On September 20, 2010, the National Bureau of Economic Research (NBER) announced that the Great Recession that began in December 2007 officially ended in June 2009. The NBER based its analysis on a number of factors, which concluded that a trough in business activity occurred in June, marking the beginning of an economic expansion. The recession, which lasted 18 months, is the longest in U.S. history since World War II—hence the name the Great Recession.
Despite its stated end, economic conditions in the U.S. remain depressed. Consumer demand and bank lending remain weak, as the broadest measure of unemployment rose for the fourth straight month in October (to 17.1 percent) and, as of the time of writing, homes are going into foreclosure at a rate of 120,000 a month. Unfortunately, the monetary and fiscal policies enacted since the Great Recession’s beginning have yet to contribute to sustainable growth. And now that the Federal Reserve enacted a similar policy in early November, the new policy is not only expected to prove just as successful as its predecessor—not at all—but also to foster in unintended consequences that could potentially further depress economic conditions and increase the probability of a relapse to negative growth greater than 50 percent.
Summer of Recovery?
Despite extreme economic intervention by federal authorities, U.S. real Gross Domestic Product (GDP) has only increased by a paltry 3 percent since the Great Recession ended in June. That number is less than half the 6.6 percent average growth in comparable periods during the prior ten recoveries. Inventory investment, or the difference between goods produced and goods sold in a given year—a trendless component of GDP—has accounted for nearly two-thirds of the entire rebound in economic activity from the economic contraction. Over the past four quarters, inventory investment has moved from contracting real GDP at a 5 percent annual rate to boosting it at a 2 percent annual rate.
Meanwhile, real final sales (GDP less inventory investment) grew at a very meager pace of 1.1 percent, less than one-fourth the average 4.5 percent rate of increase in the comparable rebounds. Whether measured by GDP or final sales, economic growth needs to expand at least at the pace of population growth to sustain a steady standard of living. In this rebound, per capita real final sales grew by 0.2 percent—again, much lower than the ten previous postwar expansions when the growth in real per capita sales was a robust 3.2 percent. Thus, the U.S. standard of living has remained stagnant at a very depressed level. Moreover, the upward inventory thrust is complete, and probably over-extended.
The flaccid nature of this recovery should serve notice that current economic conditions are far more precarious than generally understood. Federal Reserve forecasts were obviously flawed and have now been significantly lowered since they placed great emphasis on the presumed stimulative power of massive deficit spending and numerous aggressive monetary actions. The Fed enacted another round of quantitative easing (QE2, the first round of spending being QE1) in November because the weakness of the economy surprised them and they felt the political pressure to act. The Fed’s position is that more of the same economic policies are needed, even though they have failed to produce the advertised results.
But as a result of QE1, the banks are holding close to $1 trillion of excess reserves, unwilling to put them to work. Why? Because the banks either have shaky balance sheets and therefore are not in a position to put additional capital at risk, or they are continuing to experience large write-downs on commercial and residential mortgages, as well as on a wide variety of other loans. In addition, it is possible that customers do not have the balance sheet capacity or the need to take on additional debt. They could also see no expansionary prospects, or fear an uncertain regulatory future. Simply put, no viable outlets exist for banks to loan funds.
A parallel situation exists in the corporate sector. Non-bank corporations are sitting on huge cash reserves. In the past two quarters, liquid assets amounted to 7 percent of total assets—the highest level since 1963—reflecting a lack of compelling uses for the funds, as well as the need to hedge against risks, including those of dealing with potential vulnerable counter-parties. The fact that substantial bank and corporate funds remain idle is a strong signal that U.S. economic problems exist outside the monetary sphere.
The problem with the U.S. economy is fourfold: 1) The economy is grossly overleveraged, with many asset prices falling; 2) fiscal policy is counter-productive and debilitating to economic growth as government expenditure multipliers are near zero; 3) proposed tax increases are already curtailing economic activity and tax multipliers approach -3 percent; and 4) increased bureaucracy with many new and yet unwritten regulations from the Dodd-Frank bill, along with health care regulations, make business planning nearly impossible.
With existing excess liquidity in banks and companies, and the above-mentioned key economic problems, it should be clear that QE2 and the purchases of additional assets by the Fed will, like previous purchases in QE1, serve only to bloat excess reserves without advancing income, spending, or jobs. From this point in the cycle, for QE2 to generate expansion, money growth—and therefore debt levels—would have to rise.
According to economist Hyman Minsky, there are three phases of credit extension: hedge finance, speculative finance, and Ponzi finance. In view of the extremely leveraged conditions, additional credit would be almost exclusively of the Ponzi finance variety—loans with no reasonable prospect of repayment. Indeed, Ponzi finance appears to typify the bulk of the loans currently being made by the Federal Housing Authority to unqualified home buyers, replicating the practices underwritten by Fannie May and Freddie Mac during the heyday of the sub-prime lending extravaganza whose consequences linger.
For the purpose of argument, assume that the Fed’s logic is correct in that the banks, with additional excess reserves as a result of QE2, will lend to other potential Ponzi-like borrowers, increasing the money supply. Indeed, even if this were the case, the net result may still not stimulate faster growth in GDP because velocity would fall, as it did from 1997 to 2007.
The Velocity Impediment
For a rise in excess reserves to boost GDP, two conditions must be met: the money multiplier must become stable and the velocity of money must not decline. But as history teaches, the second condition is highly unlikely. Velocity, or the average frequency that a unit of money such as the dollar is spent over a period of time, is primarily determined by financial innovation, leverage (provided that the debt is for worthwhile projects and the borrowing is not of the Ponzi finance variety), and numerous volatile short-term considerations.
Since 1900, the velocity of M2, the amount of money in circulation, has averaged 1.67 and has demonstrated distinct mean reverting tendencies. Velocity has been declining irregularly since Ponzi finance took over in the late 1990s. For leverage to lead to an expansion of velocity, the loans must meet the requirement of hedge finance—meaning, there must be a reasonable expectation that the borrower can repay both principal and interest. This simply cannot be expected in today’s markets.
Fundamentally, the secular prospects for velocity have not improved even though velocity recovered by 2.1 percent in the past four quarters. This marginal uptick in velocity reflected an assist in federal spending along with the unparalleled recovery in inventory investment discussed previously. Without the gain in these two GDP components, velocity was unchanged over the past four quarters.
Now that the Fed has adopted QE2, one of two possibilities will come to fruition. Either QE2 manages to temporarily improve GDP via continued overleveraging of the economy with non-repayable loans, or QE2 goes into the history’s dustbin of failed projects, along with QE1, cash for clunkers, tax credits for first time home buyers, and other numerous failed attempts to boost the economy with rebate checks.
Either way, QE2 will likely cause severe unintended consequences. For QE2 to work, a renewed borrowing and lending cycle must take place, resulting in a further leveraging of the already highly overleveraged U.S. economy. Such additional leverage would not be beneficial since increasing indebtedness from these levels ultimately leads to economic deterioration, systemic risk, and in the normative case, deflation, as documented by Rinehart and Rogoff in their book, This Time Is Different. Therefore, at best QE2 will be nothing more than a short-term panacea exacerbating the serious structural problems already facing the United States.
More importantly, however, QE2 has the potential to eventually end the Fed’s historical independence. With its implementation, the Fed has taken additional actions that will likely be as ineffectual as they previously were, leading Congress to assume that the Fed should be given more direct instructions regarding the purchase of financial assets. Congress might conclude that QE1 and QE2 were unsuccessful because they were too small, not that they are fundamentally flawed concepts. On such a path, monetary policy could then become a mere branch of fiscal policy—a sure road to economic perdition.
As an example of the headwind the Fed faces, consider present fiscal policy. Between the taxes in the 2010 medical reform law and the sun setting on the 2001 and 2003 tax cuts, several credible researchers calculate that taxes will rise about $3 trillion over the ten-year period starting in January 2011. Despite what President Obama claims, the vast range of tax increases will affect all tax brackets as a result of the following: 1) the return of a marriage penalty, alternative minimum tax (impacting 28 million families), and the death tax to 55 percent; 2) the elimination of health savings accounts, charitable contributions from IRAs, and adoption tax credits; 3) the inclusion of employer-paid health insurance on individual W2s, lower dependent care, and special needs tax caps; 4) the reduction of the child tax credit by 50 percent; 5) the rising of capital gains and dividend taxes; and 6) the shifting of expensing by small businesses.
A tax multiplier in the mid-range of estimates (-2) is a contractionary force of $6 trillion, or $600 billion per year on average for the next decade. For a fragile economy that grew only $500 billion in the past four quarters (including the aforementioned inventory surge), this tax blow is too large to absorb and beyond the scope of any monetary policy. In addition, a new array of bureaucrats necessitated by new regulations have increased uncertainties and problems, making planning by businesses nearly impossible and paralyzing commerce. This lagging business regulatory environment is typical.
QE2 is an ill-advised program that offers little prospect of boosting economic activity. Any gains in economic activity will be for a very limited period of time with major risks that any short-term gain will be swamped by incalculably high costs in the future. Rather then experiment with monetary policy, the Federal Reserve should use its good offices to influence the fiscal and regulatory policymakers to take actions that are far more critical for the U.S. economy than any gamble the Fed is in position to take.
Lacy Hunt is a chief economist with Hoisington Investment Management.