Monday March 25, 2020
While the country and the stock markets reel from the impact of the Coronavirus, many economists and politicians are calling for the government to fight the pandemic as if we had to fight the Second World War all over again. In his address from the White House on March 18, President Trump made this comparison explicit when he said that we must sacrifice the same way our parents and grandparents fought the War in the 1940s. The President likened himself to a “wartime president” as he invoked the Defense Production Act, a Korean War era measure that allows the president to exert tremendous authority over key industries deemed important for the war effort.
Although it seems absurd to compare a war and a virus, there are some similarities in the way WWII and Coronavirus are impacting the economy. Both are unexpected international events that shattered Americans’ sense of isolation and fundamentally altered the U.S. economy almost overnight. The attack on Pearl Harbor and the Coronavirus both too the country by complete surprise, and in both cases politicians can argue, correctly, that the crisis was not America’s fault.
For needed perspective, it must be said that the Coronavirus is not shaping up to produce a bloodletting anywhere like WWII. But from an economic perspective, that almost doesn’t matter. In order to slow the spread of the disease, we are seeing a near total shutdown of economic activity. In that sense, it does feel like Pearl Harbor has been attacked again. But the government’s response could not be more different.
On December 8, 1941, the day after more than 2,000 Americans were killed at Perl Harbor, then president, Franklin Delano Roosevelt, addressed the nation to explain how the United States needed to undertake a momentous challenge: To fight two enemies on either side of the world, a task that would clearly require an enormous expense of money and resources.
But imagine that instead of warning that the effort would require Americans to work harder (in ways they wouldn’t necessarily choose in times of peace), pay more taxes, lend more money to the government, and reduce consumption of consumer goods and services, FDR promised the opposite? Suppose he said that in order to defeat Germany and Japan, the U.S. government would suspend taxation, guarantee income continuity by sending checks to all adults, and bail out every business that lost sales due to a “crisis that was not their fault.” And rather than asking Americans to join the Army to fight on the beaches of Normandy and Iwo Jima, Roosevelt instead asked the people to stay at home and do nothing for possibly months on end?
As absurd as this sounds, this is precisely how the government is proposing to fight the current crisis. So while FDR asked the people to support the government during a time of crisis, Donald Trump, Nancy Pelosi, and Jerome Powell, and nearly every major economist and corporate executive, are asking the government to support the people during a lesser crisis. Apart from proposing an impossibility, because governments have always drawn resources from the citizenry, this contrast perfectly describes how the American economy has so utterly changed over the past 80 years.
It may come as a shock, but a very large chunk of WWII was paid for by rank and file Americans, who worked longer hours, paid much higher taxes, and dipped into savings to loan money to the Federal Government. From when it was passed in 1913, up until 1941, the income tax was largely a burden that fell on the rich. During the War the income tax collections, which formerly had been paid almost exclusively by the rich, increased more than three times and were paid by a much wider cross section of Americans.The “Victory Tax” Act of 1942 introduced the payroll withholding tax to most Americans who had never seen taxes withheld directly from their pay. This was followed by the Revenue Act of 1943 that raised excise taxes on a broad scope of consumer goods. As a result, the tax burden became more widely shared than it had before the war.
During the War, sales of automobiles, houses, clothes, travel, tourism, and entertainment all plunged, causing huge disruptions in those industries. But no bailouts were offered. Business owners and workers were not compensated for lost sales or lost hours. In fact, consumers had to contend with higher prices and reduced supplies of all manner of goods and services. Some staples, like gasoline, meat and butter, were rationed. Rather than dropping out of the workforce to self-quarantine, millions of new workers, primarily women, were drawn into the labor force to replace the 16 million men (12% of the U.S. population, equivalent to about 40 million today) who were sent overseas. No federal aid was offered to help defray childcare expenses in cases where fathers went off to war and housewives went off to work.
However, the threefold wartime tax increases were not enough to fund the sixfold increases in government spending. During the War, the national debt increased from $43 billion to $259 billion. But the vast majority of that new debt was financed by average citizens who dipped into their own savings to buy more than $150 billion of War Bonds (about 3 trillion in today’s dollars). Instead of spending on themselves, Americans sacrificed by loaning money to the government. The absurdity of today’s crisis is that this time the Federal Government is proposing to loan money to the people, and to guarantee private debts.
Its surprising that consumers of 1941 were equipped at all to shoulder the unprecedented burden of paying for WWII. Many Americans had not fully recovered from the ravages of the Great Depression, which began in 1929 and lasted to the very late 1930s. In late 1941, the Dow Jones Average was still approximately 60% below the peak it had achieved 12 years earlier, before the Crash of 1929. The Depression had taken a buzzsaw to consumer net worth and savings. But Americans had managed to repair their balance sheets, primarily by paying down debt. As percentages of the economy, consumer debt, through mortgages, and auto, student, and personal loans, was far smaller than it is today.
Compare that to the situation today. By early 2020 the U.S. economy was riding high on the longest economic expansion in our history. The last recession had begun way back in 2007. Since that time, consumer spending had risen to levels never before imagined. In the decade between 2010 and 2020, the Dow Jones more than doubled.
But the big difference between 1941 and 2020 is the level of debt that burdens the economy. Because the Fed has held interest rates artificially low for so long, today’s consumers, businesses, and governments are loaded down all manner of debt that our grandparents and great-grandparents would find shocking and absurd. In addition, consumers and businesses have almost no savings to draw on in the case of a crisis, let alone to pay higher taxes or loan money to the government. That’s why the economy is so vulnerable to the disruptions brought by the Coronavirus. We have nothing saved for a rainy day, and now it’s pouring. In order to finance the ongoing spending spree that kept our bubble economy going, businesses and consumers have become accustomed to being “one paycheck away” from bankruptcy. So, the prospect of diminished earnings, even for a few months, shapes up to be an existential threat.
Public corporations exploited the artificially low interest rates that Fed policy created over the past 12 years to sell low interest bonds and use the proceeds to buy back their overpriced shares. Everyone, especially President Trump, cheered the markets as they kept hitting record highs, without any regard for the debt-financed buybacks powering the rise. That is why today’s stock market has already crashed more during the past several weeks than it did in the entirety of World War II.
The Second World War was not kind to stock investors. From peak to trough the Dow Jones dropped 30% from its 1941 high to its 1942 low. But these losses are tame compared to what we are seeing now. By late March the Dow has already dropped more than 30%, and the Russell 2000, which is more reflective of the domestic economy, has dropped by by more than 40%. As bad as the Coronavirus threat is, does anyone really believe it’s even close to being as bad as World War II? Recall that in the first year of the War, it did not even appear as if the Allies would win! This reveals how over-valued our stock market is, and how today’s debt-driven consumer-based economy pales in comparison to the savings and manufacturing driven economy that existed in 1941.
And so, everyone turns to Washington for more money, ignoring the fact that government debt now surpasses $23 Trillion, and is currently increasing its debt by more than $1 Trillion per year (even before the virus). Despite this, the government is promising much, much more.
In recent days, some of the policies that had been floated include the indefinite suspension of payroll taxes (the opposite of what happened in 1942), which would drain hundreds of billions annually from Federal coffers, the suspension of debt payments on student loans, direct payments of $1,000 per month for every household in the country, bailouts to businesses that will be required to pay for months of paid sick leave. The list is expanding hourly. In last week’s Democratic presidential debate, candidates Sanders and Biden fell over each other to see who could dream up the biggest Federal programs to shower free money on the public. In fact, it doesn’t really matter if Joe Biden wins the nomination, Bernie Sanders has already won by pulling the entire Democratic Party into the socialist camp. In fact, Sanders has had a similar effect on the Republican party as well.
Recall that before the last recession began in 2007, annual Federal deficits were in a range of $300 billion annually. Two years later, the deficit had expanded nearly 5 times to $1.5 Trillion. That explosion resulted from falling tax receipts collected during the recession and the government bailouts of the financial sector. This time around, similarly large sectors of the workforce will be losing their jobs, at least temporarily, and many more sectors (besides just the banks) will be receiving Federal bailouts. If the same math applies now as applied in 2008, we could be looking at a 2020 deficit in excess of $4 trillion. Where is that money going to come from? From the Federal Reserve, of course.
Right on cue, the Fed just announced the emergency restart of the Quantitative Easing engines, which had been on hiatus since 2015. (Although we should consider the Fed’s repo interventions, which started in 2019 as the official return of QE). In a surprise Sunday announcement, Fed Chairman Powell, after being threatened with demotion by President Trump, detailed plans for $700 billion purchases in government and mortgage backed debt. Although no time frame was given as to how long it will take for the Fed to unload this bazooka, most assumed that this was just the opening salvo. Given that the Fed announced an additional $500 billion the very next day. It only took a few more days for the Fed to make the program completely open-ended.
So, from now on, it will be the government that supports the people. Apparently, the idea that governments are supported by taxation from the people who produce the wealth is outmoded. But there is no such thing as a free lunch. Many policymakers are actually calling for a policy of “helicopter” money to cover the costs of fighting this war, not realizing that Milton Friedman, who first coined the phrase, meant it as a joke.
In reality, paper money by itself has no value, so dropping it from helicopters merely succeeds in raising prices. Had Roosevelt called on the Fed to finance WWII with a printing press, we would have surely lost. Paper money derives its value from the goods and services those who earn it produce. But if people are watching Netflix instead of providing services or producing goods, what will all this newly created money buy?
The bond market is already buckling under the weight of trillions of additional supply of Treasuries. But since rising interest rates would only weaken a highly indebted economy further, producing an endless cycle of rising rates, rising deficits, and economic weakness, the Fed will monetize all this debt instead of forcing the private credit markets to absorb it. Therefore, it’s the dollar that should be buckling. But, for now, a global liquidity crisis is driving the dollar higher, despite the fact that tens of trillions will soon be created out of thin air.
The 64 trillion-dollar question is when will the markets come to terms with the inflationary tsunami headed to our shores? The Coronavirus is reducing the supply of goods and services, just as the Fed is increasing the supply of money to buy them. Creditor nations that have traditionally helped finance America’s deficits are struggling with Coronavirus financial struggles of their own, so they no longer have surplus savings to finance ours. Foreign producers, dealing with decreased production and disrupted supply chains, will no longer be positioned to export as much to the U.S.
Once this liquidity crisis ends, the dollar could drop like a stone. As it does, soaring inflation may ensue, pushing bond yields higher, despite the Fed’s efforts to contain them. Hyperinflation, that I once considered a long shot, now looks like the most likely outcome. That means the government’s cure for the Coronavirus will inflict far more economic damage than the virus itself. Ironically, the biggest casualties will be the very segment of the population we are trying to protect. The elderly may not die from the Coronavirus, but the cure will kill their retirements. Hyperinflation will ravage the life savings of the elderly, destroying the value of their bonds, pensions, annuities, and even their Social Security benefits. Winning a war that leaves the elderly destitute can hardly be considered a victory.