Wednesday, June 30, 2010

Fiscal and monetary policy are headwinds, not tailwinds

The yield on 2-yr Treasury Notes yesterday dropped to its lowest level ever. As this chart suggests, that means the market has never been so pessimistic about the economy's ability to grow. Short-term Treasury yields typically track the growth of nominal GDP, mainly because they present a risk-free alternative to having exposure to nominal GDP through investments in equities and/or corporate debt. That yields are under 1% for the first time ever suggests the market is expecting that an extended period of recessionary conditions and very low inflation are right around the corner. In other words, 2-yr. Treasury yields provide strong evidence that the economy is already priced to the double-dip recession that so many pundits seem to be calling for.

Let me explain. If nominal GDP is rising 5% a year, for example, then your baseline expectation for the growth rate of corporate cash flows should be something similar. After all, no business can have a cash flow growth rate which exceeds nominal GDP forever, because at some point that business would consume the entire economy. So it stands to reason that on average and over time, corporate cash flows, and profits, will tend to grow by a rate that is close to that of nominal GDP. You can capture that growth rate in your portfolio by holding equity exposure (in the hopes that growth will be positive and you will earn more than 2-yr Treasury yields), or by buying the 2-yr. Treasury if you're not sure and don't want to take any risk.

This chart is also instructive because it shows that yields tended to equal or exceed nominal GDP from the early 1980s through the early 2000s. That same period happened to be one in which inflation was generally falling and relatively low. It was also the same period during which the Fed almost always proclaimed that it was pursing a restrictive monetary policy (which involves pushing interest rates up relative to inflation so as to increase the demand for money). But beginning in 2002, the Fed began pursuing an overtly accommodative monetary policy, and this translated into yields generally being less than the growth of nominal GDP.

When 2-yr Treasury yields exceed the growth rate of nominal GDP, investors are naturally drawn to financial assets (e.g., cash, Treasuries), because they tend to outperform nominal GDP on a risk-adjusted basis. But when yields are less than nominal GDP, investors tend to prefer investments which are tied to the physical economy (e.g., commodities and real estate), since they tend to outperform the returns on financial assets. Corporate bonds and equities do especially well when money is tight and real yields are high, because in a tight money environment yields tend to fall and inflation stays low; falling yields make the return on equities look attractive, and so investors tend to bid up PE ratios; PE ratios tend to be highest when growth and inflation are lowest. Low inflation also tends to discourage investments in real assets (like real estate and commodities), and by doing so, low inflation discourages speculation and instead encourages investments in productive activities; low inflation thus tends to lead to stronger growth.

The fact that we've had easy money for most of the past 7-8 years helps explain why equities have performed poorly—with PE ratios declining of late—and corporate bond spreads are still historically wide. It also explains the strong performance of commodity prices, and—until a few years ago—the strong performance of real estate.

I have said this many times before and I'll say it again: the two most significant headwinds facing the economy today (and for the past year) are faux-stimulative fiscal policy and excessively "easy" monetary policy. (This of course flies directly in the face of the common perception that the economy has only managed to recover thanks to stimulative fiscal and monetary policy.) The huge expansion of government regulations and spending under the Obama administration, the fact that most of the spending took the form of transfer payments, and most of the tax cuts were temporary rebates, coupled with the Fed's $1 trillion injection of bank reserves via the purchase of MBS, have done almost nothing to increase hard work and risk taking, while greatly increasing investors' uncertainty regarding the future. How high will taxes have to rise to restore some semblance of sanity to the budget? How can spending be throttled back without creating even more pain and suffering? How high or low might inflation be in the future?

The great economist Allan Meltzer has an excellent op-ed in today's WSJ titled "Why Obamanomics Has Failed." Read it, since it adds a lot more substance to my sparse remarks on fiscal policy here.

It's important to note that these headwinds have been with us for some time, and they help explain why the economy has experienced a sub-par recovery to date. Business investment is improving on the margin, but as I have pointed out before, investment is severely lagging the rise in corporate profits, and a lack of confidence in the future surely helps explain why.

Does this mean we are doomed? No. It's always dangerous to extrapolate recent trends into the future, and that is especially the case today. There is a sea-change underway in the public's willingness to tolerate larger and more intrusive government, and this will very likely result in some huge changes to policy in the wake of the November elections.

Meanwhile, as the chart above suggests, the economy is moving in a positive direction, and the fears of a double-dip recession which have brought the equity market down may well prove to be unfounded. Holding cash or short-term Treasuries because one expects the economy to collapse may prove to be a very expensive hedge, not least because yields on risk-free investments are very close to zero, while yields on alternative investments (equities, corporate bonds, etc.) are historically high.


Benjamin Cole said...

I am glad to see that Scott Grannis is back on the wagon, after his recent flirtation with "let's run a $500 billion deficit forever, borrowinf=g from overseas."

Balancing the federal budget is do-able, what with some large whacks in Dept of Ed., DoD, USDA and Labor. I might even go for gasoline taxes, in favor of lower corporate income taxes or capital gains taxes.

Still, taxes are much lower on America's wealthy today than in the 1950s and 60s, when we had good growth and no inflation, so I think too much complaining is just sniveling.

On monetary policy, I am not sure I follow. Scott Sumner (Monetary Illusion) is calling for an expansionist monetary policy, and maybe he is right. Grannis has been hinting at inflation for a while, but we seem to be going the other way. I would rather endure an inflationary boom than a long depression.

Egads, if you can remember George Gilder, in the Reagan days he extolled the virtues of inflationary booms. Deficits don't matter was another Reagan-Bush era mantra. Obama deficits do, I guess.

I am still threatening all of you with my book report on Panic, Redleaf/Vigilante.

Scott Grannis said...

Tax rates were quite high in the 50s and 60s, but tax revenues as a % of GDP were not any higher than they were prior to the recent recession. That means that tax policy back then was horribly inefficient. If you can collect the same revenues with a lower tax rate, that is always preferable. Tax rates should be as low and as flat as possible, as Art Laffer so convincingly teaches.

The Reagan deficits (4-5% of GDP) were manageable, but Obama's deficits (>10%) are definitely a problem, and an order of magnitude larger. No country with deficits that high has ever enjoyed a very healthy economy (e.g., Japan and Italy).

Public Library said...

Scott great post. My only quibble is you do not give enough lip service about the problems the Fed has and continues to do to this country.

We have a two-pronged problem. Yes Government needs a slashin', but unless we reign in the Fed we are selling ourselves a temporary illusion.

I think the next few decades will bare this out as we depart from the mindset of the "Great Moderation".

Paul said...

"I am glad to see that Scott Grannis is back on the wagon, after his recent flirtation with "let's run a $500 billion deficit forever, borrowinf=g from overseas."

Not to worry, Benji. We won't be seeing $500 billion deficits anytime soon while your boyfriend is in charge.

Benjamin Cole said...

On what basis does anyone believe the Fed is being too expansionary?

House prices? Commercial real estate prices? The Dow? Unit labor costs? GDP growth? There has been asset-price deflation, and in a serious way.

Everything is down, not up.

We are entering an era of very, very low interest rates. Get ready for zero. Inflatrion is dead too.

Bill said...


Can you have a bear market without a recession?

Scott Grannis said...

Benjamin: signs of easy money: a generally weak dollar, $1200 gold, strong commodity prices, a steep yield curve, low or negative real interest rates.

Scott Grannis said...

Bill: there have been lots of bear markets without recessions, though it may depend on your definition of a bear market. In any event, the stock market can be wrong, just as the bond market can be wrong.

W.E. Heasley said...

Mr. Grannis:

Allan Meltzer is exactly right. You can not create a world of negative expectations and expect a positive reaction/outcome. Tax increases, ObamaCare creating expected cost increases to businesses and consumers, Medicaid expanding and expected to hamstring state budgets, the expectation of temporary spending to merely delay state and local employee contraction in the face of plummeting state tax revenue receipts, cap and trade legislation creating the expectation of increased production costs, accelerated short term spending measures expected to contribute to long term debt drag, and demonizing profits (profits being the cost of efficiency-Thomas Sowell) creating the expectation of lower profits.

Meltzer makes an excellent point about the expectations of taxes. Tax rebates and short term tax changes do nothing to stimulate an economy. Its very clear that expectations and tax policy have an important relationship based on time. That short term tax rebates/reductions merely cause the recipients to take the proceeds and save and/or pay down debt. However, long term tax cuts have the phenomena of a “tax horizon”.

If the tax horizon is set for a medium or long term time frame then firms and households can plan investments and consumption accordingly. For example, if firm ABC knows a tax reduction law has been set for the following 8 years, then investment/consumption decisions can be made over an expected tax time horizon. More medium and long term investment and consumption decisions can be made as the tax time horizon has an extended time frame which directly affects medium and long term expectations (a known tax rate reduction over an extended period).

Benjamin Cole said...


Commodities? Global demand and speculation now sets the tune--but even so, according to this chart, commodities just are not that hot---had a rush in 2008, then poof.

I just don't see how to explain decreasing asset values and declining unit labor costs as being consistent with loose money.

You seem to looking at a few carefully selected trees, as opposed to the forest.

You know how you sink a Polish submarine? Wait until it submerges, then knock urgently on the hatch.

Scott Grannis said...

WEH: in a sense, Meltzer is giving Obama & Co. an "F" in economics 101. I think that the typical liberal has a very poor or uneducated understanding of the basic principles of economics.

W.E. Heasley said...

Mr. Grannis:

It appears to me that liberals see economics from the view point of “the political power of the transfer payment”. They have spent 80 years using unfunded entitlements (hollow promises) and general spending for constituency building. That each round of new unfunded entitlements and general spending comes with permanent increases in the size and scope of government.

But what goes around comes around in political-economy: not only have they created unfunded hollow promises which are now clearly unsustainable, the unsustainable spending and unsustainable accumulated debt has created an unsustainable constituency.

Hence the constituency building episode was based on constant increases in debt and unfunded future entitlements that has reached its end cycle. From the very beginning of the constituency building episode, there was an unknown yet certain point where you run out of money and/or it becomes an unsustainable financial situation. We have reached that certain point and now the built constituency , the political base created through hollow promises, is about to learn they bought into a scheme. That built constituency is going to very upset when the transfer payment scheme is unveiled and the transfer payment stream is interrupted.

Benjamin Cole said...

I guess, then that Bush jr. was a liberal.

Cabodog said...

Got to admit it, despite all the economic good news I've got a bad, bad feeling about this week. Just a hunch that the market's going to break down.

DaleW said...

It appears to me that liberals see economics from the view point of “the political power of the transfer payment”. They have spent 80 years using unfunded entitlements (hollow promises) and general spending for constituency building.

It should be as plain as day that both parties view entitlements this way, not just Democrats.

DaleW said...

Just to set the record straight, the largest recent federal deficit / GDP was run under a Bush budget, in federal FY 2009. Net federal borrowing / GDP was 10.73% in CQ3 2009, which falls wholly within the 2009 federal fiscal year. Obama's first budget was FY 2010. Q2 2009 wasn't far behind, at net federal borrowing of 10.67% of GDP. Bush broke the fiscal sound barrier way before that, though. In Q4 2008, we were already at 7.05%, worse than the eurozone is today. The moment this policy conversation gets away from hard data, it's about neither policy nor data and it's not a conversation.

Paul said...

"Just to set the record straight, the largest recent federal deficit / GDP was run under a Bush budget, in federal FY 2009."

Dale, sorry but that's not a fair assessment. Bush spent waay too much money on failed liberal programs, but FY 2009 was largely the result of the Democrat Congress passing continuing resolutions in order to avoid negotiating with a departing President Bush. In fact, you may remember Obama(who promised to go line-by-line through the budget and deliver a "net spending cut") signing the $410 billion pork filled omnibus FY 2009 spending bill in March of '09.

Public Library said...

I'm with DaleW. Scott is out of his depths when swimming into politics.

Not that there is anything wrong with his opinion but we can only take it with a grain of salt and definitely not in the context of this economics blog.

Bush Jr ran two wars now costing us a trillion dollars and countless lives. Republicans have done nothing for this country but polarize it. The Dem are just as responsible but opinions of these sorts are wasted energy.

Anonymous said...
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Benjamin Cole said...

The long R-Party record, I am sad to say, is terrible, and rotten.

Debt as a percentage of GDP soared under Reagan, Bush, Bush jr, relieved only by the Clinton days. In the R-Party era, debt rose from roughly 40 percent of GDP to roughly 80 percent (I am eyeballing a chart).

Grannis has stated the R-Party debt assumption levels were okay, but not Obama.

I beg to differ.

The huge run-up in public indebtedness, under Reagan, Bush, Bushjr, and justified by R-Party talking heads as "deficits don't matter" was crime against taxpayers.

Obama is no better, but not much worse.

Indeed, it was in the day of R-Party domination 2000-2006--when they controlled House, Senate, White House and Supreme Court, that our nation economically speaking, headed straight into the toilet, culminating with the collapse of our financial system, bank runs (Indy Bank), huge debt, and rapidly sinking GDP. Huge bailouts galore for Wall Street, and a policy so bad that Redleaf/Vigilante called it crony capitalism at its worst. It all happened on the Bush watch.

Obama's team seems serious, and to be dedicated public servants--they at least show up for work. Obama inherited a train wreck into a sewage treatment plant. I do no agree with his health care plans, his increased engagement of Afghanistan, nor his poorly considered rhetoric. But other than that, he seems to have made the right steps, and the economy is recovering.

Give unto us a liberal like Clinton any day (he was praised by Redleaf/Vigilante btw).

Paul said...

"Obama is no better, but not much worse."

Such are the blinders Benji wears for his boyfriend Barack. Obama's fiscal recklessness is unprecedented, several standard deviations worse than Bush.

"Obama's team seems serious, and to be dedicated public servants--they at least show up for work."

And they've done a bang up job adding $2 trillion to the debt in around 500 days. Nothing better forecast for the future, either.

The GOP battles Obama's staggering propensity to spend even now. They tried to stop the stimulus, Obamacare, and most of this mega-billion dollar gimmicks that never fail to blow up in his face.

Even the Europeans have been telling Benji's boyfriend they are no longer going to participate in his conga-line over the cliff.
The freakin' Europeans!