal: “For a healthy politics to flourish it needs reference points outside itself—reference points of truth and a conception of the common good. When everything becomes political, that is the end of politics.”
Without “reference points of truth and a conception of the common good”—which today seem conspicuous by their absence—it could be democracy itself that pays the bill, not to mention the piper. Eat hearty, whoever you are. This may well be the most expensive “free lunch” in modern history.
 The Economist, “Governments Must Beware the Lure of Easy Money,” July 23, 2020.
 The Economist, “Putting the Capital into Capitalism,” June 25, 2020.
 Thomas Friedman, New York Times, August 9, 2020: “Beirut’s Blast Is a Warning for America: In this country, as in Lebanon, everything is now politics.”