The Sunshine Report

Tag Archive: Fiscal Policy

1. Goodbye Recovery, Hello Recession

   June 18, 2011 10:18 am Leave a Comment

   I’m no pilot, but I imag­ine that if I were fly­ing a plane and a moun­tain appeared in front of me, I’d pull up to avoid crash­ing. Instead, I am an econ­o­mist and busi­ness per­son and I see an eco­nomic moun­tain loom­ing in front of the U.S. I only wish I could explain why Wash­ing­ton insists on fly­ing straight into the moun­tain rather than pulling up.

   Wash­ing­ton politi­cians are point­ing the U.S. econ­omy straight into a liq­uid­ity trap and instead of a bright eco­nomic future, the U.S. is look­ing at years of high unem­ploy­ment, weak GDP growth and the pos­si­bil­ity of wide­spread deflation.

   When the econ­omy is in a liq­uid­ity trap, mon­e­tary pol­icy is inef­fec­tive because indi­vid­u­als and busi­nesses hoard money rather than spend it. The more money the Fed makes avail­able, the more con­sumers hoard.

   Will I be able to feed my fam­ily and pay the bills? Is my job secure? Is my house worth less than the mort­gage? Will the gov­ern­ment help me when I am old or will Medicare be denied when I need it the most? Why is the school board cut­ting pay and fir­ing teach­ers? Does a gov­ern­ment shut­down mean that I won’t be paid? Is the Trea­sury raid­ing my pen­sion to pay bondholders?

   When ordi­nary peo­ple aren’t sure how to answer those ques­tions, they become gripped by fear and uncer­tainty. To assuage their fears, they spend their time and resources get­ting ready for what­ever bad news comes their way. They hoard cash and try to save for the rainy day that they are con­vinced will come. As a result, demand for goods and ser­vices falls caus­ing prices, wages and liv­ing stan­dards to plunge. Before you know it, we’re in the midst of what econ­o­mists call a defla­tion­ary spi­ral with no end in sight.

   Last week the Fed­eral Reserve of Bank St. Louis pub­lished an update to its M1 Money Mul­ti­plier chart that shows ordi­nary Amer­i­cans are hold­ing on to cash. In the last six months the Money Mul­ti­plier has gone into a down­ward spi­ral. When the Money Mul­ti­plier falls, it’s tough for the econ­omy to sus­tain growth.

   

   It’s not just the M1 Money Mul­ti­plier that is falling; M2 Veloc­ity is falling as well. M2 veloc­ity is a mea­sure of how fast broadly defined money sup­ply turns over each year. When M2 veloc­ity falls, con­sumers, busi­nesses and investors are slow­ing the rate at which they spend and invest their money. Annual GDP equals the amount of money avail­able to spend mul­ti­plied by the num­ber of times the money turns over in a year. When veloc­ity goes down it is a sure bet that a reces­sion is right around the corner.

   As the below chart illus­trates, M2 Veloc­ity resumed its down­ward tra­jec­tory about six months ago after recov­er­ing a lit­tle from the 2008 finan­cial crisis.

   

   Falling veloc­ity is a sign that con­sumers and busi­nesses are los­ing con­fi­dence in the future.

   Beyond the obvi­ous incli­na­tion to hoard, one of the side effects of falling mon­e­tary veloc­ity is the ten­dency of investors to sell more risky and less liq­uid assets and invest in Trea­sury bonds which are con­sid­ered “as good as cash.” Right on queue in the last two months, the stock mar­ket has been in decline while the Trea­sury mar­ket has been rising.

   Con­fi­dence in the future is needed to get money turn­ing over again. Yet, con­fi­dence is being destroyed by a lethal com­bi­na­tion of nat­ural and man-made disasters.

   In the last six months there have been nat­ural dis­as­ters of epic pro­por­tion, but the worst dis­as­ters are man-made and caus­ing self inflicted wounds.

   The earth­quake and tsunami in Japan were nat­ural dis­as­ters with wide spread eco­nomic con­se­quences for both Japan and the global econ­omy. Flood­ing in the Mid­west and tor­na­does through­out the East were no one’s fault, but still rocked the world of mil­lions of Americans.

   Even so, it’s man-made dis­as­ters that are hurt­ing the most.

   Con­flict in the Mid­dle East is a man-made dis­as­ter that has the poten­tial to take a turn to the dark side with last­ing con­se­quences. Also, the Euro­pean sov­er­eign debt cri­sis is a man-made cri­sis that still isn’t under control.

   How­ever, by far the biggest eco­nomic dis­as­ter is being cre­ated in Wash­ing­ton and in state capi­tols. The deaf ear of politi­cians and pol­icy mak­ers to the unin­tended side effects of their words and deeds is almost beyond com­pre­hen­sion. Cer­tain politi­cians seem to think that they were elected to play Russ­ian roulette with the econ­omy and don’t under­stand the con­se­quences of their actions.

   In the last six months investors, busi­nesses and con­sumers have watched the U.S. come within min­utes of defund­ing itself and shut­ting down.

   This month every­one is won­der­ing if Con­gres­sional lead­ers will com­mit col­lec­tive sui­cide and fail to pass an increase in the debt limit. Every night on TV mem­bers of Con­gress seem almost giddy at the prospect of serv­ing the U.S. econ­omy cyanide-laced Kool-Aid.

   Con­sumer and busi­ness con­fi­dence requires pub­lic sec­tor cer­tainty. It can’t be up for debate whether or not the gov­ern­ment should honor its commitments.

   Sev­eral state and local gov­ern­ments aren’t doing any bet­ter. Solv­ing bud­get prob­lems by going to war with work­ers and con­stituents is like pour­ing acid on confidence.

   The Fed’s abil­ity to help the econ­omy is very lim­ited when fear drains money from the pro­duc­tive econ­omy. For bet­ter or worse, when the Fed can’t help, it’s up to our elected offi­cials to fix the econ­omy. Unfor­tu­nately, it’s these elected offi­cials that led us into the shadow of the val­ley of eco­nomic death.

   Despite evi­dence to the con­trary, politi­cians con­tinue to believe that their words and per­sonal deeds don’t mat­ter; that there are no con­se­quences to cre­at­ing uncer­tainty by threat­en­ing to uni­lat­er­ally break con­tracts and bank­rupt peo­ple that trusted the word of the United States.

   Until our elected offi­cials stop threat­en­ing an eco­nomic Jon­estown, we are doomed for as far as the eye can see.

2. Congressman Ryan, I Don’t Want To Be A Lab Rat

   April 22, 2011 8:18 pm Leave a Comment

   An open and a sent let­ter to Rep. Paul Ryan (R-Wisc.)

   Dear Con­gress­man Ryan,

   Please explain your Medicare plan to me and my wife. We are in our early fifties and are con­cerned about how your changes to Medicare will affect us. We know that Wash­ing­ton can seem dis­con­nected from the real world but, for peo­ple of our age, your plan to do away with Medicare is very real.

   Get­ting rid of Medicare feels like a free mar­kets exper­i­ment to us and nei­ther of us wants to be a “lab rat” for a social and eco­nomic exper­i­ment gone awry. Lab rats are usu­ally expend­able and we don’t want to be part of a dis­carded generation.…

   .…Con­gress­man Ryan, please feel free to pro­vide as much detail as pos­si­ble on how, as a prac­ti­cal mat­ter, your plan will be imple­mented. I under­stand that your objec­tive is to save money — I just won­der if there isn’t a less rad­i­cal approach that would work.

   For exam­ple what’s wrong with mod­i­fy­ing the cur­rent Medicare sys­tem to include means test­ing on co-payments and deductibles, increas­ing the eli­gi­bil­ity age by a few years, restrict­ing pay­ment of cer­tain elec­tive pro­ce­dures and work­ing to reduce hos­pi­tal and provider admin­is­tra­tive costs. Tort reform relat­ing to end of life care couldn’t hurt either. These changes would be easy to imple­ment, fair to all and still pro­vide pro­tec­tion for the elderly.

   When I was a child I read sto­ries about how ani­mals that that get old walk into the for­est to die. They are never heard from again and as a result aren’t a bur­den on their herd. The remain­ing ani­mals have bet­ter sur­vival odds because they are not forced to waste pre­cious resources on old ani­mals that are going to die anyway.

   For bet­ter or worse, a long time ago we decided that we were dif­fer­ent than ani­mals and that old peo­ple shouldn’t be asked to “take one” for the team.

   Con­gress­man Ryan, I am wor­ried that your plan basi­cally is telling me and my wife to get ready for that long walk into the for­est. Please tell me it isn’t true and that I am over reacting.

   Read the rest of this post and the ques­tions I ask Con­gress­man Ryan at Forbes.com.

3. II" rel="bookmark">Don’t Worry About The Debt Tsunami Part II

   June 8, 2009 7:04 pm Leave a Comment

   Last week I wrote that the for­ward cal­en­dar of to-be-issued gov­ern­ment and mort­gage related debt isn’t going to swamp the economy.

   Since I wrote my arti­cle Paul Krug­man wrote an arti­cle cit­ing research done by Brad Setser that sup­ports my the­sis. Setser’s analy­sis pre­dates my arti­cle and is really high qual­ity work.

   I am cer­tain that Krug­man didn’t have any idea what I wrote when he pub­lished his arti­cle but, just the same, Krugman’s sub­se­quent writ­ing is a help­ful adden­dum to my “why not to worry about the debt tsunami” theme.

   Basi­cally, accord­ing to the ana­lyt­i­cal work done by Setser, the amount of pub­lic bor­row­ing is being off­set by a fall off in pri­vate bor­row­ing. Less pri­vate bor­row­ing is another way of say­ing that the sav­ings rate has risen. Below is a graph from Setser’s arti­cle illus­trat­ing how the rise in gov­ern­ment bor­row­ing is more or less being off­set by a drop in pri­vate borrowing.

   

   Krug­man con­cludes “We’re actu­ally bor­row­ing less from for­eign­ers than we were before.”

   Setser, on the other hand, wor­ries that “…the challenge…will be to bring down the government’s bor­row­ing as pri­vate bor­row­ing resumes.“
   

4. 7 Faint Signs That The Economy’s Bottom Is In Sight

   February 25, 2009 12:32 pm 1 Comment

   There are opaque and early signs that the U.S. econ­omy has started the begin­ning of a bot­tom­ing process. Just like a div­ing sub­ma­rine needs to stop its down­ward motion and reach its low­est depth before it can resur­face, the econ­omy needs to go through the steps of slow­ing its decline and sta­bi­liz­ing before it can start ris­ing again. Some recent eco­nomic data seems to sug­gest that the rate of eco­nomic decline has started to slow and that some­time in the sec­ond or third quar­ter the bot­tom maybe found.

   Of course, exter­nal events such as a large nat­ural dis­as­ter, war or a regional eco­nomic col­lapse (like of China, Japan, the EU or East­ern Europe) will push the U.S. into a renewed freefall. But, assum­ing the rest of the world isn’t dead weight on the U.S. econ­omy, we are head­ing into a period of crummy eco­nomic per­for­mance with a dra­mat­i­cally dimin­ished base of recur­ring eco­nomic activ­ity. The eco­nomic bot­tom­ing won’t feel like recov­ery because it won’t be; it will merely be an arrested freefall of a dam­aged economy.

   Recent news on con­tin­ued home price defla­tion and sales, Bernanke’s tes­ti­mony that the econ­omy could be worse than expected and record low con­sumer con­fi­dence all mean the econ­omy is still shrink­ing. The econ­omy is, how­ever, start­ing to show signs of shrink­ing at a slow­ing rate which is the begin­ning of the bot­tom­ing process.

   The early signs of find­ing a bot­tom include:

   • Money sup­ply is essen­tially sta­ble and in the case of M1 slightly down (on a sea­son­ally adjusted basis) since the begin­ning of Jan­u­ary.
     

      

     Money sup­ply (as mea­sured by sea­son­ally adjusted M1 and M2) has sta­bi­lized and is no longer grow­ing at weekly dou­ble digit rates. Sea­son­ally adjusted M1 is actu­ally slightly down since the begin­ning of Jan­u­ary and sea­son­ally adjusted M2 has been essen­tially unchanged since the mid­dle of Jan­u­ary. Expo­nen­tial money sup­ply growth is a sign that the Fed­eral Reserve is try­ing to per­form eco­nomic resus­ci­ta­tion while slower money sup­ply growth indi­cates that the Fed­eral Reserve believes that the econ­omy is start­ing to sta­bi­lize. Hope­fully the Fed­eral Reserve knows more about the econ­omy than we know.

      

   • Excess reserves, while still at his­tor­i­cally unprece­dented lev­els, are drop­ping.
     

      

     Excess reserves at the Fed­eral Reserve are a barom­e­ter for the amount of cash hoard­ing that is tak­ing place by banks. When banks hoard cash they increase their deposits at the Fed­eral Reserve and “excess reserves” are cre­ated. On Jan­u­ary 13^th Ben Bernanke gave a speech where he said that when banks start lend­ing again excess reserves will decline. Excess reserves peaked in early Jan­u­ary at approx­i­mately $843 bil­lion and have been steadily declin­ing so that as of Feb­ru­ary 11^th excess reserves were down to $611 bil­lion. While the cur­rent level of excess reserves don’t mean that the econ­omy is healthy (prior to the cri­sis excess reserves were around $2 or $3 bil­lion), the direc­tion of excess reserves is down which is a good sign.

      

   • After 5 straight months of pro­ducer price defla­tion, PPI increased by 0.8% in Jan­u­ary.
     

      

     The econ­omy won’t slow its freefall as long as there is defla­tion. The PPI data for Jan­u­ary was very good news regard­ing pro­ducer prices. While one month of pro­ducer price increases doesn’t mean defla­tion is gone, the amount of the increase and that there were increases in fin­ished goods sug­gests sta­ble demand at cur­rent depressed inven­tory, price and pro­duc­tion levels.

      

   • Con­sumer prices increased in Jan­u­ary by 0.4%, before sea­sonal adjust­ments, which indi­cates that the risk of run­away con­sumer price defla­tion has got­ten lower.

      

     Just like the PPI num­bers were a good sign of restored supply/demand equi­lib­rium, the CPI num­bers also sig­naled that con­sumer prices maybe find­ing a floor. If the econ­omy is going to find a bot­tom con­sumer prices can­not be drop­ping. January’s CPI num­bers were a good sign for the economy.

      

   • Hous­ing con­struc­tion and auto­mo­bile man­u­fac­tur­ing are hit­ting bot­tom; after all $0 of sales is the absolute bot­tom and the U.S. is get­ting close to that boundary.

     These two sec­tors prob­a­bly can only go up from here. When pro­duc­tion and sales hit post WWII lows and approach “$0″ of sales, there isn’t much far­ther to fall which by def­i­n­i­tion puts them at a bot­tom. And, believe it or not auto­mo­bile sales are show­ing the signs of future strength. Used cars sales were rea­son­ably strong in Jan­u­ary with some price hard­en­ing tak­ing place. When used cars go up in price that is usu­ally a pretty good pre­dic­tor of new car sales rebounding.

    

   • A few weeks from now fis­cal stim­u­lus will start kick­ing in.
     

      

     Pay­roll tax cuts from the fis­cal stim­u­lus will begin in the next few weeks and will start to pro­vide some added dis­cre­tionary income to con­sumers. If the stim­u­lus works as planned this should pro­vide some addi­tional cash for con­sumer which will prop up demand. Also, con­struc­tion spend­ing from stim­u­lus bill will start to help the econ­omy in the next few months.

      

   • The newest ver­sion of TALF hasn’t started yet but when it does it will pro­vide addi­tional cash to prop up con­sumer demand.

     TALF is a tril­lion dol­lar pro­gram that should almost imme­di­ately help con­sumers get financ­ing for pur­chases of auto­mo­biles, edu­ca­tion and other con­sumer related items. TALF will also pro­vide some relief for SBA lenders and small busi­nesses. As TALF kicks in it should pro­vide some addi­tional under­ly­ing sup­port for con­sumer demand and pro­vide sup­port to the economy.

   Let’s hope that what the U.S. econ­omy is look­ing at the bot­tom and not its own reflec­tion before being pulled down into a deeper abyss.

5. CPI Indicates" rel="bookmark">Money Supply and Economic Data Weekly Watch – Deflation Is Worse Than CPI Indicates

   November 24, 2008 5:01 pm Leave a Comment

   Last week’s eco­nomic data is under­es­ti­mat­ing defla­tion. On Wednes­day the Bureau of Labor Sta­tis­tics (“BLS”) announced that the con­sumer price index (“CPI”) declined by 1.0% in Octo­ber which was the biggest sin­gle one month reported decline since before World War II. Broad based defla­tion exac­er­bates the already severe credit cri­sis and increases cash hoard­ing by house­holds and busi­nesses. How­ever, CPI defla­tion esti­mates are wrong because defla­tion is much worse than reported and the United States has already entered into a defla­tion­ary death spiral.

   Unfor­tu­nately, many econ­o­mists are look­ing at the flawed his­tor­i­cal and cur­rent CPI data to con­clude that defla­tion isn’t a clear and present dan­ger. Fed offi­cials also don’t seem to under­stand the threat. In a dis­turb­ing denial of real­ity, on the same day as CPI reported broad based defla­tion, Fed Vice Chair­man Don­ald Kohn said that the risk of sus­tained and broadly falling prices was slight.

   Defla­tion destroys cor­po­rate prof­its and is like pour­ing hydrochlo­ric acid on bank loan port­fo­lios because bor­row­ers have less cash and assets to pay back lenders. Obvi­ously, cor­po­rate bor­row­ers that can’t ser­vice their debts because of defla­tion aren’t a very good stock invest­ment. A real life les­son in how defla­tion affects bor­row­ers, lenders and investors is the fall in home prices and the destruc­tion to national wealth that occurred as a result. There are no win­ners in the cur­rent res­i­den­tial real estate price crash as fam­i­lies lose their life sav­ings, lenders fail and 401(k)‘s and other invest­ments crash.

   Defla­tion is here and is prob­a­bly worse than the offi­cial sta­tis­tics indi­cate for the fol­low­ing reasons.

   • BLS is over­es­ti­mat­ing the price level for hous­ing which makes up approx­i­mately 42.4% of CPI.

   Curi­ously BLS is report­ing that hous­ing costs went up 3.2% from Octo­ber, 2007, to Octo­ber, 2008. It isn’t clear whose house went up in value or how hous­ing costs could have pos­si­ble increased. But some­where in the alter­nate uni­verse of BLS sta­tis­tics it must have hap­pened and CPI is sig­nal­ing hous­ing infla­tion. Specif­i­cally, CPI data includes an increase of 2.3% in the cost of home­own­er­ship (through an obscure def­i­n­i­tion of the cost of own­ing a house exclud­ing util­i­ties, fur­ni­ture, heat­ing and other oper­at­ing expenses), 3.7% increase in rent and a 2.0% increase in the cost of fur­nish­ings. Some­how CPI has missed the res­i­den­tial real estate cri­sis and as a result is grossly under­es­ti­mat­ing deflation.

   • BLS is over­es­ti­mat­ing the cost of new and used cars which make up approx­i­mately 7.2% of CPI.

   Sta­tis­ti­cians from BLS prob­a­bly only take mass tran­sit because they can’t have been in a car deal­er­ship lately. BLS is ignor­ing that auto­mo­bile prices are col­laps­ing. BLS esti­mated that the drop in new and used motor vehi­cles was 2.3% from Octo­ber, 2007, to Octo­ber, 2008, which while in the right direc­tion, is still very wrong by a large mag­ni­tude. Read­ing any local paper that runs auto­mo­bile adver­tis­ing quickly val­i­dates dou­ble digit declines in vehi­cle prices.

   • BLS is over­es­ti­mat­ing apparel prices which make up 3.7% of CPI.

   BLS is esti­mat­ing that apparel prices actu­ally increased 0.3% from Octo­ber, 2007, to Octo­ber, 2008 which I find shock­ing. First Cap­i­tal finances scores of apparel man­u­fac­tur­ers and over the last 12 months the prices that retail­ers are pay­ing for goods from our clients has dropped. And, whole­sale price declines are being passed on to con­sumers. As an exam­ple, last week my wife pur­chased cloth­ing for our 11 year old daugh­ter. They went to Macy’s and pur­chased 2 pairs of jeans, a shirt with leg­ging and a shirt with a scarf. The total cost for the 4 gar­ments, includ­ing tax, was $21.57. The price tags on my daughter’s cloth­ing indi­cated an orig­i­nal retail price, includ­ing tax, of $71.57 which means that the mer­chan­dise was dis­counted by approx­i­mately 70%. Recently, my wife and I pur­chased men’s printed tee shirts for our 15 year old son and paid $1.99 per tee shirt. And, last month I pur­chased pants for myself and paid less than $20 a pair. 12 months ago the same pants were sell­ing for $45. BLS hasn’t noticed that apparel retail­ers are going bank­rupt by the dozens and one of the rea­sons for the retail­ing col­lapse is that prices are rapidly falling.

   While on the sur­face falling prices seems to help con­sumers pay their bills, that analy­sis only works if con­sumers also don’t need jobs. Defla­tion has a quick cor­ro­sive effect on the via­bil­ity of employ­ers because they pur­chase goods at one price and then because of defla­tion have to sell their inven­tory at a loss. While a lot of infla­tion feels like an eco­nomic flu, defla­tion is like “car­diac arrest” for business.

   With­out real­is­tic and reli­able eco­nomic sta­tis­tics pol­icy mak­ers can­not do their jobs. More­over, until gov­ern­ment econ­o­mists get “real” about where the econ­omy is, and where it is going, they will con­tinue to destroy con­fi­dence with incon­sis­tent and reac­tive pol­icy solutions.

   Since defla­tion is both real and more severe than being reported, fis­cal and mon­e­tary pol­icy options need to be re-examined through the sharp lens of a “wage price death spi­ral.” The longer gov­ern­ment fails to respond to defla­tion the worse the econ­omy is going to get.

   Since the week end­ing Sep­tem­ber 22^nd sea­son­ally adjusted M2 hasn’t changed very much. Dur­ing the same period the Fed­eral Reserve’s bal­ance sheet grew from approx­i­mately $1.1 tril­lion to $2.2 tril­lion. I think that M2’s fail­ure to grow indi­cates a type of cash hoard­ing in accounts that would have been picked up in M3 (if the Fed­eral Reserve still pub­lished the sta­tis­tic) which is con­sis­tent with deflation.

   Dur­ing the 1970’s Pres­i­dent Ford started the WIN cam­paign, i.e., Whip Infla­tion Now, as he used the Pres­i­den­tial bully pul­pit to try to jaw bone infla­tion down. On inau­gu­ra­tion day Pres­i­dent Elect Obama needs to start the DDT cam­paign, i.e., Defeat Defla­tion Today. But he needs to use more than the bully pul­pit to defeat defla­tion, mas­sive emer­gency fis­cal stim­u­lus is needed to shock the econ­omy back to into its nat­ural rhythm before it is too late.

6. The Argument For A New Fiscal Stimulus Bill

   November 14, 2008 9:12 am Leave a Comment

   I believe that another fis­cal stim­u­lus bill is going to be passed by Con­gress and signed into law by either Pres­i­dent Bush or Pres­i­dent Obama (obvi­ously after his inau­gu­ra­tion). Fis­cal stim­u­lus is the most likely way that the gov­ern­ment will be able to stop the rapid decline of the econ­omy caused by the hoard­ing of cash by banks and con­sumers. When the pri­vate sec­tor hoards cash, mon­e­tary stim­u­lus stops work­ing and the gov­ern­ment needs to step in with fis­cal stim­u­lus to spur demand and help stop hoarding.

   Last Sun­day Robert Reich pub­lished an inter­est­ing blog arti­cle about why fis­cal stim­u­lus is nec­es­sary and how it will spur demand. While I often dis­agree with Mr. Reich, his arti­cle on Sun­day was right on point. Below are some excerpts from Mr. Reich’s arti­cle. If you would like to read the entire arti­cle just hit this link to be redi­rected to Mr. Reich’s blog.

   …The real prob­lem [with the econ­omy] is on the demand side of the economy…

   ….Intro­duc­tory eco­nomic courses explain that aggre­gate demand is made up of four things, expressed as C+I+G+exports. C is con­sumers. Con­sumers are cut­ting back on every­thing other than neces­si­ties. Because their spend­ing accounts for 70 per­cent of the nation’s eco­nomic activ­ity and is the fly­wheel for the rest of the econ­omy, the pre­cip­i­tous drop in con­sumer spend­ing is caus­ing the rest of the econ­omy to shut down.

   I is invest­ment. Absent con­sumer spend­ing, busi­nesses are not going to invest.

   Exports won’t help much because the of the rest of the world is slid­ing into deep reces­sion, too. (And as for­eign­ers — as well as Amer­i­cans — put their sav­ings in dol­lars for safe keep­ing, the value of the dol­lar will likely con­tinue to rise rel­a­tive to other cur­ren­cies. That, in turn, makes every­thing we might sell to the rest of the world more expensive.)

   That leaves G, which, of course, is gov­ern­ment. Gov­ern­ment is the spender of last resort. Gov­ern­ment spend­ing lifted Amer­ica out of the Great Depres­sion. It may be the only instru­ment we have for lift­ing Amer­ica out of the Mini Depres­sion. Even Fed Chair Ben Bernanke is now call­ing for a siz­able gov­ern­ment stim­u­lus. He knows that mon­e­tary pol­icy won’t work if there’s inad­e­quate demand.

   So the cru­cial ques­tions become (1) how much will the gov­ern­ment have to spend to get the econ­omy back on track? and (2) what sort of spend­ing will have the biggest impact on jobs and incomes?

   The answer to the first ques­tion is “a lot.” Given the mag­ni­tude of the mess and the amount of under­uti­lized capac­ity in the econ­omy– peo­ple who are or will soon be unem­ployed, those who are under­em­ployed, fac­to­ries shut­tered, offices empty, trucks and con­tain­ers idled — gov­ern­ment may have to spend $600 or $700 bil­lion next year to reverse the down­ward cycle we’re in…”

7. Money Supply and Economic Data Weekly Watch – The Next Crisis Is On The Horizon

   November 1, 2008 4:55 pm 1 Comment

   Even while the Fed and Trea­sury are fight­ing defla­tion and a seri­ous reces­sion, they are lay­ing the ground work for a new liq­uid­ity bub­ble with the poten­tial for dev­as­tat­ingly high infla­tion. While the cur­rent news is dom­i­nated by reces­sion­ary GDP, falling con­sumer con­fi­dence, bank­ing res­cues, incred­i­ble stock mar­ket volatil­ity and frozen short term money mar­kets, believe it or not we need to look beyond these once in a life­time events to the longer term con­se­quences of cur­rent policy.

   The Fed and Trea­sury have made it clear that they will do what­ever it takes to save the econ­omy and pre­vent a depres­sion. I gen­er­ally agree with what they are doing. I believe that the Fed and Trea­sury have hard work­ing, smart and car­ing lead­ers and staff who are try­ing to do the best that they know how for the United States and the rest of the world.

   But, I am start­ing to ques­tion some key ele­ments of Fed­eral Reserve pol­icy. I don’t under­stand why in the face of a liq­uid­ity trap the Fed is increas­ing money sup­ply at a rapid rate instead of using their reg­u­la­tory pow­ers to dis­cour­age the hoard­ing of cash and Trea­suries by banks. When a liq­uid­ity trap exists inter­est rates are at or near 0% and mon­e­tary pol­icy has lit­tle or no effect because indi­vid­u­als and insti­tu­tions hoard cash. Increas­ing money sup­ply or cut­ting the Fed Funds Rate isn’t the cure for a liq­uid­ity trap.

   Annual GDP is more or less the prod­uct of two fac­tors, aver­age money sup­ply and the annual veloc­ity of money (i.e., the turnover rate for money). The Fed attempts to con­trol the amount of money in the econ­omy through mon­e­tary pol­icy. How­ever, when banks and other finan­cial inter­me­di­aries delever­age they destroy money sup­ply. When money sup­ply is destroyed (which means it goes down a lot) that has the effect of reduc­ing GDP, reduc­ing infla­tion (or even caus­ing defla­tion), increas­ing the value of the Dol­lar, depress­ing com­mod­ity prices and caus­ing credit rationing (i.e., not enough money to lend). In Feb­ru­ary, 2008, I appeared on FOX Busi­ness and pre­dicted that for most of 2008 the destruc­tive effects of uncon­trolled delever­ag­ing were the biggest prob­lems that would face the U.S. econ­omy. I said that, as a result of delever­ag­ing, defla­tion was a much big­ger prob­lem than infla­tion. At the time, no one lis­tened to me because oil prices were sky­rock­et­ing and infla­tion fears were rag­ing. Dur­ing the sum­mer I started to write in this blog about how real money sup­ply (i.e., money sup­ply adjusted for infla­tion and growth) was declin­ing at an alarm­ing rate. Sure enough, all of the “text book” effects of declin­ing money sup­ply that I pre­dicted occurred (includ­ing credit rationing which man­i­fested itself in the fail­ures and near fail­ures finan­cial insti­tu­tions and the freez­ing of the loan mar­ket). And, as pre­dicted, GDP went down in the third quar­ter. With­out increased gov­ern­ment spend­ing (i.e., fis­cal stim­u­lus), GDP would have crashed.

   The risks of money sup­ply destruc­tion haven’t gone away but the Fed and Trea­sury have worked hard at mit­i­gat­ing these risks with suc­cess­ful pro­grams. As de-leveraging occurs, the Fed­eral Gov­ern­ment and the gov­ern­ments of other nations are replac­ing pri­vate lever­age and cap­i­tal with gov­ern­ment lever­age and cap­i­tal. As a result, money sup­ply isn’t plung­ing and unless there is an exter­nal shock to the bank­ing sys­tem (or a change in pol­icy), I believe that the risk of a cat­a­strophic delever­ag­ing has past.

   How­ever, there was the new September/October sur­prise of liq­uid­ity hoard­ing and falling veloc­ity of money. Lower veloc­ity has the same effect as falling money sup­ply; GDP is destroyed, com­mod­ity prices fall, defla­tion occurs, and credit is rationed.

   But, the Fed’s effort to increase money sup­ply doesn’t do any­thing to stop hoard­ing and maybe makes things worse. A bet­ter pol­icy would be increased fis­cal stim­u­lus and qual­i­ta­tive adjust­ments to bank­ing reg­u­la­tions. Qual­i­ta­tive reg­u­la­tory changes that dis­cour­age hoard­ing include incen­tives for lend­ing and dis­in­cen­tives for hold­ing cash and Treasuries.

   For exam­ple, the Fed and Trea­sury could increase the risk based cap­i­tal require­ments for banks to hold Trea­suries and decrease the risk based cap­i­tal require­ments to own com­mer­cial and con­sumer loans. Increas­ing the risk based cap­i­tal require­ments on Trea­suries decreases the prof­itabil­ity of own­ing Trea­sury secu­ri­ties while decreas­ing the risk based cap­i­tal require­ments of own­ing loans increases their prof­itabil­ity. The Trea­sury can also change tax laws to favor lend­ing over the hold­ing of Trea­sury secu­ri­ties. Of course, any lend­ing that is encour­aged must be accom­pa­nied by reg­u­la­tory enforce­ment of safety and sound­ness reg­u­la­tions so that impru­dent lend­ing doesn’t occur as a new unin­tended side effect.

   Instead, the Fed­eral Reserve is increas­ing money sup­ply at an alarm­ing rate. For the week end­ing Octo­ber 20^th sea­son­ally adjusted M2 increased to $7.9252 tril­lion which was an increase of $54.3 bil­lion. Since the week end­ing Sep­tem­ber 15^th the Fed­eral Reserve has increased sea­son­ally adjusted M2 by $256.3 bil­lion which is approx­i­mately an annu­al­ized 35% rate of increase.

   If the Fed con­tin­ues to increase money sup­ply at the cur­rent rate, hyper-inflation will occur some­time in late 2009, 2010 or 2011. There is a risk that sud­denly the liq­uid­ity trap goes away and veloc­ity accel­er­ates. If money sup­ply con­tin­ues to rise at its cur­rent pace for another 3 to 6 months, when the liq­uid­ity trap ends a large mon­e­tary bub­ble will form. If the bub­ble is large enough (and a 35% annu­al­ized increase in money sup­ply is cer­tainly a pace that will cre­ate a bub­ble), asset infla­tion will be fol­lowed by hyper-inflation. Obvi­ously, hyper-inflation is bad and could result in both eco­nomic cat­a­stro­phe and polit­i­cal unrest.

   Instead of increas­ing money sup­ply at an uncon­trolled pace, the Fed and Trea­sury should be work­ing on a coor­di­nated reg­u­la­tory response to dis­cour­age hoard­ing and another fis­cal stim­u­lus pack­age should be passed by Con­gress. Pulling these two pol­icy levers will stop hoard­ing with fewer unin­tended side effects than con­tin­u­ing to grow money sup­ply at a hyper fast rate.