The Great Crash of 2022
by Kristoffer Mousten Hansen, Mises Institute:
We are now well past the corona crisis of 2020, and most of the restrictions around the world have been repealed or loosened. However, the long-term consequences of arbitrary and destructive corona policies are still with us—in fact, we are now in the middle of the inevitable economic crisis.
Proclaiming the great crash and economic crisis of 2022 is at this point not especially prescient or insightful, as commentators have been predicting it for months. The cause is still somewhat obscure, as financial and economic journalism still focuses on whatever the Federal Reserve announces. But the importance of the Fed’s moves is greatly exaggerated. The Fed cannot set interest rates at will; it cannot generate a boom or a recession at will. It can only print money and create the illusion of greater prosperity, but ultimately, reality reasserts itself.
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The real driver of the present crisis is monetary inflation. Back in 2020, I (along with many others) pointed out the role of inflationary monetary policy in the corona crisis. While consumer price inflation is now the most apparent consequence, the real damage occurred in the capital structure of the economy. This is the cause of the present crisis.
A Business Cycle, of Sorts
While to most people the most obvious consequence of the corona inflation was the transfer payments they received from the government, the real action occurred in the business sector. Through various schemes, newly created money was channeled to the productive sector from the Fed via the Treasury. The result was a classic business cycle of unsustainable expansion ending in inevitable depression.
The immediate effect of the inflow of easy money was twofold. First, it hid some of the economic distortions that lockdowns and other restrictions caused. Since they received government funds to make up for lost revenue and to cover higher costs, businessmen maintained production lines that really should have been shut down or altered in some way due to lockdowns. Second, easy money induced capitalists to make new, unsound investments, as they thought the extra money meant greater capital availability.
These investments were unsound not because the government quickly turned off the money spigot again: they were unsound because the real resources were not there; people had not saved more to make them available. The supply of complementary factors of production had not increased, or not as much as suggested by the increase in money available for investment. As the businesses expanded and increased demand for these complementary factors, their prices therefore rose. To keep the boom going, businesses have started to borrow more money in the market, driving up interest rates. But there is no cheap credit to be had at this point, since there haven’t been additional infusions of cheap money since the initial inflation of 2020, so interest rates are quickly rising. This is the real explanation of the inversion of the yield curve: businesses are scrambling for funding as they find themselves in a liquidity shortage, since their input prices are rising above their revenues. It’s not the market front-running the Federal Reserve or any other fancy expectations-based cause: interest rates rise because businesses are short on capital.
The following chart shows the increase in producer prices compared to consumer prices—an increase of almost 40 percent since the beginning of 2020 is clearly unsustainable. That consumer prices have not increased as much is a clear indication that we’re dealing with a business boom and that businesses can’t expect future revenues that will cover their elevated costs. Nor are we simply seeing oil price increases due to disruptions in supply. Oil and energy commodities complement virtually all production processes, so inflation-induced investment will lead to an early rise in oil and energy prices.
Figure 1: Producer and Consumer Price Indices, January 2019–May 2022
Eventually, interest rates will be bid too high, and businessmen will have to abandon their investments. Many will throw inventories on the market at almost any price to fund their liabilities, cut back their workforces, and likely go bankrupt. This appears to be happening already, as CNBC is reporting many layoffs in tech companies.
A likely consequence of this bust will be a banking crisis: as the share of nonperforming loans increases, bank revenues will dry up, and banks may find themselves unable to meet their own obligations. A crisis could develop, leading to what has been called “secondary deflation”: the contraction of the money supply as deposits in bankrupt banks simply evaporate. While that is a consummation devoutly to be wished, it is unlikely, to put it mildly, that the Federal Reserve will let things get to that point. This neatly brings us to a central question: What is the central bank doing right now?
The Contractionary Fed
Surprising as it sounds, the Fed really is pursuing a tightening policy. Not necessarily the one they officially announced—they are not, in fact, reducing their balance sheet, but an extremely tight policy nonetheless.
It is worth pointing out that the Fed is really a one-trick pony: all it can do is create money, either directly or indirectly by giving banks the reserves necessary for bank credit expansion. All the stuff about setting interest rates is secondary, if not irrelevant: the market always and everywhere sets interest rates. Central banks can only influence interest rates by, you guessed it, printing money.
Figure 2: M2 (billions of dollars), January 2019–April 2022
While the Fed was very inflationary back in 2020 as figures 2 and 3 show, it has since reversed course and become not only conservative, but outright contractionary. That is, not only has the growth rate slowed down, but there was a real, if small, fall in the quantity of money in early 2022.
Figure 3: M2 (percent change), January 2019–April 2022
This contraction is not immediately evident if we only look at the Fed’s overall balance sheet, because since March 2021, the Fed has aggressively increased the amount of reverse repurchase agreements (reverse repos) they hold (or owe, technically). In a reverse repo transaction, the Fed temporarily sells a bond to a bank (just as they temporarily buy a bond from a bank in a repo transaction). This sucks reserves from the system, just as repos add reserves to the system. From virtually zero in March 2021, the amount of reverse repos has increased to $2,421.6 billion as of June 15, reducing the amount of available reserves by the same amount. The Fed balance sheet has not shrunk due to simple accounting: the bond underlying the repo transaction is still recorded on the Fed balance sheet.