In a healthy economy, the productive activity of one sector opens a vent for the productive activity of other sectors of the economy. The useful allocation of resources in one area of the economy reinforces the useful allocation of resources in another. Economic growth continues as the efforts of each sector focus on the production of those things that will be of demand and use to others. Each productive act is not simply an event, but contributes momentum to a virtuous cycle.
The difficulty emerges when something is brought into production that is not desired – that fails to align with the actual demand for it. In that event, the value of the product itself may be less than the value of the resources committed to its production. Since it is not consumed, it simultaneously becomes “savings” and “unwanted inventory investment.” Long-term growth is harmed, because economic effort and resources are wasted and fail to open a vent for other production. If this occurs at a large scale, jobs are lost, inventories build, and the economy suffers the long-term effects of misallocated activity.
When we review the economic narrative of the past 14 years, this is exactly what we observe. The first insult occurred during the excesses of the tech bubble and the severe misallocation of capital that resulted. Next, in response to the economic downturn in 2000-2002, the Federal Reserve held interest rates down in the hope of reviving interest-sensitive spending and investment. Instead, the suppressed interest rate environment triggered a “reach for yield” that found itself concentrated in enormous demand for mortgage securities. Wall Street was more than happy to provide the desired “product,” but could do so only by creating new mortgages by lending to anyone with a pulse.
The resulting housing bubble became a second episode of severe capital misallocation, and led to the economic collapse of 2008-2009. In response to that episode, the Federal Reserve has now produced and largely completed a third phase of speculative malinvestment, this time focused on the equity market. On historically reliable valuation measures, equity prices are now double the level at which they would be likely to provide historically normal returns. As in 2000, three-quarters of the record new issuance of equities is now dominated by companies that have no earnings. The valuation of the median stock is now higher than it was at the 2000 peak. NYSE margin debt as a percent of GDP exceeds every point in history except the March 2000 peak. All of this will end badly for the equity market, but the real insult is what this constant malinvestment has done to the long-term prospects for U.S. economic growth and employment.
The so-called “dual mandate” of the Federal Reserve does not ask the Fed to manage short-run or even cyclical fluctuations in the economy. Instead – whether one believes that the goals of that mandate are achievable or not – it asks the Fed to “maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
What the Fed has done instead is to completely lose control of the growth of monetary aggregates, in an effort to offset short-run, cyclical fluctuations in the economy, so as to promote maximum speculative activity and repeated bouts of resource misallocation, and ultimately damage the economy’s long-run potential to increase production and promote employment.