Out of the Mouths of Banks

I don’t usually turn to the annual reports of banks for policy advice but this report from M&T Bank in upstate New York which primarily serves the Mid-Atlantic region is exceptional. On fiscal policy:

Rather than spending to promote growth, the government instead enacted legislation and regulation that in practice restricted it—effectively, a form of negative fiscal policy. Put forth in the name of preventing a recurrence of the circumstances that led to the financial crisis, the plethora of new regulations intended to limit taxpayer risk have ultimately proved a drag on growth. Regulation took many shapes and forms across all sectors of the economy, affecting not only the financial sector but also industries as diverse as energy, healthcare, housing, and construction. Businesses were no longer willing or able to take the prudent risks that even moderate growth expectations demand.

With the benefit of hindsight, it appears the economy in recent years has fallen out of balance—overly reliant on monetary policy not accompanied by traditional fiscal stimulus. Policies designed to benefit the majority have perversely only benefited a few. The impacts of these decisions or non-decisions are real. In particular, the middle class and small businesses are losing ground. So, too, are their communities. The details that follow illuminate trends that should be of concern to all.

“Recent years”, presumably refers to 2012 through 2016 since from 2007 through 2011 government spending assumed a percentage of total GDP unprecedented other than at the height of World War II.

The problems with fiscal stimulus were multiple. Changes in our economy rendered it much less effective and more concentrated than it had been in the past because of our greater reliance on imports. Fiscal stimulus was political to an unprecedented degree and there was relatively little actual additional spending—spending at the federal level was offset at the state and local levels.

Monetary policy posed problems, too:

Policymakers were compelled to reduce rates time and again, ultimately reaching a practical limit as short-term rates approached zero, the lowest level ever in the U.S., and remained there for more than seven years. The march into uncharted territory continued. To address the crisis and its aftermath, the Federal Reserve directly infused cash into the economy by purchasing more than $3 trillion of securities, equivalent to nearly a year of federal government spending. This unparalleled use of monetary policy helped to avert a depression.

[…]

This extended period of ultra-low interest rates no longer benefits the average U.S. household. The majority of the wealth of the typical M&T customer, like that of most Americans, takes the form of equity in their homes, retirement savings, bank deposits and, to a lesser extent, stock market investments. Low rates initially provided middle class households with relief both by lowering monthly mortgage payments and supporting a recovery in home values. However, the investments of these same families have suffered. Indeed, many middle class families, frightened by the precipitous market decline of 2008, responded by pulling out of the market. Only half of these households today hold any stocks or mutual fund shares; before the crisis, fully 72% did so. Crucially, without stocks and the growth in value and dividends they can provide, most households must rely on interest from their investments to save for college, a down payment on a home, or to prepare for and navigate retirement. It is here that they have felt the sting of near-zero interest rates.

Interest income for households has declined sharply in the aggregate. In 2014, it had, compared to 2005, fallen by some $64 billion. This disproportionately affected households with an income less than $100,000; their interest income declined by $44 billion, or 68% of the total decrease for all households. There are, to be sure, some who can take such a drop in stride—those, for instance, fortunate enough to hold dividend-paying stocks. Dividend income in 2014 was, in fact, $162 billion higher than it had been in 2005. But 95% of that increase in dividend income has accrued to households whose income was greater than $100,000. Indeed, only $9 billion of the $162 billion increase in total dividend income has found its way to households with annual earnings under $100,000—not enough to offset the lost interest income.

Investments managed on behalf of the typical American family are not immune to these economic trends. At the heart of the issue is the declining rate of return on investments—particularly secure investments like bonds. The practical implications for the alternatives through which typical households preserve and grow wealth, such as insurance, retirement accounts, and pensions, are troubling.

Indicative of what has happened in the marketplace, insurers that have traditionally invested premiums in safe, long-term instruments such as government securities and high-quality corporate bonds have come under pressure. The average yield on 10-year U.S. Treasury bonds since 2010 has, unfortunately, declined to a level 274 basis points, or 53%, below the 30-year average. Insurers ultimately have limited options to offset sustained low yields on their investments. Should rates remain low, it will eventually be necessary to raise prices or invest in assets that offer higher returns but also carry higher risk. Neither outcome would benefit middle class families.

Pension plans sponsored by employers, long a pillar of retirement savings for many workers, face similar pressures. Low rates that pension funds earn on investments mean either that businesses and governments must set aside more to ensure future benefits, or put those benefits at risk by under-funding them. The trend is disconcerting. Although, at the end of 2007, corporate pension plans showed a modest surplus, they had, by the end of 2016, developed a $408 billion deficit. Not even public sector employees can remain confident in the health of their pension plans, as some major state pension funds reduce their estimated rates of return and contemplate reductions in benefits. To offset the impact of low returns and still deliver on their promises to consumers, investment professionals are increasingly turning to alternative investments such as hedge funds and private equity that offer the potential for higher returns, but come with more risk.

In other words if the Fed’s policies had been specifically designed to aggravate income inequality it could hardly have been more effective. In summary:

No wage growth. No investment earnings growth. No wonder families are stretched and stressed. We should hardly be surprised, then, to see a sharply increased rate of savings—fully 1.5 percentage points higher than that in 2000-2004. Accompanied by lower interest income, this has led middle class families to spend less, dampening economic growth. Simple math suggests that a 1.5 percentage point increase in the savings rate equated to nearly $200 billion in consumer spending—spending that did not occur as families instead saved more to make up for their lost income. Monetary policy was intended to act as an accelerant for an economy in recession, and did in fact accomplish that goal early on; however, its benefits have waned, if not reversed, over time.

As James Freeman notes at the Wall Street Journal, that’s about as far as you need to look to figure out why Trump won in the states he did.