Fed shock therapy: how the United States is approaching a large-scale crisis

2024 Author: Seth Attwood | [email protected]. Last modified: 2023-12-16 15:55

Donald Trump managed to achieve the greatest success in the economy. He was elected with a large and ambitious reform program. Trump managed to implement some of them, others did not. But in general, he has something to show by the result of his work. However, despite the good performance, the growth of stock indices has practically stopped. And October will be remembered as a Shocktober - the shares of the largest companies collapsed, by the beginning of November, the key US indices had lost all their achievements since the fall of 2017. Many economists put all the blame on the Fed's policy. Malek Dudakov tells what it is and whether it can cause a cascade of bankruptcies and defaults around the world.

Reforms, attempts

Many remember Trump's various promises in the context of immigration. He intended to finally solve the problem of illegal migration and significantly reduce the flow of legal migrants to America. So far, he has managed to adopt only a few presidential decrees in this direction - such as a ban on the entry into the United States of residents of a number of Middle Eastern countries, Venezuela and the DPRK. The notorious wall on the border with Mexico has just begun to be built. So far, about 15-20 km have been erected near San Diego - not a very significant result in two years in office.

The Trump administration, despite several attempts, has failed to implement a full-fledged health insurance reform. Trump is gradually repealing various clauses of the current health insurance system approved by Obama (ObamaCare) with his decrees. However, this can hardly be called a successful resolution of the situation on the insurance market.

Of course, not all of Trump's actions depend on him alone. In many ways, they are associated with the balance of power in the Congress, which is precisely what should pass new laws and approve reforms. During the first two years of Trump's presidency, Republicans held a majority in both chambers. In theory, this allowed them to adopt any legislative norms. In practice, however, the situation was different.

For example, in the House of Representatives, various factions within the Republican Party often could not find a common language with each other. This was the case, for example, on the issue of medical insurance. The conservative part of the Republicans demanded simply to abolish state regulation of this sphere and give it to the free market. More moderate representatives of the majority wanted only to slightly reform the existing ObamaCare system, but not to touch its foundation.

Trump tried to get somewhere in between these two positions. As a result, four or five votes on the abolition of ObamaCare were simply failed, and the issue was left to chance.

In the Senate, the opposition, represented by the Democrats, in every possible way blocked any initiatives of the majority of the Republicans. To move from debate on a draft law to a vote, it is necessary to enlist the support of at least sixty senators. The Republicans had only 51 or 52 seats, so their numerous bills remained under discussion.

Basically, all legislative successes of the Republicans were based on the adoption of new budgets. It is approved by a simple majority of votes, so the Democrats had no room for blocking. It is most logical to include economic innovations in the budget, which the Trump administration has successfully done.

A gift to business and a flourishing economy

Late last year, the White House, with Republican support, implemented the largest tax reform in 35 years. In the course of it, rates on the income of American citizens were lowered by 3-5%. For example, the maximum rate has been reduced from 39% to 35%. But most of all the preferences were given to businessmen. The maximum rate on business income has decreased from 35% to 21% - by almost a third. Trump intended primarily to reduce the tax burden on entrepreneurs. Indeed, before this reform, corporate income tax in the United States was the highest among all economies of developed countries (including Europe, Israel, Japan and South Korea).

These precipitous tax cuts, coupled with Trump's deregulation process, have led to rapid economic growth. In 2017, the US economy grew by 2.3%, a third higher than in the previous year (1.5%).

In 2018, for several quarters in a row, GDP has been growing at a rate of over 4% - the American economy has not seen such indicators since the 1990s, which were favorable for the United States. The level of confidence in the future among Americans has climbed to the highest level since 1997. The unemployment rate fell to its lowest since 1969 at 3.5-3.7%. And for the first time ever, minority unemployment fell to the same level as white American unemployment. Although generally African Americans and Hispanics have more difficulty finding work than white Americans.

The acceleration in the growth of the American economy began to be observed in the first months of 2017. Then Trump's reforms had not yet been implemented. However, optimism among businessmen and consumers about future tax breaks and the removal of excessive regulations has already begun to help the economy. Entrepreneurs began to invest more in expanding their business, and consumers began to spend more money, confident that they would be fine with their work.

Rampant growth of indices

The optimistic sentiment was most clearly reflected in the stock markets, which broke one record after another throughout 2017. The Dow Jones Index, which measures the stock price movement of the thirty largest US corporations, hit a record 31 times in a year. At the very beginning of 2017, it surpassed the 20,000 mark for the first time, up about 1,000 over the past year. And after 12 months, the Dow Jones exceeded 26,000 points, breaking all previous records for the rate of annual growth.

Dow Jones Growth Dynamics

A similar trend was shown by the S&P 500 index, which tracks the shares of the 500 largest US public companies. In 2017, it rose from 2,200 points to 2,700, showing an increase of more than 22%. And the Nasdaq Composite, an index of IT corporations, last year for the first time exceeded the level of the previous peak of early 2000. Then, after the collapse of the dot-com bubble, the Nasdaq lost two-thirds of its value in a couple of years. He managed to return to that level only in 2017.

Throughout the past year, Trump has often pointed to the dynamics of market growth as a sign of the success of his policies. Although it often did not correlate at all with the presidential ratings. For example, in the fall of 2017, against the background of a fall in trust in Trump to lows in the 35-37% region, markets, on the contrary, grew faster and faster. White House economists expected this trend to continue into the new year. Indeed, it is in 2018 that the economy will feel all the consequences of Trump's reforms. Companies will save on taxes, which can then be invested in expanding production. Unemployment will continue to decline, as before, while consumer spending will only grow.

Shock October

However, from the very beginning, things went on an unplanned course. Although all major economic indicators were normal (and some even improved), the growth of stock indices has practically stopped. This was followed by a landslide fall in share prices, which stretched over February and March. Closer to the summer, many market indicators returned to normal, but in the fall, the rapid sell-off of shares resumed again.

October of this year will surely go down in economic history textbooks as "Shocktober" (or "Shock October"). In just one month, the Dow Jones lost more than 2,000 points (although then it was able to partially recover some of the losses). The Nasdaq Composite fell nearly 12%. The leaders of the fall were the shares of the so-called. FAANG - Facebook, Amazon, Apple, Netflix and Google. A year ago, investors considered them the most reliable for investments on the market - they almost always grow and quite rarely fall.

But in October, Facebook alone, for example, collapsed 22% and Netflix nearly 30%. General Electric, one of the largest companies in America and managing most of the country's electricity grid, lost 45% of its market capitalization in October. The volatile cryptocurrency market went down following the stock market, losing 32-34% of the September capitalization. The list of losses can be continued for a long time.

Fall of the largest stock indices in October

Perhaps the main shock of October was not so much the landslide fall in securities in all key markets, but how rapid and unexpected it turned out to be. Most of the investors returning from summer vacations hoped to see stock markets rise in the fall, which could compensate for the spring losses. However, in reality, everything turned out quite differently. By the beginning of November, the key US indices had lost all their gains since last fall. At the same time, China's Hang Seng and Japan's Nikkei fell to spring 2017 levels, while European stocks were in their worst condition in 2.5 years. Traditionally, international investors have experienced all the problems with the American stock markets even more painfully.

Federal Reserve Against Growth

But what is the reason for the falling markets? As usual, economists are divided. Someone sees this as a natural stage of price correction, which will be followed by a new long period of growth. But there is also a completely different point of view. She puts all the blame on the policy of the Federal Reserve, which since last year has been trying with all its might to contain the growth of stock indicators.

Earlier this year, Jerome Powell, a conservative economist at Princeton University, became the new head of the Fed. He is a supporter of tight monetary policy. It means rapid increase in the Fed ratefrom those non-zero positions in which it was for a long time after the 2008 crisis.

In principle, the outgoing head of the Federal Reserve Janet Yellen has already begun to pursue such a policy. But Powell intends to speed up this process. Over the past two years, the rate has grown almost 10 times. Back in the summer of 2016, it was only 0.15%, and now it is approaching 2.25%. Powell is expected to complete another 3 or 4 rounds of its increase by the end of 2019 - to 3.5-4%.

In the eight years since the start of the 2008 financial crisis, the Federal Reserve has aggressively pursued a low rate policy. His example was followed by the central banks of other leading countries of the world - the European Union, Japan, Great Britain and China. They in a coordinated manner "flooded" the stock markets with cheap money, which they provided to banks practically free of charge (after all, one can hardly consider 0, 1-0, 2% as significant amounts for bankers).

Bubble Shock Treatment

The cheap money policy helped soften the impact of the crisis and led to unprecedented growth in equity markets. Stock indices have grown almost nonstop since 2009, if you do not take into account the short periods of recession in 2013 and 2015. However, central banks are now concerned that such policies have contributed to massive bubbles in all major markets. If these bubbles begin to burst one after another, then the world will end up in the abyss of a much worse crisis than it was in 2008.

By itself, the constant rise in key stock markets can be counted as new bubbles. The mortgage market in America is picking up steam again, as it was before the 2008 crisis. The US university student debt market is constantly growing and increasing in volume. Major metropolitan areas of the world (London, Hong Kong, New York) are faced with a sharp rise in property values. In the event of a new global recession, all these bubbles will begin to deflate one after another, causing a chain reaction. The consequences can be extremely dire.

That is why the head of the Federal Reserve Powell decided to work proactively. By quickly raising the rate, he intends to achieve a kind of "shock therapy" for the markets. It will allow them to collapse for a short time, but will not lead to a major recession. Nobody is happy with his actions: neither institutional players like banks and hedge funds, accustomed to a period of cheap money, nor politics at the head of the United States. Trump, who had previously supported Powell's policies, faced the consequences and began to scold him more and more. He probably did not expect that the Fed's actions would lead to such rapid and dramatic consequences.

The smell of the crisis

In American history, the crash in the stock markets has not always led to a large-scale economic crisis. For example, in October 1987, the sudden drop in the Dow Jones by 23% had almost no effect on the real sector of the economy. The October collapse of this year may well end with a similar outcome. Indeed, despite all the panic in the markets, most of the indices only rolled back to the level of last year. Affected by the rapid growth of stock markets in 2017. When, for example, in October-November 2008, at the peak of the financial crisis, the indices lost all their gains in 4-5 years.

However, the similarities with the major crises of the past can be traced elsewhere. The Great Depression began with a major collapse in the value of stocks on the New York Stock Exchange in October 1929. The main reason - the end of the policy of cheap money during the "Roaring 20s". And the trigger to the collapse was the decision to raise the rate by the New York Fed.

The mortgage bubble in the mid-2000s. was also largely formed by the cheap dollar policy pursued by the Fed to quickly exit the 2002 recession. And already in 2005, the Fed began to gradually raise the rate from 0.5% to 5%, which ultimately led to the mortgage crisis, which caused a financial collapse.

Will this story repeat itself today? After all, now we are witnessing the completion of another nine-year experiment on "flooding" the markets with cheap money. However, now all this is added to the serious problem of debt burden of states and major corporations. And with an increase in the rate, the cost of servicing loans also increases. If the Fed and the central banks of other countries play too much, they can cause a cascade of bankruptcies and defaults around the world. In this case, the current market volatility will seem like flowers against the background of berries - a long and painful economic crisis.