QE3 is no substitute for leadership vacuum

Keynesian theory advocates monetary expansion during recessionary periods and monetary contraction during periods of high inflation. In theory it makes sense. Although the Fed isn’t inclined to suggest publicly that they are doing all they can to promote inflation, that is exactly what they are trying to do with their various quantitative easing (QE) programs — QE1, QE2 and Operation Twist.

As a strong proponent of Keynesian theory, it is quite disturbing to find that the economy is simply not responding to the traditional tools of the Fed. During recessions, the Fed attempts to expand money supply. It is a misnomer to accuse the Fed of printing money, though.

The Fed doesn’t create money directly. Rather it can facilitate the creation of money through the private sector fractional banking system. Money expansion is the result of private banks creating more new loans than their customers are paying off. The fractional reserve arrangement allows banks to loan more money than they have on deposit — the result being that as net new loans are made the money supply increases. If that new money is spent, it does add to GDP and promotes the economic growth process.

The Fed, in an effort to induce private borrowing, manipulates interest rates to a low enough level that consumers and businesses determine the cost is low enough to borrow and spend or invest. As consumers and businesses borrow and spend, they are adding to the GDP. As more spending occurs, it creates additional demand. For instance, a loan used to purchase a car increases by one unit the number of cars that need to be built. If thousands of these loans are made, then the demand for cars climbs proportionally and a factory then needs to add workers to meet the increased demand. These workers receive a paycheck and therefore become members of the consumption pool increasing the demand for goods and services further. This in turn increases the need for more workers.

That is how the Fed manipulates the economy. So what has happened over the last several years as we have climbed back from the 2008-09 recession? The Fed has done its job and has driven interest rates to all-time lows. It also has flattened the yield curve to all-time lows. The problem with the recovery in the U.S. is that its actions have failed to spur loan demand.

The charts below tell a story and the story is that we are in a deleveraging period where consumers and businesses are standing pat. They are in a holding pattern afraid to expose themselves to risk.

M2 is a broad measure of money supply. According to Keynesian theory in periods of slow growth, monetary policy needs to lower interest rates to expand the money supply. A look at the M2 chart below shows that the Fed has managed to induce a modest expansion of the money supply:

Considering the fact that the Federal Funds Rate has been at 0% for several years now, we have gone through two sessions of QE and the Fed’s Operation Twist program, the expansion in M2 must be considered modest at best. What’s most striking, though, is that the Savings portion of M2 has sky rocketed during this period:

The Savings chart above tells the whole story. In spite of extremely aggressive Fed action to stimulate money supply growth and inflation, the Fed’s actions simply are not working. Consumers and businesses are not spending. The following chart shows M2 less the Savings portion of M2:

QE1 did some good. QE2 and Operation Twist were less successful, and at this point you have to conclude that even though moderate money expansion has occurred, the increase in savings has nullified the effect fully.

The charts above support the position that Fed policy impact is almost non-existent at this point and the Fed can do no more within the constructs of Keynesian theory to induce monetary expansion.

If the Fed could just print money, as many people believe, and if they did that and sent each one of us a check for $10,000 and we elected to hoard that money for a rainy day instead of buying goods and services, then the increased money supply would do nothing to increase GDP. Without increased GDP, employment would not improve. In effect, nothing would happen at all to the economy.

That is America today, an America that was so shocked by the financial fiasco of 2008-2009 that people are fearful. They are acting prudently and not spending. GDP is simply not growing at a rate that bodes well for a recovery and that in itself instills fear that promotes less spending.

In spite of all this, as of Aug. 27 we are within a stone’s throw of the pre-recession high on the Dow of 14,198 set on Oct. 8, 2007. Some might argue that we probably should be at these levels as GDP has continued to grow, however modestly, and based solely on GDP and corporate earnings, you may have to agree with that assessment. Not all in the marketplace do agree, though.

For example, bond yields are at historically low levels and, in a normal market, bond prices and stock prices tend toward an inverse relationship. That is, when stocks are moving higher, bond prices (not yields) are moving lower. The truth is there are a large number of anomalies occurring in the markets today.

The stock and bond markets are elegant pricing mechanisms that always get it right eventually. Short-term divergence from reality does occur frequently as the market is made up of buyers and sellers who don’t always operate with objectivity and these divergences can be extreme as momentum tends to move prices much further than they should go in the short-term, but in the long-term the fundamentals of the underlying market prevail.

That said, either the bond market is pricing in a huge premium relative to reality and is going to move sharply lower, or the stock market is pricing in a huge premium and going to move sharply lower. There is little precedence for stocks and bonds to be priced at near all-time highs at the same time, except where Fed intervention creates the anomaly.

So why do these divergences exist? Let’s take a look at what has fueled the stock market rally in recent months.

Corporate America has managed to record some reasonably impressive bottom line numbers in recent months despite a backdrop of uncertainty and confusion. So how has corporate America recorded profits in spite of high unemployment and flat GDP growth?

First, those who are unemployed have remained in the consumer pool through entitlement programs. When individuals were laid-off, the government simply sent them a check. We have extended unemployment benefits to record lengths. Then there are those who are on welfare and food stamps. Those that are eligible have elected to take early retirement and/or start drawing on their social security benefits, which also has helped to support GDP. Also, some have become so discouraged that depression has overtaken them, and they now are drawing government disability checks.

All of these funds dispersed by the government have helped to prop-up the pool of consumers. Consequently, demand has slipped just slightly. Corporate America has been the beneficiary of these entitlements. Companies have slashed payrolls to cut costs, and at the same time demand for goods and services hasn’t really fallen off as severely as you would expect because the government checks keep coming.

The next step in this analysis, then, is to ask where the government is getting the money to subsidize these chronically unemployed consumers? The government has two ways to get money — borrow through the issuance of debt instruments or tax its citizens.

Tax revenues obviously shrink as the unemployment numbers increase, leaving borrowing as the only alternative. It is a real catch-22. If the government stops borrowing, it can’t feed the system the cash it needs to provide for the chronically unemployed. If the government quits pumping cash into the hands of the unemployed, they stop buying goods and services and the economy shrinks further resulting in more layoffs and an ever larger pool of men and women who are nothing but wards of the government. That phenomenon also reduces tax revenues as the work force shrinks, exacerbating the problem.  

Let’s take a quick look at the debt to GDP ratio to see if the above analysis is accurate:

Since 2007, GDP has managed a modest 12% growth while our debt has grown by 76%. The numbers tend to support the supposition that corporate profits to date since the recession ended have been buoyed by a government back stop — a back stop that has created the illusion that all is well. In other words, as layoffs occurred, the government has stepped in to fill the void. The result is a modest growth in GDP financed entirely by a massive growth in government debt resulting in a debt level that now exceeds annual GDP.

The truth is that absent the higher gas prices that have occurred on a rather sporadic basis, the world feels rather normal at the present time. Granted we like to talk about chronic unemployment numbers and massive government spending, but the truth is we haven’t really felt the consequence of these dynamics in our day to day life — at least not yet.

The question becomes one of sustainability. Can we continue to prop up the economy by incurring more and more debt? Of course the obvious answer is no, but that is not necessarily true from a Keynesian point of view. Rising debt is not necessarily a problem if we have a growing economy measured by GDP. If we also are seeing modest currency devaluation measured by inflation, that too can tend to mitigate the consequence of rising debt as we are monetizing a portion of the debt through currency devaluation.

That is the theory, and in a more normal environment it works. As the Fed moves to expand money supply by lowering interest rates, it has an inflationary effect. Inflation typically induces consumers and businesses to get ahead of the curve and borrow money to buy now rather than wait because their dollars will not buy as much down the road.

That borrowing and buying provides stimulus to the economy in the way of increased demand for goods and services, which puts pressure on companies to hire more workers. Adding workers results in an expanding consumer pool, this increases demand further and results in more new workers being added, and so on.

Of course as the economy expands and more workers are added to the workforce, tax revenues go up and entitlement payments go down, slowly bringing the imbalance between government receipts and expenditures back to a normal balance. So is that what we are seeing today? A look at the chart below suggests otherwise:

Federal Receipts vs. Expenditures Reflected by Quarter

(in millions)

This chart sets up the pro and con for the tax hike debate. If we don’t extend the Bush tax cuts, receipts will go up closing the gap in the short-term. The problem is that in the longer-term, an increase in taxes will inhibit consumption, reducing GDP and prompting more layoffs. We have reached an impasse where we are damned if we do and damned if we don’t.

The chart above is particularly disturbing to a Keynesian economist. It just isn’t supposed to work like that. Monetary expansion is supposed to induce consumers and businesses to borrow and spend as monetary expansion is supposed to be inflationary. Again, inflation mitigates some of the negative consequence of higher borrowing as a portion of the debt is monetized through inflation.

Well, maybe Fed policy is at least managing to monetize a portion of the debt through increased inflation.

This chart is encouraging only in so far as the Fed’s QE programs did manage to pull us out of the deflationary trend that we were in at the start of the recession. On the other hand, the inflation rate, which has averaged a little over 2% for the multi-year period, fully negates any real GDP growth at all once the GDP numbers are adjusted for inflation.  

A particularly disturbing trend is the fact that the inflation rate over the last two quarters of 2011 dropped. The worst of all possible scenarios for a Keynesian is for hyperinflation or deflation to occur. Although hyperinflation does pose a threat based on historically low interest rates, for the moment at least, deflation seems the more real threat.

Why is deflation such a threat? What happens in a deflating economy is a process of deleveraging. Money is hoarded and debts are paid down out of fear. The result is an economic contraction that reduces the demand for goods and services leading to more layoffs. As layoffs increase, the consumer pool is reduced as fewer consumers are able to buy goods and services, and this promotes even more layoffs. It becomes a vicious downward spiral that results in a prolonged and stubborn economic contraction — in other words a depression.

Adding to the dilemma: Currency wars

To complicate matters further, we have an economic paradigm never before seen in history — a global currency war that is further stifling any chance of positive GDP growth through monetary policy actions. Macro-economic theory tells us that in periods of slow growth the correct monetary policy is to expand the money supply. As stated above, the theory is that an increase in money supply is inflationary and causes consumers and businesses to spend now to outrun price inflation. In theory that leads to increased consumption that in turn creates a demand for more workers, which in turn creates additional consumption demand as these new workers are added to the pool of consumers.

That is the theory, and so central bankers across the world, in an effort to stimulate their own economies, implement QE strategies — that is they use open market actions to buy targeted securities to lower interest rates along the yield curve. The theory is that the fractional banking system will make loans to encourage borrowers to take advantage of the inflationary environment created by central bank policy.

Money supply increases are produced as the result of a net positive gain in bank loans. What’s happened in the last several years in the U.S. is that these super aggressive monetary actions have not yielded a significant increase in net new loans and the increase in money supply has been muted.

So why isn’t it working? The answer is multi-faceted and not particularly obvious but one of the problems is that the buying power (value) of a currency is measured against the value of other currencies. The end result is that each country attempts to devalue and the overall effect is that central bank actions are cancelling each other out, thereby negating any positive effect that otherwise would be derived from monetary policy.

The “New Age One World Economy,” however well-conceived, is in fact a serious problem for Keynesians. A case in point is the Federal Reserve’s QE and Operation Twist programs. The goal of the Fed has been to devalue the U.S. dollar. A cheaper dollar relative to other currencies has the two following effects, in theory at least:

1. It makes exports more attractively priced and thereby increases GDP through export sales.
2. A cheaper dollar implies that it would be wise to spend for goods and services rather than wait as a dollar trending lower will buy less over time — again an action that increases GDP.

One then has to ask the obvious question: Has Fed easing devalued the dollar or increased GDP? The answer is a resounding no. The U.S. GDP turned negative in the third quarter of 2008. The U.S Dollar Index closed that quarter at 79.36. At that point, the Fed went to work to expand the money supply through lower interest rates and its QE programs. These policy measures were designed to drive the value of the dollar lower. \

Contrary to expectations, the dollar index closed the second quarter of 2012 at 81.25. In other words, despite Fed monetary policy the value of the dollar has gone up, not down — a fact that may surprise a lot of people who believe that the Fed is printing money right and left and devaluing the dollar.

Let’s look at the second part of the question then: Has GDP increased because of Fed easing policy? GDP for the third quarter of 2008 was $14.395 trillion. The second quarter of 2012 produced a GDP of $15.454 trillion. A rather modest increase in GDP for four years and an increase that is fully negated by adjusting for inflation that has averaged a little over 2% over the four-year time period.

This unprecedented phenomenon has to be frustrating for a Keynesian, and central bankers across the globe are Keynesians. We now are in the fourth year following the recession and central bankers must admit that their strategies to expand the economy through the traditional approaches have failed.

There are so many interrelated factors that come into play in the context of this “New Age One World Economy” that it makes traditional Keynesian strategies obsolete and relatively ineffective. Today, a recession in Europe or a slowdown in China has a direct impact on the U.S. economy. On the other hand the melt down in the United States with the 2008 banking crisis had a major impact on China and Europe.

We are so interconnected that to varying degrees what happens in one of the major three economies impacts the others. Another major phenomenon that renders monetary policy less effective is fiscal policy. The world’s governments have moved to a very accommodative fiscal policy that set the sovereign governments up as a backstop for the chronically unemployed.

These fiscal strategies have both a positive and a negative consequence. The positive consequence is that during periods of higher unemployment, the immediate impact to GDP growth is diminished. In other words, governments acting as a backstop use taxpayer funds or sovereign debt to pump funds into the hands of those who are not contributing to growth through productive efforts. That does have the benefit of muting to a significant degree the more traditional effect of high unemployment, which is a reduction in spending.

However, after a point, if these economies don’t respond and start to grow, the cost of debt becomes so burdensome that it can no longer be sustained — a case in point is Greece and now Spain. Nobody wants to buy the debts of these countries, meaning they are effectively bankrupt. If the United States were to continue down this path, it is only a matter of time before we find ourselves in the same dilemma.

The result is that even if stock markets act irrationally in the short-term — moving in a counterintuitive way relative to the general condition of the overall economy — sooner or later they will price in reality. It is possible that companies can record solid profits for a while in a stagnating economy by slashing costs while consumer consumption is not really reduced to the degree we may expect because of sovereign governments pumping cash into the economy through backstop entitlement programs.

That in turn sets up another dynamic: Increasingly larger debt to GDP ratios. Sovereign debt must be paid in the end by tax revenues. What is occurring in southern Europe, and to a lesser degree in the U.S., is that as the numbers of unemployed increase, the government needs to borrow more money to fund entitlement programs to reduce the impact to the individual unemployed as well as to the broad economy by limiting the reduction in consumption that otherwise would occur as a result of the unemployed dropping out of the consumption pool.

The positive aspect of the backstop entitlements is that the immediate effect of increasing unemployment is that the marketplace doesn’t really feel the impact as the governments are borrowing money and delivering entitlement checks to the unemployed.

However, as the sovereign liability swells on the country’s balance sheets, the income of the sovereigns falls as tax revenues fall and as revenues to service these debts becomes suspect, the debt cost goes higher and exacerbating the problem. Now we have a sort of triple whammy that hits these sovereigns. Tax revenues are falling, debt is rising and the cost of that debt is rising making the whole situation completely unsustainable. That is where Greece is today and Spain is entering the fray as one of the countries needing a bailout.

What it all comes down to in the end is that we have a serious disconnect in a lot of areas that is preventing a recovery to full employment and worldwide growth. It is no longer possible for GDP growth and full employment to occur unless it occurs across the board. What is needed is a policy that recognizes these combating forces that tend to nullify one another.

We need a policy where fiscal and monetary policy is working in concert with one another, but more importantly the major economies need to recognize that their strategies are nullifying each other rendering traditional Keynesian macro-economic theories ineffective. If we are going to operate as a one world economy, and that is most assuredly the reality today, we must do so with monetary policy that makes sense across the spectrum of the major economies.

Perhaps the best policy for the United States right now could be counterintuitive. If the Federal Reserve would recognize that the biggest threat to the United States and the world at the moment is in the southern European countries and that the best plan to resolve these problems is a combination of austerity and euro devaluation, then they would reverse course and stop easing programs in the United States. An interest rate hike in the United States would act to drive the dollar sharply higher relative to the euro.

As the euro fell, we would hope that the money supply would expand in Europe and that the traditional and expected effects of monetary policy would work in the Eurozone. An expanding money supply would stimulate spending in the Eurozone, which would act to reduce unemployment and increase tax revenues thereby reducing borrowing costs of the sovereigns.

Perhaps the short-term effect in the United States would be a pullback in stock prices, but if the long-term effect was stabilization and economic expansion in the Eurozone, the pullback could be relatively short lived in the United States. The alternative, if something is not done to stabilize economies across the spectrum and start them on a growth path, is that they will continue to contract until a full-blown worldwide depression is the new reality.

The problem is that we do have a “one world economy,” but we haven’t yet transitioned away from the policies of the isolated, protectionist viewpoint. We still are implementing policies that worked in the pre-one world environment. If our economy in the United States is problematic, we attack the problem with traditional monetary policy. As we do this, we exacerbate the chances of recovery in Europe. China takes the same approach as do the lesser players around the world.

From the analysis above we must make two conclusions:

1. First the bond market has it right for the near-term and stocks are dramatically overvalued, or soon will be as the world realizes that we are in a deleveraging period and there’s nothing likely to change that in the near-term; the result being a severe economic contraction.
2. Absent a massive and coordinated worldwide joint attack on the problem that includes political (fiscal) as well as monetary policy leadership, we are in big trouble.

What’s most frightening about this whole scenario is what Schumer articulated to Bernanke: 

“Given the political realities of this year’s election, I believe the Fed is the only game in town. I would urge you, now more than ever, to take whatever actions are warranted."

"So get to work, Mr. Chairman."