Pain is Bliss When the Anticipated Policy Response is Infinite

By John Banks

An infinite policy response is like infinite morphine. The pain hurts, but the morphine overwhelms the pain, to the point of generating bliss.

This can create a twisted Pavlovian response, in which injury or illness is something to be happy about, because new pain means a new morphine dose. This can continue deep into the throes of addiction. It can continue until smiling death.

It appears the stock market has become addicted to the blissed-out high of fiscal and monetary policy response. It further appears the market is not just responding to what the Federal Reserve has already done — it is anticipating future actions the Federal Reserve will take.

Remember the morphine addiction feedback loop. Pain switches from bad to good if pain is a gateway to further morphine doses. In this configuration, hell on earth becomes heaven, because the policy response to hell puts you in heaven — by way of more morphine.

Here is how the rationale might work:

  • Tens of millions of Americans unemployed, with a great many of those jobs never coming back? Excellent news for stocks, because the Fed will have to respond. Another dose of morphine.
  • Ten to 15 million small businesses closed, representing one-third to one-half of all small businesses in the United States? Excellent news, because the Fed will have to respond. Another dose of morphine.
  • Entire industries (like restaurants and travel) decimated, with post-pandemic rules (like 50% capacity seating restrictions) increasing the odds many of them will never be able to come back? Excellent news for stocks, because the Fed will have to do more. Another dose of morphine.
  • A slower recovery, with even more of an “L” shape, due to COVID-19 caseload spikes in states around the country via mass-demonstration super-spreader events? Excellent news for stocks, because the Fed will have to do more. Another dose of morphine.
  • No conceivable way to avoid the overwhelming deflationary pressures of a crushing debt load, both public and private, built up over a nearly four-decade leverage-and-debt supercycle? This is the best news of all, because, in the event of an existential threat — a level of debt-induced deflation that could crush the system — the Fed may have to provide infinite morphine.

Ludwig Von Mises predicted this in the 1940s. We’ve talked about this Austrian economics “prophecy” before — you can read our write-up of it here — but it’s important to read Von Mises’ words again — carefully — because this is now almost certainly underway:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion.  The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The Federal Reserve needs to avoid “the final collapse of a boom” at all costs.

After all, the Fed’s unspoken mandate is being the buyer of last resort, and the firehose liquidity provider of last resort, in the midst of a crisis, to prevent the crisis from getting worse.

That is more or less why the Federal Reserve was created. That is why Federal Reserve policies that amount to legal market rigging are tolerated, as we explained via the Panic of 1873.

We have talked about the looming signs of deflation, and how corporate profits have been flat for eight years, and how the whole system is at the tail end of a nearly 40-year long-term debt cycle. And we have talked about how all of this, along with the demographic picture, is deeply deflationary.

Von Mises, in forecasting “the final collapse of a boom brought about by credit expansion,” was looking at the same thing from a different angle.

A boom brought about by credit expansion creates a mountain of nonproductive debt. Eventually the debt load gets to be too much — the entities that owe the debt can no longer service it.

  • At the point of debt-driven insolvency — for a quick primer on insolvency, go here — a normal human being, or a normal business, would go bankrupt.
  • A large-enough business, like a systemically important insurance company, an automaker, or a money-center bank, would look to the government for a bailout.
  • And when an entire country goes insolvent, it can either literally default on its obligations — as Argentina is in the process of doing yet again — or, if the debts owed are denominated in the home currency, it can destroy the currency to inflate the debts away.

This “inflate-it-away” activity leads to catastrophic currency flight in the end, which is what Von Mises meant when he presented the prediction as a Hobson’s choice: The endgame of a credit-massaged boom is a destroyed economy or a destroyed currency.

The destructive mechanism in this equation is debt.

In other words, you either let the debt load topple over and crush the economy in an insolvency avalanche, or you monetize the debt and utterly destroy the currency’s store-of-value proposition in the process. Of course, no government would choose to destroy the economy rather than the currency; after all, fiat currency is only a few decades old, anyway.

Here is where we have to own up to a mistake.

We thought the Federal Reserve would be constrained by the Federal Reserve Act of 1913 and the Banking Act of 1933. These two pieces of legislation restrict the actions the Federal Reserve can take; they limit what the Federal Reserve can actually do.

The Federal Reserve is not legally allowed to “print” money, for example. The Fed can only buy or sell an approved roster of government securities.

This means that, when the Fed wants to inject dollars into the system, it cannot just “print” the dollars. It has to buy Treasury bonds or notes, and then swaps out the debt for dollars. New debt, meanwhile, can only be issued by the U.S. Treasury.

And so, in a weird way, the Federal Reserve is just a bond trader. A dollar is a legal liability of the U.S. government — a kind of government security, like a bill or note or bond. That is why the Fed can swap out the “mix” of securities at will, trading dollars for notes or bonds or vice versa. In the name of providing liquidity in a crisis, that is what the Fed is allowed to do.

Except the market seems to think — and perhaps the market is correct — that the Federal Reserve can do a lot more, and will.

Given the existential threat of deflation, the Federal Reserve might choose to violate the Banking Act of 1933. It might choose to do a great many things it was never before authorized to do — and go far beyond the bounds of the law in ways never before seen.

Government laws and rules don’t always have to be followed, you see. If a government rule is broken and no policy makers follow up on it, was the rule really “broken?” Perhaps not, if nobody cares or nobody can stop it.

Then, too, if a policy action is challenged by the courts, what happens if the court case drags on for months or years? The policy action goes through, and the reckoning for the activity may only come about years later. By then the crisis, or whatever the event is, might be over.

Here is what that means in shorthand:

  • The rules of the game, meaning the Federal Reserve Act of 1913 and the Banking Act of 1933, say that the Federal Reserve cannot “print” currency directly, that instead it can only buy or sell a limited roster of securities, and by extension “lend but not spend” — with lending activities that are strictly limited, too. 
  • The current Chairman of the Federal Reserve, Jerome Powell, is a savvy Wall Street player with years in private equity and deep-core knowledge of how the system actually works on both the public side and the private side (unlike other Fed Chairmen, who were mostly academics). Powell knows the game well enough to know he can break the rules — and he is smart enough, and motivated enough, to figure out how to do it.
  • If Fed Chairman Powell believes in the “End of America” concept — that the United States economy is now at risk of being systemically destroyed by deflationary collapse in the presence of Great Depression-level danger — then Powell has full incentive to break every rule in the book, in terms of radically expanding the Fed’s mandate, in order to save the system.
  • The greatest threat to the American economy since the Great Depression — a crushing new round of debt-driven deflation, at a time when the economy is at its most vulnerable in 90 years — thus becomes the natural catalyst for Chairman Powell to unleash his inner Superman, and in so doing, to fulfill Von Mises’ prediction.

The stock market sees all this, we would wager, and absolutely loves it — and decides to go straight up.

The missing puzzle piece, for us at any rate, was connecting the dots between the false constraints of the Banking Act of 1933 and Powell’s ability and willingness to break them. His actions are already a “tell” in this regard.

In April, the Federal Reserve announced the details of two new lending facilities, the “Main Street Lending Program” and the “Municipal Liquidity Facility.” One facility is designed to offer $600 billion in loans to mid-sized businesses. The other can provide up to $500 billion to states and municipalities.

Both of these ideas are nutty, at least in relation to what the Federal Reserve used to do (and the limitations that used to be placed on it).

And so the Federal Reserve has already blazed well beyond its charter, and almost certainly taken actions beyond its legal remit.

But so what? Nobody is going to stop them this time.

The Fed has lost in court multiple times before, most notably in the 1930s — the Banking Act of 1933 was explicitly designed to put limits on what the Fed could do — but in an existential crisis, Chairman Powell is not likely to be constrained.

“In the situation we face today, many borrowers will benefit from these programs, as will the overall economy,” Fed Chairman Powell told the Brookings Institution on April 9.

And then the Fed Chairman added this: “There will also be entities of various kinds that will need direct fiscal support, rather than a loan they would struggle to repay.”

Hint, hint. More money will be coming. We’ll figure out how to get it to you. Maybe we’ll find a way — if your business has the right connections — so you don’t have to pay it back.

This is printing — or, if you like, helicopter-dropping — in all but name. And to the stock market, a rose by any other name would smell as sweet.

At least in theory, only the U.S. Congress can authorize “direct fiscal support.” But who cares about theory when you are savvy enough to break the rules, mostly under cover of obfuscation if not darkness, in the name of saving the system from itself, with nobody standing in your way?

“Dow rallies 500 points, heads for three-day winning streak on hope of economic recovery,” a June 3 CNBC headline reads. That headline is backwards in our view.

A more accurate one might be: “Dow rallies 500 points, heads for three-day winning streak in gleeful anticipation of infinite Federal Reserve policy response aimed at saving the system from collapse.”

At the time of this writing we are witnessing “the greatest 50-day rally in the history of the S&P 500,” according to LPL Financial.

Would a bear market rally that is not just strong, but powers beyond every other bear market rally in recorded history, make sense under the current circumstances, if powered by anything other than the greatest anticipated policy response in the history of mankind?

To see stock valuations not just levitate but leave earth’s orbit like a Falcon 9 rocket, in the midst of a very-much-ongoing pandemic, with a backdrop of Great Depression-level unemployment, extreme and sometimes violent levels of civil unrest, hospital systems in rural regions like central Alabama overwhelmed with new COVID-19 cases, and corporations (whose profits have been flat since 2012) facing a COVID-wracked and socially distanced post-pandemic world, seems not just dystopian but nihilist to a cartoonish extreme.

And yet, perhaps it is all connected in a backwards but rational way.

  • Perhaps if the riots get worse, the market will go up more.
  • Perhaps the more that recovery prospects darken, the more the market will rejoice.
  • Perhaps if U.S.-China relations go into outright hostility mode, the market will rise even further.

It is all “morphine logic,” you see. Pain is bliss when the anticipated policy response is infinite.

If the U.S. economy is the patient, then perhaps for the stock market — a different entity than the U.S. economy entirely — all forms of illness are upside, because as long as the patient doesn’t die, in the end it just means additional morphine. 

And Federal Reserve Chairman Jerome Powell, following his December 2018 conversion — in which he pivoted on a dime from fiscal hawk to the ultimate dove —  is the man to carry out what Ludwig Von Mises so long ago foresaw.