At first glance, the headline may seem like a silly question. The stock market bottomed in March 2009 at approximately 6,500 in the Dow Jones Industrial Average and today sits right around 25,000. Unemployment exceeded 10 percent at the bottom of the crisis yet today sits at a 50-year low of 3.9 percent. In less than a decade, the conversation has shifted from concerns about an inadequate number of positions for a growing supply of unemployed workers to concerns about unfilled positions and an inadequate supply of laborers. Corporate earnings of S&P 500 companies were below $50 per share in 2008 but were over $150 per share in 2018 (and moving higher still in 2019). From industrial production to manufacturing to labor-market conditions to corporate profits to gross domestic product, the economic conditions of 2019 are categorically different from the economic conditions of 2009. And that is a good thing for all.
The challenges of 2018 that carry into 2019, though, are almost entirely related to the financial crisis, as the economy continues to absorb the effects of unwinding the very treatment that policymakers most relied on to alleviate the pain of the Great Recession: mainly, monetary stimulus more dramatic than was ever thought possible in the United States. Indeed, with roughly $4 trillion of assets still on the balance sheet of the Federal Reserve, the unwinding is in early innings.
It would be impossible to analyze the current challenges without a cogent assessment of events between 2008 and today. After Congress granted the Treasury Department the right to inject equity into the nation’s financial system via the Troubled Asset Relief Program (TARP), the fiscal prescriptions for the Great Recession were mostly complete. Yes, President Obama had his stimulus program, but it was widely considered a flop. His own allies acknowledged it was so but blamed its lack of effect on “inadequate firepower” (i.e., they argued that we needed to spend even more money). His critics pointed at the antiquated attempts to favor municipal-employee unions with public-works projects. Unemployment actually worsened after the stimulus program, reaching a new peak well into 2010, two years after the recession had begun.
With fiscal firepower largely ineffectual, the Federal Reserve took the lead in combating the deflationary spirals of the Great Recession. Standard Keynesian playbooks were even more ineffective than normal, because this contraction was not a standard business-cycle recession but instead was related to the very solvency of the nation’s financial system and the liquidity necessary for corporate America to function.
After solvency problems were addressed (often very imperfectly) via TARP, the post-TARP strategy focused on increasing liquidity in the economy and stimulating financial activity. And while, at the bottom of the crisis, the Fed had relied on emergency conventions (various borrowing facilities in the commercial-paper market, money-market facilities, foreign-currency liquidity-swap lines, etc.), its main tool after the crisis was its most traditional: the federal funds rate. Reducing the rate is rather vanilla for central bankers, but reducing it to 0 percent, as the Fed did (in what became known as “ZIRP,” zero-interest-rate policy), was unprecedented. And if ZIRP was unprecedented, maintaining it for eight years was revolutionary.
In late 2008, still the Code Red phase of the financial crisis, the Federal Reserve announced a strategy supplemental to the plethora of conventions it had already deployed, and this strategy would become known as “quantitative easing.” It involves the Federal Reserve’s purchase of bonds, in this case a combination of mortgage-backed bonds and Treasury bonds, but with money that doesn’t exist. It is a form of digital money printing, but it does nothing to necessarily increase the amount of money in circulation.
The policy was not then called “QE1,” for no one imagined that a QE2 or QE3 was coming. In fact, with a housing market in utter freefall, many just assumed that the initial $600 billion of purchases of mortgage-backed securities was a backdoor way to bail out homeowners. It was the least controversial of public-policy decisions at the time (in the aftermath of the AIG bailout, the death of Lehman Brothers, the aforementioned TARP legislation, threats from the Fed and the Treasury Department to Bank of America to complete its acquisition of Merrill Lynch, and more). These “purchases” effected with money that did not exist were intended to hold long-term rates down and stimulate economic activity by adding to bank reserves, thereby increasing liquidity in the corporate economy.
That $600 billion round of asset purchases had become well over $1 trillion by the summer of 2010, and the Fed’s balance sheet sat at $2.1 trillion, significantly more than double its size at the beginning of 2009. From late 2010, after a rather frightful summer economically, through the first half of 2011, the Fed then added another $600 billion to its balance sheet. Markets responded with much angst to this second round, known as “QE2,” to default scares in Europe, and to a downgrade of the U.S. credit rating when the government failed to lift its debt ceiling. But the economy advanced through various headwinds, and the Fed took a hiatus from quantitative easing that would last over a year.
But by September 2012, the Fed had decided it was time to pull out all the stops. QE3 was now front and center not only in the Fed’s monetary strategy but in the media’s coverage of it. The Fed left this round open-ended, and the size of the purchases varied from $40 billion to $85 billion per month.
Not everyone at the Fed was comfortable with quantitative easing. One Fed governor who expressed trepidation about continuing and expanding the program was none other than today’s Fed chairman, Jerome Powell. His worries about creating “bubble-like terms” in corporate finance (meaning that borrowing could get ahead of the capacity to pay back) are quite telling now, as capital markets revolted at the reversal of liquidity in late 2018 — the very thing Powell warned about. In mid 2013, as the Fed was discussing “tapering” its purchases, Powell stated that “the market does not understand when we will reduce purchases or why; this is a dangerous state of affairs.” Perhaps most impressively, given that present circumstances show the challenge of unwinding the stimulus given to credit markets, he added: “Long periods of suppressed volatility can lead to the buildup of risks and to a disruptive ending. The idea that monetary policy can ignore that . . . is not credible to me.”
By the time the Fed ended its bond purchases, in October 2014, its balance sheet had reached $4.5 trillion. The stock market gained 29.6 percent in 2013, its strongest year since 1997. When QE3 came to an end, markets took a pause that would last from mid 2014 through early 2016. The dollar moved significantly higher, punishing the currencies of emerging markets; oil prices were in freefall; and global markets fretted greatly about a coming slowdown in China.
The Fed’s zero-interest-rate policy would remain in effect for over two more years, with the Fed raising rates just one time, in December 2015, and then pausing for all of 2016.
During the latter Ben Bernanke years and throughout Janet Yellen’s reign, the Fed was highly influenced by concerns over exogenous shocks to the system. A new set of criteria, far outside the traditional “dual mandate” of the Fed (a stable currency and low unemployment), were introduced to monetary policy — from emerging-markets distress to inflation targets to GDP growth. External threats were always discoverable, and the Fed didn’t like it one bit.
The economy spent these years of great monetary assist expanding, but only modestly. The significant increase in government spending had the effect of “crowding out” investment in the private sector, and while unemployment slowly but surely declined, wage growth remained stagnant and the lion’s share of economic improvement was felt by those who owned financial assets whose valuations were pushed higher as the Fed held its discount rate down. But the Fed did something else as well, and in spades: It releveraged corporate America. Mortgage borrowing by homeowners leveled out and never picked back up to pre-crisis levels (thank God). Consumer debt likewise leveled out and never reestablished an upward trajectory. But corporate America returned to pre-crisis levels of debt relative to GDP and then exceeded them.
Aggregate U.S. corporate debt sat at $4.5 trillion at the beginning of 2009, the low point of the financial crisis. It sits at $8.5 trillion now, the effect of a 131 percent increase in middle-market lending (lending focused on companies too large for small-business loans and not large enough for traditional senior bank-loan funding), a 160 percent increase in investment-grade-bond issuance for triple-B-rated debt (the lowest credit rating in the investment-grade universe), an 81 percent increase in senior bank loans (those legally first in line to be paid before any other debt or equity instrument), and a 76 percent increase in private investment-grade debt.
This is not cause for alarm, per se. It was the stated objective of the Federal Reserve, in conducting quantitative easing, to reliquefy the American economy, and that reliquefication found its way into the corporate sector. The $4 trillion increase on the Fed’s balance sheet coincides almost perfectly with a $4 trillion increase in corporate borrowings. For the most part, that debt has been put to productive use. Hiring has increased, wages have increased, and clearly profits have increased.
So why can’t the Fed just declare victory and call it a day?
In 2017, the Federal Reserve began selling the assets it had acquired through quantitative easing. It did not begin by selling the bonds that it had originally purchased with computer-generated money, because doing so would have meant actively pulling money out of the financial system — indicating a hyper-aggressive tightening of monetary policy. Rather, it began with a process called “roll-off,” in which, as bonds mature, the Fed ceases to reinvest proceeds from them (thereby reducing the liquidity in the system passively and slowly). Initially, the Fed did $10 to $20 billion of this per month. More recently, the level has reached $50 billion per month. As it stands now, the balance has come down $400 billion in 18 months, to $4.1 trillion. If the policy objective was to reach some sort of post-crisis equilibrium, it could be argued that the Fed still has $1.5 to $2 trillion to go.
And it is this that has created one of the most significant economic vulnerabilities we face. The quality of corporate borrowings has, in concert with the massive liquidity expansion of 2009–16, declined, but this was not unexpected.
Corporate borrowings rated as triple-B have grown from 32 percent of the sector to 50 percent. Borrowing ratios have moved toward less earnings coverage and less asset coverage. Leverage is higher, and with it, so is economic vulnerability.
In other words, the great risk in a reversal of post-crisis policy is the unwinding of what the Fed very purposely created post-crisis: a releveraged corporate sector.
When markets began their violent selloff in the fourth quarter of 2018, the levered-loan bank market was no exception, and high-yield bond spreads expanded rapidly, indicating the beginnings of distress in credit markets. The numbers did not indicate a complete cutoff of access to credit, but it is clear that the path to Fed normalization now threatens a backlash in the very area of the economy that most participated in the policy initiatives of the central bank since the financial crisis.
While this is unsurprising, it offers a crucial truth about the reality of treating economic distress with aggressive monetary medicine: The cost of weaning off such medicine is not free. The unprecedented nature of the Fed policies that followed the financial crisis means that predictions must be taken with a grain of salt. What we know is that the patient became very accustomed to heavy doses of medicine, and that the dosage was maintained and increased well past the crisis. Economic logic did not fail, as corporations responded to the incentives by increasing operating leverage on their balance sheets. They seem to have mostly done so quite effectively.
But the risk inherent in stopping the treatment given to the financial crisis will generate its own challenges, and meeting them may prove much harder than policymakers imagine. As America has become less tolerant of Keynesian fiscal interventions, we have become much more reliant on monetary interventions intended to ease the pain of difficult business-cycle hangovers. The question facing the Fed and the entire American economy is whether a “hair of the dog” approach to monetary policy will just make the hangover worse.