We have improved the prospects we won't be consigned to a long period of subpar growth [but] it's going to be a slower than typical recovery, and right now, downside risks continue to outweigh those that are positive. We've got the first stage [of recovery], better than I would have expected
—Tim Geithner
There is no "there" there
—Gertrude Stein
The American economy has reached a dangerous new phase. We are now in the "recovery" period, but what kind of rebound will we have? In No L, Professor James Hamilton (along with Paul Krugman) takes note of some positive news from the Fed. Capacity utilization has been climbing since June (Figure 1 below).
Output is up, there's no doubt about it. Calculated Risk notes that "an increase in capacity utilization is usually an indicator that the official recession is over." Putting this in perspective, "in September [2009], the capacity utilization rate for total industry increased to 70.5 percent, a level 10.4 percentage points below its average for 1972 through 2008." That's not much of a comeback.
Figure 1 — Capacity Utilization in the United States, 1965 to the present. Utilization remains at its lowest level since 1960s. You can see that a rise in utilization signals the "official" end of the recession (gray bars). Source: FRED.
Few understood in 1930 what lay ahead. The Wall Street Journal disputed a pessimistic view on October 17, 1930—
Gov. Black of the Atlanta Fed. takes a defeatist attitude in saying that the US must accept a lower standard of living and that the “load of debt around our necks” is the root of the problem. Contrast this with President Hoover's optimism: “Any retreat from our American philosophy of constantly increasing standards of living becomes a retreat into perpetual unemployment and the acceptance of a cesspool of poverty for some large part of our people.” Can Gov. Black really say going into debt has been a net negative for the American people? “Has there been any greater blessing than the building and loan associations which have lent billions of dollars to millions who would never otherwise have had the means to build.” Home ownership has stimulated people's desire for the other comforts of life, resulting in activity and progress; the fact that some excesses have taken place doesn't negate our whole course. “Governor Black says that what is needed in American business today is not confidence but courage. But surely courage lies in going forward, not backward. The American emblem is an eagle not a crab.”
Poor Mr. Black. He had the temerity to tell the truth and got lambasted for it.
It is the very nature of the "recovery" itself in October, 2009 that tells me that it's looking more and more like a Depression every day. I will explain myself, but first let's be clear on what we do not have—yet. We do not have a collapse of the financial system with the accompanying debt-deflation spiral that we had in the early 1930s. It is said we averted this outcome, and maybe we have.
In the 21st century, in a new kind of Depression, it is possible to have a statistical recovery (positive GDP growth) and rising asset values (in equities, in housing) in the short-term. We are witnessing this now. The difference between the Great Depression and now is due to the massive fiscal & monetary stimulus applied to fix the problem. The Fed's short-term benchmark interest rate was also set to zero and could not be lowered further. All this "free money" is meant to counter deflation by reflating the economy (e.g. stimulating new demand).
To be sure, the big banks would have collapsed in 2008, and still would in many cases, were it not for the massive bailouts and guarantees from the Central Bank and the Treasury. To be sure, we would not be seeing rising asset values without the flood of newly printed money from the Fed.
But the magic of additional liquidity only goes so far. Bearish commentators sometimes refer to this as pushing on a string. It is helpful to quote President Obama to contrast the stated goal for recovery with what is actually happening.
Of course, there are some who argue that the government should stand back and simply let these banks fail – especially since in many cases it was their bad decisions that helped create the crisis in the first place. But whether we like it or not, history has repeatedly shown that when nations do not take early and aggressive action to get credit flowing again, they have crises that last years and years instead of months and months – years of low growth, low job creation, and low investment that cost those nations far more than a course of bold, upfront action.
And although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – "where's our bailout?," they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.
[My note: Here is Obama's economic top adviser Larry Summers talking about a multiplier on government stimulus dollars.]
Here the President sketches out his vision of a credit-driven recovery by citing the money multiplier effect in which a dollar of capital in a bank can result in eight to ten dollars of new loans for families and businesses. Presumably, families will want more credit to expand their consumption while firms will borrow money to expand their inventories to meet the new demand. Presumably, the banks are eager to make these new loans.
The President also refers obliquely to deflation and the need for renewed household spending. Nowhere does he refer to household debt.
To begin with, economists on both the left and right agree that the last thing a government should do in the middle of a recession is to cut back on spending. You see, when this recession began, many families sat around their kitchen table and tried to figure out where they could cut back. So did many businesses. That is a completely responsible and understandable reaction. But if every family in America cuts back, then no one is spending any money, which means there are more layoffs, and the economy gets even worse. That's why the government has to step in and temporarily boost spending in order to stimulate demand. And that's exactly what we're doing right now.
[My note: Perhaps it is merely a coincidence that the neoclassical economic theory practiced by Larry Summers and evinced by the President neatly coincides with the extraordinarily cozy relations between Wall Street and Washington.]
The President is referring to the paradox of thrift.
The notion is generally credited to Englishman John Maynard Keynes—seemingly the source of every important economic idea these days—although he doesn't appear to have actually used the phrase. Paul McCulley, an economist and portfolio manager at bond giant Pimco, defines it like this: "If we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person's spending is another's income—the fountain from which savings flow."
But what if people absolutely can not spend money because they're broke? Or what if they will not spend money because of their considerable uncertainty about the future? One way to force some of them to spend money is to print a bunch a new money, get it circulating & multiplying in the economy, and thus create some inflation. (The bond market has currently priced in 1.75% inflation at an annual rate as measured by inflation-adjusted treasury bond yields.) Unless your income is rising at the inflation rate, inflation erodes the purchasing power of your dollars. Thus inflation provides an incentive for you to spend money now instead of later.
This liquidity-with-inflation trick does not work unless that fresh money is getting loaned out and thus those crisp, new dollars are propagating in the economy like an exploding population of rabbits. President Obama trotted out the money multiplier effect in April, 2009, so it behooves us to examine how we're doing in that regard in October, some six months later. Jim Jubak covers some of the territory in Are banks starving the recovery?
We've got a little problem in the economy. Tiny really. Nothing to worry about.
The Fed is buying mortgage-backed securities ($1.25 trillion) and debt from Fannie Mae and Freddie Mac ($200 billion), expanding its lending to banks by keeping interest rates close to zero and buying up U.S. Treasuries [$300 billion].
All that, according to the textbooks, should be flooding the economy with money. And that's exactly what you're supposed to do to get the economy running again and to avoid turning the Great Recession into a rerun of the Great Depression.
Let's look at the details (Figure 2 and another quote below from Jubak).
Figure 2 — Comparison of the monetary base MO and the M2, which is the broadest measure of the money supply the Fed compiles. You can see the multiplier working in the years 1985 to 2008 as the M2 grows at a much higher pace than MO. The upward surge in the monetary base in 2008 was due to Fed printing. After a smaller surge in the M2 accompanying that boost in the base, there has been no multiplier effect—those dollars aren't breeding like rabbits in the economy. Source: FRED.
... this isn't good, folks. It's a problem big enough to jeopardize the recovery that the economy seems to be building. And that's because what's called the velocity of money, the speed with which a dollar moves through the economy, has fallen. That's not unexpected. During the Great Depression the velocity of money fell 22%. In tough times, people from consumers to bankers sit on more money longer.
Look at what's happened to M2 since it hit $8.39 trillion on June 22:
- By July 20, M2 had dropped to $8.34 trillion, down $50 billion.
- By Aug. 24, it was down to $8.28 trillion, down $110 billion.
- By Sept. 14, the latest data point from the St. Louis Fed, M2 recovered slightly to $8.30 trillion, still down $90 billion from June 22.
Economists who study this data use a four-week moving average to eliminate some of the week-to-week noise. At the worst point in the decline, the four weeks ending Aug. 24, M2 was dropping at an annualized rate of 12%. That's the kind of contraction you get in a financial panic. Not the kind of growth you want to see as you're trying to guide an economy to recovery.
[My note: The falling velocity of money is "not unexpected" only if you're expecting a Depression.]
I do not want to be excessively wonkish, but I need to relate how a slowing velocity of M2 money and a falling M2 money supply stand in the way of a credit-driven recovery—
We are now entering treacherous waters for monetary authorities in highly-leveraged economies. Given the decade(s)-long dependence on the credit mechanism to spur economic growth, the financial crisis has brought about a precipitous decline in the velocity of money- i.e., how much economic activity is generated per unit of money supply.
Bloomberg helpfully calculates a velocity indicator; as you can see [in Figure 3 below], while the recent fall has been steep, velocity never really recovered from the heady days of the 90's productivity boom (and..err....internet bubble.)
[My note: Velocity V of money supply M is conventionally measured as GDP/M. Look at Wikipedia. Holding GDP constant, a decrease in the money supply M (the denominator) results in a decrease in the velocity of money V.]
Figure 3 — Bloomberg's velocity indicator. Except for temporary rebound at the height of the Housing Bubble after the Fed reflated the economy following the Tech Bubble recession, velocity has been dropping since its peak in 1997. In fact, this graph demonstrates that increasing the money supply to spur new economic activity has been less and less effective over the last 12 years—less bang for the buck (economic activity per unit of money, as above).
In short, adding new money to the economy has not increased the speed at which the dollar moves through the economy (the velocity). In tough times, people from consumers to bankers sit on more money longer. Thus economic activity appears to be decreasing in so far as the amount of M2 money circulating in the economy was actually falling in the 3rd quarter. For a credit-driven recovery to work in a fiat money system, fiscal & monetary stimulus must increase the amount of money flowing through the economy (which creates inflation, which spurs spending & investment, and so forth).
On the other hand, Professors Hamilton and Krugman (correctly) foresee a rise in GDP into positive territory in the 3rd quarter just passed. Technically speaking, and holding the M2 money supply constant, the velocity of money (V above) would again decrease in this anomalous case (Look again at Figure 3.) And as we've just seen, the amount of M2 money circulating in the economy appears to have actually decreased in the 3rd quarter just passed, which makes things worse.
Thus we will have a statistical recovery in GDP even as economic activity stagnates and unemployment rises, despite the fiscal & monetary stimulus. Welcome to a new kind of Depression.
What has happened to the new cash reserves the Fed made available to the banks? From Jubak again—
The problem is that the banks still aren't lending. They're sitting on a huge proportion of all the money that the Fed is pumping into the economy, and because the money they're sitting on isn't moving, that's putting the brakes on the velocity of money... [M2] doesn't include the reserves that banks keep in their own vaults or at the Fed...
Why are banks cutting back on their lending?
Part of it is that they don't trust the recovery. With unemployment still rising and consumers still not spending as before, being cautious about extending new credit doesn't seem particularly outrageous.
But that's not the major part of the problem. Banks aren't lending because they still haven't cleaned up their balance sheets. Many of them are still in the process of writing down credit card debt or mortgages or commercial loans -- not to mention the complex derivatives they've still got in their portfolios... [and they face stricter capital requirements]
[The Fed] knew that they potentially faced exactly this problem. But they hoped that by unleashing a campaign of financial shock and awe that involved heavy fire from all monetary and fiscal weapons, they'd be able to convince banks that it was only sensible to lend more rather than to sit on their money.
It's not clear that this policy has failed. The worrying trends really include just four weeks or so of data. But the short-term trend is worth worrying about because, having fired all their guns, the world's central banks really don't have much left in their arsenals to roll out in a new assault.
Watch the data. We're not out of the woods yet.
Financial Shock & Awe! It's the American Way.
Jubak is certainly right, but only up to a point. He provides a finance-centric, neoclassical economic view of the recovery. The implicit assumption is that when the banks have finally cleaned up their balance sheets, met their capital requirements and started lending again, the economy will grow vigorously as it did before the crisis. The money multiplier will kick in and the velocity of money will pick up as it did after the post-Tech Bubble recession. This is Summers' and Geithner's view, the Wall Street view, and thus Obama's view. Remember the President's words—
... the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.
So much is left out of this calculation. What about demand for credit? What about household debt? What about Middle Class households, as opposed to the banks, repairing their balance sheets? What about Baby Boomers retiring? Money is not circulating vigorously despite the Fed's large increase of the monetary base. Can this be due entirely to the fact that the banks are not lending?
On the surface, so it might appear. But beneath the surface? Certainly not. Are hoards of credit-worthy borrowers lining up at Bank of America or Citigroup clamoring for new loans? Of course not.
And getting the impaired financial system straightened out, especially in view of the crashing commercial real estate market, will take several years.
The notion of a credit-driven recovery is a repeat of the very blindness—a fundamental error in neoclassical economic theory—that got us into this mess in the first place. The underlying problem is too much debt, not just in over-leveraged banks, but also in over-leveraged households. The fundamental principle, as I reiterated at the ASPO-USA conference, is—
- Endless growth based on endless debt is impossible
Any reflation of the economy will only work for a short while. You can not borrow from the future forever. You can not push on a string. The time has come for American households to pare down debt and increase savings, which is very hard to do when
- unemployment is very high & rising;
- asset values are falling but debt levels are not (e.g. in mortgages, credit cards);
- real (inflation-adjusted) wages are stagnant.
Recessions are always fundamentally due to a lack of demand for goods & services. You can print money to stimulate demand, but the "economic activity generated per unit of money supply"—the velocity—need not increase, as we have seen, if lenders are unwilling (or unable) to lend and borrowers are unwilling (or unable) to borrow.
Recessions (or Depressions) are always ultimately due to lack of final demand for goods & services. When will consumption return to pre-2008 levels in the United States? Your guess is as good as mine, but I suspect it will take many years, assuming it ever happens at all. We will likely have an short-lived statistical recovery, but it will feel like a Depression nonetheless. Watch out for 2010. I am now in the W ("double dip" recession) camp. That's my best guess.
It's not your Grandfather's Great Depression...
... it's this one.
Contact the author at dave.aspo@gmail.com
Comments