Real output flows of the US are below potential as
evidenced in the low labor participation rate, high unemployment rate and low factory
utilization rate (i.e. we’re not using or maintaining a portion of our real
asset stocks, Chart 1a, 1b & 1c). This “output gap” is the most urgent economic
issue facing the country because this “gap” lowers the country’s standard of
living irreversibly (smaller “pie” to go around either now or in the future)
and because it has large impacts on the distribution of real/money flows (e.g.
newly unemployed get smaller real flows, etc.). The main macro driver of the
output gap can be identified by looking at aggregate money flows since these
money flows drive real flows. As discussed previously nominal economic growth
only occurs via spending of prior period savings or via increases in debt
(which creates money stocks that increase money flow/real flow transactions
unless used exclusively for existing asset purchases). This is the case because
either action by an actor in the economic flow (see previous blog post)
increases the money flow rate around the cycle. One way to evaluate these
actions is to examine the sectoral balances, which combine these two actions
into an overall net saving or net borrowing position by sector (with the net position being zero overall, because again - the US$ economy is "closed" in that there are two sides to every transaction, so every debtor has a creditor). Looking at the
sectoral balance graphic (Chart 2) we can see that the foreign sector has not
changed much – it is still in surplus (spending less than it earned during the
period – subtracting from the economic flow), that the government sector has
increased its deficit (but is otherwise similar in sign to prior years) and
that the household/business sector has had a drastic swing from deficit (spending more
than they are earning) to surplus (spending less than they are earning).
Clearly the sector which has had the biggest change is the private domestic
sector (households & businesses) and which therefore should be the chief
suspect as the main driver for the current malaise.
GDP = Income = C + I + G + (X - M) = Spending = C + S + T
Rearranged:
(I - S) + (G - T) + (X - M) = 0
GDP = Income = C + I + G + (X - M) = Spending = C + S + T
Rearranged:
(I - S) + (G - T) + (X - M) = 0
Chart
1a
Chart 1b
Chart 1c
The unusually large surplus in the private domestic
sector (households and businesses) is why this recession has been called “a
balance sheet recession” since the surplus has been thought to reflect
individuals and businesses spending less than their incomes in an effort to “fix”
their balance sheets. Savings are being used to either 1) pay off debt (e.g.
underwater mortgages, excessive leverage relative to newly adjusted risk
assessments (credit market freeze impact, etc.) or 2) increase stocks of money
(e.g. increased savings for retirement since housing wealth decreased,
increased rainy day fund due to increased perception of financial liquidity risks,
etc.). The degree to which each of these factors are driving saving desires is observable
in economic data – for example the drop in mortgage debt since the financial
crisis (Chart 3) shows that some savings are being used to pay down debt (I’m
assuming bank loan write-downs cannot explain the entire decrease since I don’t
believe they have the capital to absorb this). More broadly, Chart 4 shows that
private debt levels overall have decreased over the last few years, and
therefore that increases in saving desires are not all due to increases in
money stock hoarding.
Chart
3
Chart
5
This reality of private sector deleveraging does not
necessarily mean that an output gap must occur. The other players in the
economic cycle can more than offset this reduction in money flows and in fact
lower the output gap relative to pre-crisis levels. The foreign sector can
provide money flow increases by spending more USD$ than they earn, yet
unfortunately we see, via the sectoral balance diagram, that this is not the
case. The foreign sector continues to spend less than they earn (i.e. they have
a trade surplus with the US – instead of goods they get USD$ money stocks),
which has been a drag on money flows for a few decades now. The drivers for
this accumulation of USD$ money stocks are many but include 1) foreign currency
reserve needs (to “guarantee” access to foreign goods and to provide foreign
currency which can be used to manipulate exchange rates in the future), 2) the
result of prior foreign currency interventions made to support export led economic
growth strategies and 3) the desirability of USD$ savings vs. foreign currency
savings. The foreign sector money flow “leakage” is clearly something the US
needs to address as it exacerbates, not helps, the money flow problems coming
from private sector saving desires.
With the foreign sector unable to offset the money flow
decrease caused by private sector deleveraging the government has been forced
to try and fill the gap. Specifically, with the “river” of money around the
economic cycle being diverted to the private domestic sector and foreign sector
money stocks (lakes) the government has been forced to inject money flows into
the economic cycle to maintain real flow production. Since state and local
governments are unable to run large, sustained budget deficits (by law) it is
the federal government that has been forced to inject money flows. The federal government
has been “forced” to act in such a way due to public opinion (e.g. the stimulus
act) and, more importantly, due to existing legislation. Such legislation falls
under the label of “automatic stabilizers” since they remove money flows when
the economic cycle flows are “too large” and add money flows when cycle flows
are "too small". We all know of the money injections that increase when the economic
cycle slows – unemployment compensation, welfare, food stamps, etc., yet often
forget that money flow removal (i.e. taxes) is designed to slow during
downturns as well due to the income based source of most federal government imposed
taxes. The end result of both the discretionary and “automatic” federal
government money flow changes can be seen in Chart 7 – very large money
injections which, by accounting identity, produce corresponding debt stocks.
Chart
7
In addition to fiscal policy the government has also
responded to the great recession using monetary policy, which is executed thru
the Federal Reserve. Most of the Federal Reserve’s post-financial crisis
activities (e.g. lowering the Fed Fund’s rate, buying Treasury bonds and
private mortgage backed securities) have focused on lowering interest rates in
order to 1) make debt levels more manageable (decreasing debt repayment and freeing
up money flows for non-interest related purposes), 2) to increase asset prices
due to lower discount rates/opportunity costs of capital (which affect money flows
via the “wealth effect” ( increased balance sheet net worth)), 3) to encourage
new debt accumulation (which may increase money flows) and 4) to decrease
saving desires directly thru consumer intertemporal optimization effects. The impact
of this monetary policy endeavor is hard to quantify since it works thru
multiple pathways and empirical studies have many confounding factors to deal
with, but in my opinion the positive effects of these monetary policy actions
are vastly over-rated. It is true that lower interest rates have lowered debt
service costs (see Chart 8) and increased asset values (see Chart 9), yet I do
not believe that lower interest rates appreciably impact intertemporal optimization
(see Chart 9a - people do not consume more simply because the real rate of interest has
decreased) or business investment (since there are much bigger drivers, like
sales, plus the fact that business investment spending is no longer usually
funded by new debt (retained earnings provides most funding)). Further, as I repeat often, interest payment transactions
impact at least two parties – if debtors pay less interest then creditors receive
less interest. The net impact on money flows going to real flow production
depends on which party is more likely to spend the resulting money stock on
real flows. You might believe that debtors, by their very nature, would be more
likely to spend the "saved" interest money flows, except when you realize that the
largest debtor is the US government which is not constrained in its spending
like non-currency issuing entities are (ignoring the extremely misguided debt
limit). The Federal Reserve returned nearly $89 billion to the Treasury in 2012
(see Chart 10) a large part of which is due to interest paid on government
bonds that are now owned by the Fed (reserves at the Fed yield much less than
the bonds they replace). These interest expense savings reduced the federal
budget deficit and the money flow injections they represent. Overall I believe
the Fed’s actions since the financial crisis has helped to increase money
flow/real flow transactions, but to a small degree and in a way that may not be
beneficial in the long term (more on this later).
Chart
8
Chart 10
The final actor in the economic cycle – the banks, were initially
the main cause of the money flow decreases that created the US economic output
gap (i.e. when solvency issues became apparent trust between transacting parties
disappeared which resulted in a credit freeze - another paper in itself). Due
to rule changes and central bank interventions this source of money flow
reduction was quickly addressed, and to a large degree the banking system is now
operating in a similar manner as before the crisis (sadly). An example of this
is shown in Chart 11 – consumer credit (loans to households excluding housing-backed
loans) continues to increase (hopefully creating/sustaining human, physical or
technological real assets which will allow for debt repayment). [Note that this
does not contradict earlier charts – the increase in this type of debt is
simply smaller than the decrease in housing debt]. The banking sector is an
integral part of the economic cycle but one which is supposed to facilitate,
not drive, money flows around the economic cycle. This is of course only partly
true, and there are many very important (and troubling) issues surrounding
banks, but for the sake of brevity I will not discuss banking in detail at this
point but instead focus on bank controlled factors that are contributing to or
ameliorating the current output gap.
If you have made it through my last few blog posts you
understand that bank lending is constrained by bank capital (shareholder
equity) – so the first question must be – is this constraint currently binding?
[Note – if you still don’t believe this read the following: http://rwer.wordpress.com/2012/01/26/central-bankers-were-all-post-keynesians-now/
] Based on government stress tests almost all banks are adequately capitalized
and able to issue new loans. This is partly due to continued bank profitability
and optimistically valued (or hidden) assets (i.e. asset held off balance sheet
or valued based on book value, not market values, due to the partial removal of
mark-to-market rules). Lower interest rates (which are set by the Federal
Reserve exogenously) impacts the demand for loans but generally does not impact
the profitability of loans since this is just a function of the spread between
lending rates and funding rates (i.e. yield on asset side of the balance sheet
vs. the cost of the liability side of the balance sheet), assuming of course
that banks have properly hedged/matched the duration of their assets vs.
liabilities. Treasury bond purchases by the Federal Reserve do not increase
lending directly (the “money multiplier” is a myth) but they do increase bank
profits since the resulting expansion of bank balance sheets (bonds are
transformed to bank deposits and reserves at the Fed) creates another spread
(with virtually no risk weighted capital requirements) which banks can collect
(i.e. rate paid to depositors is less than the rate received from reserves).
Mortgage backed security purchases by the Fed is potentially even more
profitable for the banks as unlike Treasury purchases MBS securities contain
credit risk – did the Fed pay too much for the MBS’s (money flow spent >
money flow ultimately received)? Did the Fed buy the junk that the banks do not
want to hold? Regardless of the effect on profitability the off-loading of
MBS’s to the Fed does increase bank’s lending capacity as it reduced their
capital requirements (which are based on risk weighted assets). This effect
somewhat offsets new rules which are increasing bank capital requirements (to
help prevent future bailouts). From a flow of funds perspective this is a good
thing as increasing bank capital requires money which could otherwise flow through
the economic cycle (bank capital is essentially bank savings (a stock), and
like all savings represents a leakage to the economic cycle flow). The total
collapse of the securitization market does negatively impact bank capital as it
would require banks to own more risky assets, such as home mortgages. However,
the GSE’s (e.g. Freddie and Fannie) continue to lessen this impact by insuring,
or outright owning, most mortgages issued today. Lastly, we should remember
that bank profits are like business profits in that they do not necessarily slow
the economic cycle flow as long as they are returned to their owners (although
they can still impact flows through their distributional ramifications – more
on this later). Retained earnings on the other hand does slow money flows as
they represent savings which add to money stocks (note that bank balance sheets
are like business balance sheets in that they are linked with their owners, so
bank dividends do not change net worth). So to conclude I believe that banks
themselves are not a major, direct driver of the current output gap.
Chart 11
Now that we have detailed how the actors in the economic
cycle have contributed to the current output gap we can begin to identify ways
in which the output gap can be eliminated. This process will be the focus of my
next blog post and will involve less aggregated data which will provide a
better understanding of why each sector is acting in the way which we have identified
above. To preview an issue which will feature prominently in this discussion, I
quote a former Federal Reserve Chairman (from 1934-1948) Marriner Eccles:
“We could do business on the basis of any dollar value as long as we
have a reasonable balance between the value of all goods and services if it
were not for the debt structure. The debt structure has obtained its present
astronomical proportions due to an unbalanced distribution of wealth production
as measured in buying power during our years of prosperity. Too much of the
product of labor was diverted into capital goods, and as a result what seemed
to be our prosperity was maintained on a basis of abnormal credit both at home
and abroad. The time came when we seemed to reach a point of saturation in the
credit structure where, generally speaking, additional credit was no longer
available, with the result that debtors were forced to curtail their
consumption in an effort to create a margin to apply on the reduction of debts.
This naturally reduced the demand for goods of all kinds, bringing about what
appeared to be overproduction, but what in reality was underconsumption measured
in terms of the real world and not the money world. This naturally brought
about a falling in prices and unemployment. Unemployment further decreased the
consumption of goods, which further increased unemployment, thus bringing about
a continuing decline in prices. Earnings began to disappear, requiring
economies of all kinds – decreases in wages, salaries, and time of those
employed.
…..
It is utterly impossible, as this country has demonstrated again and
again, for the rich to save as much as they have been trying to save, and save
anything that is worth saving. They can save idle factories and useless
railroad coaches; they can save empty office buildings and closed banks; they
can save paper evidences of foreign loans; but as a class they can not save
anything that is worth saving, above and beyond the amount that is made
profitable by the increase of consumer buying. It is for the interests of the
well to do – to protect them from the results of their own folly – that we
should take from them a sufficient amount of their surplus to enable consumers
to consume and business to operate at a profit. This is not “soaking the rich”;
it is saving the rich. Incidentally, it is the only way to assure them the
serenity and security which they do not have at the present moment.”
However, my recommendations will not simply entail money
flow redistribution. As I have discussed previously, the level and efficiency of
real stock utilization (current standard of living) and the rate and wisdom
of real stock production (future standard of living) is a function of current
money flows, expectations of future money flows and the institutional structure
and functioning of markets (which equate money flows with real flows via value
judgments). My policy recommendations will therefore address all of these
factors – simple recommendations such as more progressive taxes (which shift
money flows to the less wealthy) or a workfare program (like the MMT job guarantee
proposal) can potentially address the output gap issue, but by treating the
symptom instead of the underlying cause.
No comments:
Post a Comment