Tuesday, June 7, 2022

Stop Blaming the Fed and QE for the Current Economic Inequality Problem

The narrative that the Fed, by virtue of lowering interest rates, has been a significant cause of today’s wealth inequality is pervasive, particularly on Wall St. I don’t know why but people love to find a bogeyman to blame all the problems in the world on; call it intellectual laziness. Despite being supposedly intelligent, thoughtful people, many in finance are guilty of this.

Wall St equated QE with “money printing” and believed it would result in high inflation. That inflation never materialized. I distinctly remember being an intern at Tudor Investment Corp, a renowned macro hedge fund, and a PM there was explaining to me that the Fed was purchasing bonds from banks, injecting dollars into the banks, and those dollars were bound to leak out into the economy and cause inflation. After over a decade of historically low inflation rates, this turned out to be spectacularly wrong. But this was consensus on Wall St at the time; people got paid millions of dollars for this “analysis.”

The consensus on Wall St has now shifted. People will say that they misinterpreted what was happening, and that the inflation showed up in asset prices rather than consumer prices. They weren’t “wrong,” just misjudged where the money would flow to i.e. the capitalist class. This has created and exacerbated wealth inequality and is therefore a moral catastrophe.

Here’s the problem with that analysis: it completely ignores the role that Congress and the Courts play in influencing economic outcomes. Take for example a Boomer refinancing their home(s). Doing so essentially enables them to monetize their home equity tax-free. The equity in a home grows over time as 1) the principal for the mortgage is paid off and 2) the inherent scarcity of land combined with strict zoning laws leads to home price appreciation. Said differently, the loan-to-value (LTV) goes down as the mortgage is paid off or the house appreciates in value. By refinancing, the owner is able to monetize the equity in their home: it gets re-appraised at a higher value. The inflated equity means that the bank won’t need to charge as much interest. Not only that, but if the Fed is holding rates down, then the owner has a real home run: their income is unchanged but now they get cheaper cost of financing. Essentially, they get to keep more of their gross income. And the best part is this is considered by law to be a non-taxable event! That is the real key: they leverage their home equity to reduce their monthly mortgage payment without paying taxes. This is essentially tax-free income for property owners. The same logic works with Private Equity/LBOs; the equity in the company grows as they pay down debt, and they can refinance, lowering their interest cost, without paying taxes.

The key in refi’s is the fact that they are a non-taxable event. If they were treated like a sale, then there would be a capital gains tax charged on the owner; perhaps this cost would be amortized and included in the new mortgage service cost.  This would negate much of the advantage of doing a refi, and wouldn’t be such a sweet deal for the owners. Thus, it is the laws on the books (as written by Congress and interpreted by the Courts) that create these economic outcomes. The Fed’s lowering of rates wouldn’t matter nearly as much if people either a) weren’t allowed to refinance (i.e. it’s banned outright) or b) had to pay taxes on such a transaction. The argument that the Fed’s policies “supported asset prices” and therefore “exacerbated inequality” isn’t correct. It’s the tax-free income to property owners while the federal government gutted other programs that supported lower income households that caused it, among other factors.

What’s important to emphasize too is that this benefit only accrues to the incumbents/property owners/capitalist class, who borrowed at a higher rate and can now refinance to a lower one. It does not stimulate new investment. The government sets the price for money, and all other prices in the economy adjust relative to that price. For someone who wants to launch a new business, it doesn’t help if interest rates are “low” by historical standards; for them, the cost of money is what it is. Generally speaking, it’s not the absolute level, but rather the change, in interest rates that influences economic decisions. If someone launches a business and they want to make a certain margin, they’ll look at their total cost structure - including interest cost on debt - to determine how much they should charge. This is part of the reason MMT argues that raising rates is a lousy antidote for inflation, because raising the cost of debt means borrowers need to raise prices in order to maintain their margins. This is part of the reason why new business starts hit a 40-year low pre-COVID; it wasn’t until people received stimulus checks that the economy saw a burst in launching new businesses. 

I’m not necessarily advocating for the Congress to pass laws to change with regards to refi’s. I believe the ability to refinance makes our economy more flexible and resilient. But it is important to recognize the source of problems if we want to solve them. The Fed’s monetary policies mean nothing without laws that enable property owners to utilize lower rates to create tax-free income for themselves. Combatting inequality requires fiscal support from the federal government, not monetary “support” from the Fed.

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