Tuesday, July 22, 2008

Prospects for Stagflation

There has been a lot of talk recently about the United States economy entering a period of Stagflation. Stagflation can be defined as a period of time in which economic growth remains below historical averages while significant inflation is present. A period like this is looked on as the worst of two worlds: the low economic growth results in a higher ‘natural’ rate of unemployment than in more normal times; and the economy still has to deal with an inflation rate that erodes earnings and causes an allocation of resources favoring wealth protection and not productivity. A period of Stagflation tends to be self-perpetuating because the lower productivity results in slower growth and the slower growth exacerbates inflation which further stymies productivity, and so on.

Stagflation also puts the Federal Reserve System “in a box”. If the Fed attempts to ease during such a period, the argument goes that its efforts will tend to go into further inflation. If the Fed attempts to restrain inflation, it will only worsen the unemployment situation. The monetary authorities are faced with a real dilemma.

One of the problems in understanding how Stagflation can occur is that people tend to focus on aggregate demand factors when studying economic fluctuations. If economic shocks come from the demand side, a slowdown in demand translates into slower economic growth which is accompanied by higher unemployment and lower inflation. But, this is not how we define Stagflation.

Instead, Stagflation comes about due to a supply side shock which produces both a slowdown in economic growth and higher rates of inflation (for a given amount of aggregate demand). But, how does this come about?

In terms of economic growth I would argue that two things contribute to the possibility of a slower expansion. First, there is the restructuring that most financial and non-financial firms are going through right now. When firms are going through the process of restructuring they lose focus as to what they really should be concentrating on. I know this sounds contradictory, but my business experience points to this very thing happening at a time like this. When you are restructuring you are concentrating on getting back to basics, eliminating those things that you shouldn’t be involved in and retrenching into those things that you should be involved in. (Should you sell businesses, something that takes time and attention?) Also, financials need to be cleaned up. (Perhaps new capital needs to be raised, something that takes time and attention.) Furthermore, expenses need to be trimmed, people let go, and superfluous efforts eliminated (all taking time and attention).

During such times, executives do not focus on creating or sustaining competitive advantages because their focus lies elsewhere. Achieving and sustaining competitive advantages are what produce exceptional returns over time. But, achieving and sustaining competitive advantages takes time and effort since the primary sources of competitive advantage result from things like barriers to entry and from customer captivity. Barriers to entry come from economies of scale and research programs that create a continuous competitive flow of innovation. Customer captivity comes from building customer relationships through product and service quality and support. A firm generally has to restructure first before it is able to concentrate on these paths to better than average performance. And, since building competitive advantage must be very intentional, it must be the primary focus of management.

The second factor that contributes to slower economic expansion is the impact that inflation has on economic performance. As we saw very clearly in the 1970s, an inflationary environment results in managements directing attention away from longer-lived more productive investments and into shorter-term assets that act like an inflation hedge. Such investment slows down improvements in productivity because productivity improvements tend to be more prevalent in longer-term assets than in short-lived ones. The threat of higher inflation results in lower productivity growth.

Both factors, loss of focus and reduced productivity growth (each of which tend to reduce innovation), contribute to slower economic growth and a less vibrant business environment. This re-focus also results in a change in business leadership. As the culture of businesses change due to different economic environments, management leadership tends to change as well. Promotions and hiring’s go to managers that are more risk averse and less dynamic and this contributes to a slower pace of economic expansion.

On the policy side, both monetary and fiscal policies are directed to stimulate aggregate demand. The general prescription for monetary policy is to lower interest rates (or at least not raise them) and speed up monetary growth. On the fiscal side , a general effort is made to cut taxes and/or increase government expenditures. If the above analysis is correct, both efforts will go to produce more inflation rather than stimulate production, and this, as we have seen, will just contribute to making the situation worse.

If we think we are entering a period of Stagflation, then we must be sure that we understand where the economic shock has come from…the demand side or the supply side. If Stagflation results from a supply side shock then pursuing demand side remedies will only make the situation worse. If Stagflation is coming from the supply side then the government must create more appropriate policy responses fit to meet the needs of the times.

If Stagflation is a supply side problem then we must look at the behavior described above in order to come up with appropriate actions. First of all, inflation is an enemy and its fire must not be fanned! (This even ignores the impact that inflation potentially has on the value of the dollar.) Any policy actions that encourage inflation only create a cumulative problem that just adds fuel to the fire and makes the inflationary spiral that much more difficult to stop. It is hard for policy makers to fight inflation at a time like this because voters and politicians are clamoring for more economic growth and less unemployment.

The second part of the problem is not only difficult but slow to unwind. Also, there are two components to this second part. The restructuring of businesses, both financial and non-financial, must take place and it must take place in as orderly a fashion as possible. This takes time. It has taken the American economy quite a few years to get into the situation it is now going through and getting out of it will be painful and time consuming. Adding to the normal adjustment process is the added problem that the United States, as well as the world, is also in need of moving away from fossil related energy sources and moving into an age of cleaner and more efficient energy sources that are not fossil related. So, we are going though an adjustment related to the financial excesses of the past decade or so as well as an adjustment related to the absence of a sound energy policy in the developed world.

The other thing that must be avoided at this time is the move to a more inner-directed management. For the economic growth rate to increase and unemployment to drop, managements must strive to create sustainable competitive advantage by focusing on what they do best and innovating in order to keep ahead of their competition. Costs must be contained, not through cutting back on expenses, but, through economies of scale achieved in the application of core competencies and increases in productivity. This too will take time and the intentional efforts of business leaders and entrepreneurs.

To combat Stagflation we must have monetary policy and fiscal policy working together. Monetary policy must work to keep inflation moderate. Fiscal policy must work to create an environment that encourages the improvement of productivity and risk-taking. Yes, there needs to be a safety-net for Americans that are hurt by unemployment and economic dislocation. But, if Stagflation is a supply side problem, the resolution to the problem must come from stimulus programs that impact the supply side of the economy.

1 comment:

Flow5 said...

“Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

“These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

The most egregious error in Keynesian economics is the insistence that commercial banks are financial intermediaries:

A commercial bank becomse a financial intermediary only when there is a 100% reserve ratio applied to its deposits.

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries, never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs).

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free gratis legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.

Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand.

From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

That is, CB time/savings deposits, unlike savings accounts in the “thrifts”, bear a direct, one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

Consequently, the effect of allowing CBs to “compete” with S&Ls, MSBs, CUs, MMFs, IBs and other intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.

Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

However, disintermediation for financial intermediaries-S&Ls, MSBs, CUs, (non-banks), etc., is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures.

In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the "thrifts" with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

Financial intermediaries l(non-banks) lend existing money which has been saved, and all of these savings originate OUTSIDE the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process.

Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred.

The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time.

For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity of money. Here investment equals savings (and velocity is evidence of the investment process), where in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money.

The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system.

Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy.

Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

How does the FED follow a "tight" money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted).

What would this do? The commercial banks would be more profitable - if that is desirable.

Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts.

Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.

The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,