Since the global financial crisis unfolded in 2008, the U.S. Federal Reserve and the U.S. Federal Government have showered the U.S. economy with three forms of stimulus: low real interest rates, asset purchases, and direct cash injections via stimulus checks and debt forgiveness.
Most of us know perfectly well that these freebies do not create bona fide value. Stimulus doesn’t actually create anything; it is just smoke and mirrors created by politicians and the intellectual elite.
Most critics of stimulus draw the analogy to drugs – short-term euphoria with catastrophic long-term effects – without really describing the mechanics of how it works. Here is our version of the mechanics.
Artificially low interest rates stimulate the economy by increasing the present value of financial assets, reducing the debt service costs for all existing borrowers, and creating an incentive (cheap debt) for additional borrowing. The increased value of financial assets makes people feel richer and willing to spend more money. Lower debt service frees up cash to enable borrowers to spend more on other things.
Asset purchases by the central bank stimulate the economy by creating one-sided transactions. If I buy something from you, the cash effects of the two sides of the transaction offset one another. Your cash balance goes up and my cash balance goes down. Cash is neither created nor destroyed. When the central bank buys an asset, the seller receives cash, but no offset exists. The central bank simply credits the seller’s account. That injects cash wherever the central bank choses to buy assets.
Central banks typically buy financial assets, traditionally government bonds but more recently financial instruments tied to U.S. mortgages. The seller uses the cash proceeds from the sale to buy something else, generally another financial instrument. That purchase increases the price of that financial instrument and, in the case the financial instrument is some form of debt, lowers the interest rate on that debt. That again makes the holders of those instruments feel richer and the lower interest rate lowers the debt service costs for borrowers in that particular market.
Injecting cash directly into the economy typically involves some sort of government handout like stimulus checks or debt forgiveness. Stimulus checks need no explanation; the recipients get free money and can spend it on goods and services. Debt forgiveness has a similar effect.
All three forms of stimulus have the effect of boosting consumer spending. That isn’t a shocker to anyone; increased consumer spending is the intent behind stimulus. There are armies of economists employed by the federal government with the express purpose of figuring out how to dress up the economy in the most effective way possible by getting consumers to spend more money. That is what they do.
Stimulus has a dark side, however, which is the second half of the drug analogy. All forms of stimulus create either additional debt or additional money somewhere in the system. Those by themselves can have negative long-term consequences. One we are experiencing today is inflation, the inevitable result of an increase in the money supply.
Stimulus, though, has a far more sinister effect on an economy that goes much further than the immediate effect of stimulus on debt levels and the money supply. It has far graver consequences. We call it the Pixie Dust Effect. The Pixie Dust Effect can push an economy to the brink of crisis.
Stimulus not only has the intended effect of increased consumer spending, but also the sometimes ignored effect of higher collateral values.
Consider the stock market as a way to visualize this effect. Lower interest rates increase the present value of financial assets, including stocks. Increased stock values improve the balance sheet of anyone borrowing money to buy stocks. They feel richer. They look more creditworthy to potential lenders, which allows the borrower to buy more stock on margin. Buying more stock on margin makes stocks go up, thereby enhancing collateral values.
The stock market is just one example. Stimulus directed at mortgages increases the collateral value of real estate in a similar fashion. Stimulus directed at government debt increases the borrowing capacity of the government. Stimulus targeted at the consumer increases the credit capacity of the consumer.
The Pixie Dust Effect makes participants in an economy look a little richer and more creditworthy than they really are and it is powerfully self-reinforcing. Collateral values go up which increases debt capacity which leads to more debt which causes collateral values to go up. The Pixie Dust Effect leads to mountains of bad debt that is not revealed until the stimulus stops. At that point, poor underwriting standards that justified the incremental debt based on pumped up and fleeting collateral values is exposed for what it is.
