Friday, June 29, 2012

Economic fundamentals from a monetarist perspective

This charts shows the quarterly annualized growth rates for real and nominal U.S. economic growth. Market monetarists, championed by Scott Sumner, have been arguing for some time that one of the main reasons that economic growth has been so sluggish in recent years is that the Fed has failed to deliver 5% nominal growth. When nominal growth slips below 5%, they argue, creditors can't generate the cash flow they had expected, and so defaults rise and this further disrupts economic growth. Unexpectedly slow nominal economic growth (NGDP) is disruptive for nearly everyone because income don't rise as expected. And it makes sense to think that the economy can be disrupted when key variables (e.g., cash flows, incomes, default rates) fall short of expectations.

I think he has a valid point when it comes to what happened in 2008. The worst thing that happened back then was that the financial crisis sparked by the collapse of the sub-prime mortgage market, and the housing market in general, threatened to produce a collapse of the global finance system, as loan defaults surged. The Fed was largely to blame for the intensity of this crisis—which also saw gold and commodity prices plunge—because they were very slow in responding to an overwhelming increase in the demand or dollar liquidity that occurred as the crisis unfolded. When liquidity falls short of the demand for liquidity, you have a liquidity squeeze which is effective a shortage of money. With money in short supply, deflation pressures naturally arose, as reflected in the plunge in 10-yr TIPS break-even inflation expectation to almost zero near the end of 2008, and default rates surged.

But the Fed finally did react, with two rounds of quantitative easing that left the world agape with its boldness and unprecedented size. Dumping tons of bank reserves into the financial markets was the first major step towards ending the Great Recession. Nominal GDP rose sharply from -8.4% in Q4/08 to 4.9% in in Q4/09. Since then, NGDP has grown at a 4.3 annualized rate. That's a little shy of Sumner's preferred 5%, but not by much. So I would submit that although the Fed erred by reacting slowly to the crisis in late 2008, they haven't done such a bad job since, and thus there is little reason to fear that the economy is starved for liquidity today and otherwise vulnerable to another financial collapse or recession.

QE 2 ended in mid-2011, and Operation Twist—an attempt flatten the yield curve by purchasing longer-term Treasuries while simultaneously selling shorter matures, was announced at the end of Q3/11. In the charts above I don't see that the slope of the Treasury curve has experienced any unusual flattening, given the stage of the business cycle we are in. The curve is still quite steep, and that's to be expected since the Fed is still ultra-accommodative and the economy continues to grow. Furthermore, I don't detect any significant weakening of NGDP since the Fed stopped expanding bank reserves about a year ago.

If the lack of more Fed easing or twisting is hurting the economy, I fail to see much evidence that this is the case. The dollar is very near its all-time lows—a fact suggesting that dollars are in relatively abundant supply. That is confirmed by sensitive market-based prices: gold is still 535% above its low of 13 years ago; and commodities are still 130% above their lows of late 2001. Credit spreads are still somewhat high, but I think that is a function of general fears which are keeping PE ratios low (at a time of near-record-high corporate profits. Swap spreads, on the other hand, are firmly in "normal" territory, which suggests that liquidity is abundant and systemic risk is quite low.

Finally, as this chart shows, if Operation Twist, if it has had any impact on the slope of the yield curve from 10 to 30 years, it's not been significant. Indeed, since the end of last September the long end of the yield curve has steepened, which inflation expectations have increase, which in turn suggests just the opposite of the Fed's intended effect.

The main things holding back growth are 1) widespread risk aversion on the part of investors, as evidence in a massive accumulation of banks savings deposits, and 2) the market's very dismal expectations for economic growth, which are reflected in historically low Treasury yields. I don't see how these conditions can be altered significantly through the injection of more reserves or a further extension of very low short-term interest rates. I think it's now up to fiscal policy to make the difference: we need to bolster investor confidence by increasing the after-tax rewards to work and risk-taking (by lowering and flattening tax rates and eliminating loopholes and tax credits for favored industries, and reducing the size and scope of government so that the resources can be freed up for the private sector to work it's productivity enhancing magic.


McKibbinUSA said...

Given the low yields on Treasuries, it's no wonder that government entities are main purchasers, which in my view lies at the heart of the economic problems in the US...

Benjamin Cole said...

We'll, I am a big fan of Scott Sumner, and the Market Monetarist movement, so I take issue with mush of this post.

Currency exchange rates may be meaningful; or not. The dollar is near 1990s levels---but what if other nations are following monetary policies that are too tight? Then we should want our dollar to fall. Japan is obviously following a too-tight monetary policy. I do not want the dollar to stay at par with the yen. That would produce a deflationary perma-recession. See Japan.

But what puzzles me the most about the Grannis approach is that it seems to look for tea leaves rather than the huge fundamentals.

The huge fundamentals: Unit labor costs (60 percent of business costs) are below levels of 4 years ago. The DJIA is at 1999 levels. Commercial real estate is at 2005 levels, off roughly 40 percent from tops. Commercial and industrial rents of all kinds are soft. The CPI, over four years, has been risen at 1.1 percent annually.

1.1 percent! This is inflation? I thought Friedman taught loose money produce inflation and high interest rates.

These are the huge fundamentals ignored by Grannis.

There is a great blog, R Squared, that looks at energy markets. Believe me, US monetary policy is not what drives oil prices. You have huge supplies locked up in thug nations---Iraq, Iran, Libya Russia, Mexico, Venezuela, Saudi Arabia. There are no free markets, not free enterprise, rule of law etc there. You have demand soaring in China and India (where the have aggressive growth monetary policies, btw).

Grannis warned about inflation, and hyperinflation, before and during QE1 and QE2.

Where is it?

McKibbinUSA said...

Benjamin, QE I and II were never intended to "stimulate" the economy, but rather to ensure the economy did not fall into deflation -- to that end, QE has been successful -- however, the Fed has been very careful only to apply sufficient QE to keep inflation at near zero levels -- the problem that the Fed has been fighting over the past four years is deflation -- inflation is well in check at this point -- said another way, if the Fed had not initiated QE I and II, the economy would have fallen into deflation and depression already...

John said...

Though not an economist (I'm a scientist), Scott's post made a lot of sense, to me, until it approached the end and made a (predictable) recommendation, unsupported by the previous arguments, in a run-on sentence worthy of a scientific journal article:

"I think it's now up to fiscal policy to make the difference: we need to bolster investor confidence by increasing the after-tax rewards to work and risk-taking (by lowering and flattening tax rates and eliminating loopholes and tax credits for favored industries, and reducing the size and scope of government so that the resources can be freed up for the private sector to work it's productivity enhancing magic."

In my opinion, tax cuts are not the correct "medicine." Don't expect much growth as long as businesses continue to profit finding ways to eliminate workers (would-be-consumers) and further reduce unit labor costs.

PD Dennison said...


Stick to your science and Scott will stick to economics.

What we need is to vote the Social Democrats out of office in Washington and the dwindling states that they still control. Then we will have fiscal reforms and a reduction in the bureaucratic destruction that is strangling our economy.

How's that Global Warming project you are working on going?

plykab said...

Wow. Mr scientist John your post was incredibly painful to read. To think that a "scientist" understands so little about economics. What you talked negatively of, "...profiting by eliminating workers, " is literally the very basis of human advancement. Not a part of it, but literally the entire thing. 100 years ago 90% of laborious was in agriculture, today its about 2%. Did all this elimination cause horrible growth? You may be the type to suggest making sprinklers illegal so everyone would have to hire people to water lawns and expect this to be an economic boost to society lol. I suggest thinking it over and understand how wealth is created.

marmico said...

Did all this elimination cause horrible growth?

No, if by growth you mean GDP or GDI.

But there has been a secular decline from 49% in 1929, peaking at 53% in the early 1970's to 44% today in wage and salary accruals relative to national income. Most households derive the bulk of their income from employment.

The decline is not as severe if "all-in" wages and benefits are included.

John said...

PD: Regarding "fiscal reforms," the last budget surplus came under Clinton, who raised taxes and presided over a robust economy.

See the following link with the chart showing real annualized growth in government spending through the years. It's been lower under Obama than under Bush 43, lower under Clinton than under Bush 41, and lower under Carter than under Reagan, the Great Keynesian who cut taxes and raised spending.

Regarding my "Global Warming," project, there isn't one. I consult for a major energy company. We don't talk about it much, but I think they actually are somewhat concerned about Global Warming. Many of the top brass at the Pentagon consider it a national security threat, at least indirectly.

John said...


Creative destruction of jobs, as occurred when industrial jobs replaced agricultural jobs, is fine as long as the destroyed jobs are replaced by something better.

Do you think that's what's going on now?

marmico said...

massive accumulation of banks savings deposits

How many times do we have to through this? Household savings deposits as a percentage of financial assets have increased from 13% since Lehman went bust to 16% today. The unemployment rate has exceeded 8% for over 3 years for the first time in the data series. I would think that precautionary savings are in order.

Your big ballooning cash hoard on corporate balance sheets has been revised away.

Come up with a different reason.

marmico said...

bolster investor confidence by increasing the after-tax rewards to work and risk-taking

Business had no problem increasing capital intensity during the 2007-2011 period, arguably the worst era in 75 years. It increased 1.2% annually which was higher than the growth rate in the 1987-2011 time frame. See Chart 2, PRELIMINARY MULTIFACTOR PRODUCTIVITY TRENDS - 2011.

Squire said...

What we need is spending. Obama should go to the nation:

It is become painfully clear that a lot of people are spending less that the average and not doing their share to help the economy. This is selfishness and inequality that we have come to see is a big problem within and among Americans.

Yes, I know there are a few economists who say we need savings to form capital to provide investment for our future, and they do have a point. But we really don’t need people to do that because we have much more debt we can take on as a nation to provide all the capital expenditures we need as you can see how well we have done so already in my administration.

And the New York Times, has made it perfectly clear that the science is in and the problem with our economy is lack of demand. I therefore propose legislation under the new Obama /Roberts constitutional amendment where any individual who voluntarily chooses to not be a good citizen and spends less than their neighbor, will bear a penalty, not a tax, that the IRS will add to their tax bill each year.

This tax, I mean penalty, will start with fiscal year 2014 as it will take that much time for the new Consumer Financial Protection Bureau to put in place the software for every bank to report the spending in every bank account and identify each bank account by name, address, and national id number.

Thank you very much and may the government bless you.

Unknown said...
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Dagmara FafiƄska said...

Great article.