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What effects will the Fed’s open-ended commitment to buying assets have on the economy?

The Federal Reserve has taken many measures to stem the current financial decline, but they’ll all have long-term effects. Larry Swedroe explains what’s happened so far, and what that that could mean down the road.

Transcript

Tim Maurer:
Hi, this is Tim Mauer back with another episode of Ask Buckingham, a new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Larry Swedroe, Buckingham’s chief research officer. And Larry, what longterm effects might the Feds open-ended commitment to keep buying assets under its quantitative easing measures have longterm?

Larry Swedroe:
Well, here’s what people are concerned about, Tim. The Fed can actually just create money or print money. It does that by giving it to the federal reserve and it buys assets and just credits their account. Now some people refer to that as helicopter money. And what you’ve done now is, those assets eventually have to be paid back. You owe interest on those assets and that will act as in effect, a tax on the economy going forward. The academic evidence seems to be, and there’s no exact tipping point, but once you get much above 100% of debt to GMP ratio, then you could start to act as a drag on the economy. And a simple way to think about that is, say we have $100 GMP and we can grow at 3%. If you pay 3% a year in interest, you’ll keep that stable so we could afford to be at 100% GDP.

Larry Swedroe:
If you get much above that now you don’t have enough income every year and you have to suppress something, you have to stop spending on other things and people begin to worry about, will I get my social security check? Will Medicare still be there? And people start then to save a lot more because they’re worried the government won’t be there and you could get this vicious circle of people holding back and not spending. This is the problem that Japan may be facing and created because it’s been printing money if you will for decades trying to get out of their crisis. Their debt to GMP level I think is getting up towards 300%.

Larry Swedroe:
Greece in their crisis was like 150%, 160% and we saw what happened there. Where right up around that 100% but we are rapidly increasing it here because we’re spending about a trillion dollars a month. That’s about 4% I think of the GDP every month that this lasts, if we keep the economy shut. Which is why president Trump is hoping to get the economy back sooner because we don’t want to create this big drag. If this lasted a year, we could be up at 150% of the GDP and that’s what people are worried about.

Larry Swedroe:
Nobody knows the outcome there. If we get that outcome, we might see more of a really U shape recovery with that bottom is very long or it might even be an L like Japan has faced. Personally, I think the odds of that based on history, that the average event takes us less than a year to recover from. And even the steep recessions that we have caused by events like the 2008 crisis, which was a structural change in the economy or a typical cyclical recession like we had in the early eighties because the Fed drove real interest rates way up. Those tend to last only four or five years.

Larry Swedroe:
So I would put that at only maybe a 10% chance of happening. That U shape with several years, as much more significant. And then also maybe a small chance, of a really quick recovery there. So the middle part of the curve would be where I personally would think is more likely. It’s not likely to come fully back within a year because this is a much more damaging one I think than most other events. But not likely to last that long if we can solve it within a few months and get at least parts of the economy rolling again, which seems likely it seems by let’s say end of May. Some other people are more optimistic. Maybe it’ll be end of April or mid May, so two more months.

Tim Maurer:
What difference does it make to us as individual investors? This just seems to be one of those elements that we have so little control over. Do you see any action on our part that we can or should take as a result of our approach as a country to the crisis and the stimulus measures we’ve put in place?

Larry Swedroe:
This is a tough one Tim, but I would say this, we tend to think about investing in stocks as risk where we know the odds of something happening like at the roulette wheel, we can calculate what the odds are hitting red are, little less than 50%. Or the odds at the poker table of drawing to that inside straight and we can calculate those odds against the size of the pot and make a decision whether to take that bet or not. That’s how we tend to think about stocks when the economy is good. It’s like we can know the odds of the market going up and down. We know that once every five years or so we get a bear market about which means down 20% or more. We know about a once decade now, we’ve had this is the fourth big drop of more than 30% in the last 40 years.

Larry Swedroe:
So you could think that, but once we get this situation and we move to uncertainty where you can’t estimate the odds even whether this is a two month problem for the economy being totally shut down, it may be less where it may be Wyoming that has very low incident starts rolling tomorrow or in two weeks, whatever. And we will shut down only the hotspots maybe, which some people think is a good approach. I’m not an epidemiologist so I can’t answer that. So we don’t know if it’s that shorter term or if it’s the whole economy is shut for seven or eight more months. But what happens is, when we get that uncertainty, we tend to think of the worst and rather than the optimist side of us starting to think of what is even more likely, and it seems more likely from everyone I’ve talked to, experts that have been brought onto webinars by the leading investment banks, are all hiring the top epidemiologist to give them their best insights.

Larry Swedroe:
And most people think while the economy will stay weak for quite a while, it may be six months or nine months, we will be in a bottoming out process within maybe two months or three months. And the stock market tends to recover well before the economy just as it did in March of ’09 a full 10 months before the unemployment rate peak. So you as an investor should probably be doing nothing. Don’t give in to your worst fears because it’s not likely to prove to be the actual outcome, although it’s certainly possible. But your plan should already incorporate that. When we run Monte Carlo simulations back in ’07. In 2008 that was in the bottom 5% of possible outcomes. So we run 3000, 150 of those cases look like ’08 and clients should therefore have been prepared. Doesn’t mean it was easy to live through, but if you didn’t take more risks than your ability, willingness or need to take and you had that good plan B because that 5% became a 100% and now you need to enact that plan B.

Larry Swedroe:
Then you do it. You cut your spending maybe from 150,000 to 120 to make sure your plan doesn’t blow up and you’re all set. That’s the best advice we have. Have that well thought out plan, make sure it incorporates events like this, they’re going to happen. If you’re 65 years old, you probably should expect three plus of them over the rest of your life and if you’re 35 that means six of them. Strap on that seatbelt and be ready so you don’t panic. You have that well thought out plan and can put it in place because I can assure you as Napoleon said, “Battles are won on the preparation stage, not on the battlefields”. When the bullets are flying and the cannon balls are shooting off and you get nervous, you’re not likely to make good decisions.

Tim Maurer:
Or as Mike Tyson said, “Everybody’s got a plan until you get punched in the mouth”.

Larry Swedroe:
Exactly. Just like Napoleon.

Tim Maurer:
Just like Napoleon. Well, thank you Larry and remind me by the way, not to play you in poker because I have a tendency to wait a little bit too long on that inside straight and thank you also for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating the website askbuckingham.com or emailing your question to question@askbuckingham.com or just click the upper right hand corner of your screen and watch online. Remember, there are no dumb questions but unfortunately there are plenty of poor answers out there. Our hope is that in giving you straight answers to your questions, it will bring a sense of calm and allow you to apply what you’ve learned in pursuit of good decision making. So please follow us and by all means, ask Buckingham.

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