The United States Economy Will Continue to Grow

I believe, as I have written before, that the United States economy is recovering and will continue to recover. 

However, I also believe that “financial crises are protracted affairs.” (Reinhart and Rogoff, “This Time is Different”, page 224.)

Why don’t I believe that there will be a “double dip” recession, a 1937-38 depression like the one following the 1929-33 Great Depression?

In the case of the 1930s, there were policy errors committed that resulted in the 1937-38 depression: the most prominent one being the effort of the Federal Reserve to eliminate all the excess reserves being held by the commercial banks at that time so that the Fed would have more “control” over the money markets.

Unfortunately, the banks wanted those excess reserves around even though they were not in the mood to expand their lending activities.  As a consequence, when the Fed attempted to remove those excess reserves by raising reserve requirements, the banks cut back even more on their lending activities in an effort to achieve the financial protection they believed those excess reserves brought them.    

This has not happened in the current situation because Fed Chairman Ben Bernanke (a student of the Great Depression era) and the Fed have done just about everything possible to make sure that the banking system is flooded with excess reserves so that a similar contraction of the banking system does not occur.  There are questions about what this means for the future, but we are not at that future yet.

So, I believe that the economic recovery will continue.

The economic recovery, however, will not be robust.  One reason for this is the debt overhang that exists in the private sector.  David Brooks speaks to this point in his Tuesday morning column in the New York Times. (http://www.nytimes.com/2011/10/18/opinion/the-great-restoration.html?_r=1&hp) 

“Quietly but decisively, Americans are trying to restore the moral norms that undergird our economic system.

The first norm is that you shouldn’t spend more than you take in. After an explosion of debt over the past few decades, Americans are now reacting strongly against the debt culture. According to the latest Allstate/National Journal Heartland Monitor poll, three-quarters of Americans said they’d be better off if they carried no debt whatsoever. Not long ago, most people saw debt as a useful tool for consumption and enjoyment. Now they see it as a seduction and an obstacle.
 
By choice or necessity, eight million Americans have stopped using bank-issued credit cards, according to The National Journal. The average credit card balance has fallen 10 percent this year from 2010. Banks, households and businesses are all reducing their debt levels.”

This same phenomenon is occurring in the world of state and local governments, and the non-profit world.

How is spending going to expand within the context of this kind of behavior?

The general fundamentalist Keynesian response to this is that the federal government needs to do more to stimulate the economy.  The argument is that government spending actually needs to be much greater than is being proposed at the present time.  The people that are making this argument also state that the economic recovery in the 1930s was as slow as it was because the government did not spend as much as it should have back then.  Government expenditures will never be large enough for these people. 

But, how is more government debt going to change the picture?  As Reinhart and Rogoff state in their book, “the value of government debt tends to explode” (page 224) in the aftermath of any severe financial crisis anyway.   

The reason is that as incomes drop, tax revenues decline and the government deficit increases. 
But, greater deficits mean greater interest and principal payments in the future, and someone like Robert Barro argues that this will mean more taxes for the private sector in the future so that current savings will increase even further to offset this future obligation.     

Even if the private sector does not fully discount future taxes into their current spending plans, people may just accelerate their efforts to save to provide themselves with more flexibility to manage their financial affairs in an uncertain future world dominated by huge government debts. 

The problem that results from this scenario, in my mind, is that given the behavior of the Federal Reserve System there is lots and lots of cash floating around in the economy, but this cash is not in the hands of those people and businesses that are trying to restructure their balance sheets.  Because, this cash is not in the hands of those people and those businesses that are trying to restructure their balance sheets, the fundamental economic recovery will continue to be modest. 

Thus, you have lots and lost of cash looking for places to invest where there are very few “productive” places for the money to go.  So, money seems to be chasing assets.  However, the uncertainty seems to be causing other problems and this is resulting in increased market volatility. (http://professional.wsj.com/article/SB10001424052970203658804576637544100530196.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

“The problem is a lack of liquidity—a term that refers to the ease of getting a trade done at an acceptable price.

Markets depend on there being many offers to buy and sell a particular stock, across a range of prices. But as investors have gotten nervous, many of those offers have dried up. That is causing wider-than-normal gaps between prices showing where stocks can be bought and where they can be sold—the difference between the "bid" price and the "ask" price.

Many big investors, such as hedge funds and mutual funds, which at times can act as shock absorbers for trading because they tend to trade large chunks of stocks, have been on the sidelines. Some hedge funds, for example, say they're not trading as much until they know how much money their clients will withdraw at the end of October, a deadline some clients have to inform funds of intentions to redeem money at year-end. “

In my mind, the economic recovery is going to continue on its slow path.  But, given all the money around and given the general impatience that is attached to this money, wide swings in asset prices are going to continue well into the future, especially if the Federal Reserve really keeps interest rates as low as they are into the middle of 2013.

Patience is not an attribute of traders…and of politicians…but that is another story.

The Current State of Monetary Policy

At the top of my Financial Times this morning reads the blurb: “Did Ben Bernanke Drop the Ball Over QE3?”  This is reference to an editorial by Clive Cook. (http://www.ft.com/intl/cms/s/0/7f55246e-cf2d-11e0-b6d4-00144feabdc0.html#axzz1WPnzI9CU)

In examining the speech given by Fed Chairman Bernanke, Cook takes on the Financial Times essays published last week by Michael Woodford (http://www.ft.com/intl/cms/s/0/aa41c0f2-ce78-11e0-b755-00144feabdc0.html#axzz1WPnzI9CU) and Mohamed El-Erian (http://www.ft.com/intl/cms/s/0/0472f1ea-cd89-11e0-b267-00144feabdc0.html#axzz1WPnzI9CU) that argued against the Fed implementing a QE3.  Cook contends that Bernanke missed a chance…a “chance to jolt ailing America.”

I don’t believe that Bernanke dropped the ball.  I don’t believe that a declared QE3 is necessary.  Whereas Cook believes that a QE3 would “shock” America, I believe that a QE3 would be taken as ho-hum, more of the same. 

In this, I don’t believe that QE1 and QE2 were understood. 

Michael Woodford, the “good” academic states in his essay: “The economic theory behind QE has always been flimsy.”

Get real…this is the “real world”!

QE1 and QE2 were not a result of economic theory.  QE1 and QE2, in my mind, were a response of real people to a desperate real world situation.  In the first case, the financial markets were falling apart.  In the second case, the economy was not growing. 

In both cases, the response of Mr. Bernanke and the Fed’s policy makers were to throw whatever they had against the wall to see what would stick.  There is little in the way of theory behind this.   Some of us believe that in the first case this was not one of Mr. Bernanke’s finest hours. (See my post, “The Bailout Plan: Did Bernanke Panic,” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

In my mind, what was behind these actions was not theory…but history. And, Mr. Bernanke is one of the premier students of the history of the Great Depression and the 1930. 

So, what was behind QE1 and QE2?

In the case of QE1, Mr. Bernanke was aware of the massive monetary history written by Milton Freidman and Anna Schwartz.  The famous conclusion drawn from the Friedman/Schwartz history is that the Federal Reserve allowed the money stock of the United States to decline by one third over the 1929-1933 period. 

Mr. Bernanke and the modern Fed was not going to allow this to take place.  As a consequence, they, Bernanke and the Fed, threw everything they had at the wall.  There was no theory in this.  They were just human beings re-acting in a situation in which there was extreme uncertainty and in which things seemed to be falling apart around them. 

In terms of QE2 we can also go back into the history of the 1930s to get some instruction that might help us understand what the Federal Reserve has been attempting to do over the past year.  The specific case here comes from the period 1937-1938.  The United States economy had been modestly recovering since 1933 but bank lending had not really picked up.  Excess reserves at commercial banks became, for the time under review, excessive.  Since the Federal Reserve’s policy makers did not want to have all these excess reserves around because they felt this reduced their control over the banking system they raised reserve requirements so as to get rid of these “superfluous” reserves.

The consequence? 

There was another collapse of the money stock because the commercial banks “wanted” those excess reserves due to the uncertain times and the slow pickup in business activity.  So, when the Fed took away the excess reserves, the banks reduced their lending activity even more to recover their “excess” reserves and the financial system declined once again.  There was another depression following up on the “Great” one!

Mr. Bernanke, the historian, and the Fed did not and does not want a repeat of the 1937-38 depression.  As a consequence, QE2 was created.  The thought behind QE2 was to throw enough against the wall so that something would stick!  Economic growth was sluggish at best; bank lending was still declining in the summer of 2010; debt loads of businesses, and families, and governments were huge; foreclosures and bankruptcies were at record levels; and under-employment were at levels reached only in the 1930s.  Banks had excess reserves, yet, nothing much seemed to be moving.

Mr. Bernanke and the Fed wanted to escape a replay of 1937-38!

There was little or no theory behind QE1 and QE2.  These two programs were put into place by real people facing extreme situations who did not want to err on the side of not doing enough.  They were people that would let history decide whether or not they acted correctly…and let the theorists debate all they wanted to in their own little worlds. 

And, what are we left with right now?

A commercial banking system that has around $1.6 trillion in excess reserves and about $2.0 trillion in cash assets on its balance sheets.  And, we are told that the central bank is poised to act in the future in anyway needed to shore up the banking system and the economy.  Furthermore, we are told that short-term interest rates are to stay around where they are for two more years. 

Mr. Bernanke, who has overseen both QE1 and QE2, is not afraid to throw more “stuff” against the wall if needed.  This, to me, is current state of monetary policy at the present time.