Post QE2 Federal Reserve Watch: Part I

Should there be a QE3 or not?

This seems to be the debate now going on given the sluggish performance of the United States economy.  Not only have most of the recent statistical releases been relatively weak, the government also released revised figures for real growth during the two years of economic recovery since July 2009 that were revised downwards from the previously released mediocre data. 

There is no joy in Mudville. 

President Obama is talking up jobs and infrastructure investment and business innovation, but his “room to maneuver” given the debt wars going on is “little” or “none”.  And, the White House is not feeling really good going into the re-election season.

Only a small minority seems to be calling for substantial fiscal stimulus at this time and they do not even seem to be a part of the current discussions going on.  They are like “voices calling in the wilderness” but few are listening. 

Thus, attention is focusing once again on the Federal Reserve and its increasingly unpopular Chairman Ben Bernanke.  Mr. Bernanke seemed to be the savior of the financial system at one time but now seems to be talking about a different world than the one most people live within.  His efforts at stimulating economic growth have achieved very little with the exception of providing liquidity for world commodity markets and stock markets in emerging countries. 

Yet, people keep looking for more “guns” or “tools” to address the economic malaise that we are now going through.  The FED seems to be the only game in town.  So, are we going to get QE3?

QE2 ended on June 30, 2011.  In the first six months of 2011, the Fed caused Reserve Balances with Federal Reserve Banks to increase by $642 billion reaching a total of $1.66 trillion on July 6.  (Just a note: on August 6, 2008, before the deluge, Reserve Balances with Federal Reserve Banks totaled less than $4.0 billion.)

As we know, most of these reserve balances were held as excess reserves, the growth of bank lending in the United States over this time was non-existent.

In July, the Federal Reserve “backed off” from its program of aggressive security purchases with almost all purchases of United States Treasury issues going to offset the run-off of Federal Agency issues and Mortgage-backed securities from its portfolio during the month. 

The only real activity that took place at the Federal Reserve in July was “operating” transactions, basically balance shifting between Treasury accounts and commercial banks.  These “operating” transactions generally “netted” out close to zero and did not result in much change in reserve balances with Federal Reserve banks. 

So, we watch and wait and listen. 

Will the Federal Reserve do anything more?  And, if they plan to do anything…what will it be?

In my analysis, so much of the county has too much debt that people, businesses, and state and local governments are attempting to de-leverage their balance sheets.  Too many financial commitments have been made relative to cash flows that there is a substantial effort increase savings and re-structure balance sheets. 

This is why people, businesses, and governments are not borrowing…and are not spending. 

The efforts of the Fed to stimulate bank lending has failed to this point because the banking system is, itself, still retrenching, financial institutions are still going out-of-business in a steady stream, people aren’t borrowing to buy houses, small- and medium-sized businesses are not hiring and are not borrowing to expand their operations, and state and local governments are downsizing and trying to keep themselves solvent. 

The economy is not growing because too many are trying to get back on their feet, they are trying to keep from drowning, and adding on more spending and more debt is not on their agenda.

Here is where the paradox comes in.  The massive shift in the income/wealth distribution in the country has put a huge burden on the less wealthy while those with more wealth can continue on.  We hear that the “expensive” stores are doing very well…and the dollar stores are not doing all that well.  We hear that there is a pickup in the sales of the more expensive homes, yet sales in the rest of the market continue to decline.  And, so on and so on.

In such an environment of “debt deflation” for a large proportion of the population (see http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) it is extremely difficult for the government’s economic policy to overcome the drag on spending created by the restructuring of balance sheets. 

Keynes interpreted such a situation as a “liquidity trap”, a situation where the central bank could not drive interest rates any lower because people would just as soon hold cash as hold interest-bearing debt. See David Wessel’s column in Saturday’s Wall Street Journal: http://professional.wsj.com/article/SB10001424053111903454504576490491996443926.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj.

Wessel presents one case for getting out of this trap…a period of (hyper)inflation that would substantially lower real interest rates.  This, one could argue, is what the Fed (unsuccessfully) tried to do in QE2 and it is what would be the objective of following QE2 up with QE3.  But, the strength of QE3 would have to be great enough to get over the “debt deflation” efforts of the people, businesses, and governments that are trying to get their balance sheets back in order. 

Wessel writes, “Failure to arrive at the correct diagnosis, in economics as in medicine, prolongs the illness; so does refusing the remedies. There's a reason the Great Depression lasted for more than 10 years.”  But maybe the correct diagnosis is that the problem is not a liquidity problem but is a solvency problem.  And, the people of a society may take a long time to deleverage their balance sheets when it took fifty years of credit inflation to get them in their current position.
If this is true, having the central bank create a policy of (hyper)inflation will not really resolve the issue but only postpone it for another day…something politicians are very good at.
And, as we contemplate the possibility that the Fed will engage in another round of monetary easing, word comes that the European Central Bank (ECB) is going to engage in the purchase of the sovereign debt of several European nations so as to support eurozone commercial banks and the newly proposed severe budgetary policies of Italy and Spain.  The ECB announcement came after several European commercial banks wrote down the value of the Greek debt on their balance sheets everywhere from 21 percent to 50 percent. 
To the ECB, it seems, the situation in Europe is still a liquidity problem.  But, if this is the incorrect diagnosis, as it may be for the United States, the ECB may have the same success as the Fed’s QE2 had.  Keep watchin’.  

Why This Economic Expansion is Going Nowhere

This economic expansion is now in its twenty-fourth month.  It is one of the weakest expansions on record.  And, it seems to be going nowhere.

One reason for this is that there is just too much debt still outstanding in the economy.  The economy is experiencing a debt deflation where more and more people and businesses feel over-burdened with the debt loads they are carrying on their balance sheets.

The government, especially the Federal Reserve, is trying to counter this by pushing hard on the credit inflation button to extend the fifty years or so of credit inflation we have already experienced.  The problem with this is that each new round of credit inflation puts more and more people and businesses into unsustainable positions so that expansions rely on a smaller and smaller proportion of the economy to drive further economic growth. (http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation)

 Debt takes time to work off or work out.  The bigger the debt-load the longer and harder it is for the people and businesses to climb out of their holes.  Repeated cycles of credit inflation not only end up with more people digging holes, it also contributes to some existing holes becoming deeper. 

Hence with every cycle recoveries become harder to achieve and the subsequent economic growth becomes less and less robust.

Another reason why economic growth is having trouble picking up momentum is because of the dislocations that exist within the economy.  Credit inflation causes many distortions beyond what it does to the balance sheets of people and businesses.

Most analysts concentrate on the unemployment rate.  Right now this figure rests just over 9.0 percent.  Analysts focus on this variable as the crucial one for the upcoming 2012 election. 

To me, a more important measure of the dislocation of human resources in the economy is the amount of under-employment we are experiencing.  This number includes those individuals that have left the workforce or are employed but are not fully employed.

The under-employment rate in the United States right now runs about 20.0 percent.  About one out of every five Americans is under-employed. 

This number was under 10.0 percent in the 1960s and has trended up ever since. 

The reason:  the number one goal of the economic policy of the United States government was to achieve high rates of employment…low rates of unemployment.  The best way to do this when unemployment arose was to stimulate the economy through the monetary and fiscal policies of the United States government to put people back to work in the jobs they have previously been laid off from.  This, of course, resulted in more and more of the human capital in the country being underutilized…a capacity utilization problem.

Adding to this was the shift in employment in the country with relatively more and more of the new jobs opening up being in finance and financial services and less and less in manufacturing.  Many “potential” workers find themselves limited in terms of opportunity either through geographic location or educational training.  Both of these results came from the governments attempt to achieve high levels of employment through credit inflation.

Finally, there is the problem of capacity utilization of physical capital.  As one can see in the accompanying chart, capacity utilization in American industry was in the 87.0 to 90.0 percent range in the 1960s.  As the proportion of human capital being used in this country trended downward from the1960s to the present, capacity utilization in manufacturing has also trended downward.  

One can observe very clearly in this chart the cycles of capacity utilization associated with each recession during this time period.  Also, one can not that with every cycle in capacity utilization that the “new” peak achieved is lower than the peak reached during the previous cycle…with the exception of the 1995-1997 experience.

Right now, United States manufacturing seems to be “peaking” out just below 77.0% of capacity, down from a previous peak of about 82.0 percent of capacity.  It has been stuck at this level for at least seven months now, through June.

My argument is that just as credit inflation is responsible for the growing under-employment in the United States work force, credit inflation is also responsible for the growing under-employment of the physical capital of the United States.  Credit inflation distorts business decisions and leads to a capital stock that is less and less productive over time.

So, here are three reasons why I place a low probability on the United States economy achieving a more robust economic recovery: the debt load on people and businesses; the dislocation existing in the labor market leading to high rates of under-employment; and the dislocation existing in the use of physical capital in the United States leading to low rates of capacity utilization. 

Note that credit inflation can only be a short run panacea for these problems.  Credit inflation leads to greater debt buildup adding to the unsustainability of the debt load being carried by people and businesses.  Credit inflation works to put people back into the jobs they recently lost but as the society changes, the old jobs go away.  And, credit inflation affects the productivity of the country’s physical capital making the existing capital stock less and less usable.  There are no good answers here.

The Drag Caused by American Household Debt

Today I would like to reference an article by William Galston on the website of the New Republic (http://www.tnr.com/blog/77215/getting-out-the-recession-stimulus-spending-debt-banks).

Galston’s point is this: the value of assets on the balance sheets of households in the United States has declined relative to the amount of money owed by these same households.

To quote Galston: “As the value of assets used as collateral collapses, so does borrowing. This depresses consumption (because the real net worth of households has declined), and the real economy dips, making it much harder for businesses and households to service the debts incurred during boom times. Household consumption remains sluggish until debt is reduced to a level that can comfortably be serviced out of current income, a process that cannot proceed without an increase in the household savings rate. The larger the debt overhang, the longer it will take to work off the excess.”

The figures Galston quotes: in late 2007, household debt was $12.5 trillion which was 133 percent of disposable income. In the first quarter of 2010, total household debt had declined to $11.7 trillion around 122 percent of disposable income.

The Federal Reserve Bank of San Francisco has suggested, in a May 2009 analysis, that this ratio will need to fall to around 100 percent for households to feel more comfortable and begin to loosen up their pocketbooks a little bit more.

For this ratio to decline to 100 percent, the study argues, it would take up to a decade, even if the household savings rate were to rise to 10 percent. The household savings rate is now a little above 6 percent.

Government stimulus programs are not going to counteract this de-leveraging unless they were to create sufficient new inflation to get the value of assets rising rapidly once again!

It is not surprising that small- and medium-sized businesses are in a similar situation. Many of the smaller businesses in the United States used debt much as households did during the buildup of financial leverage because…they were the same people!

And, small- to medium-sized banks are having solvency problems (http://seekingalpha.com/article/222005-where-is-banking-headed-not-up).

Foreclosures, bankruptcies, and bank failures are a common part of such an environment (http://seekingalpha.com/article/222238-why-52-is-not-a-pretty-number).

Regulators and the courts are trying to work out the difficulties connected with such problems as efficiently and smoothly as possible. Galston is just pointing up the fact that correcting such a situation is not going to be accomplished over night. Even the program Galston suggests as a way out of this malaise, a “national infrastructure bank”, would not shorten the time span needed to once again achieve a robust economy with substantially lower unemployment.