The Sunshine Report

Tag Archive: M1

1. And Now For Some Really Bad Economic News…

   October 4, 2009 10:24 pm 2 Comments

    The U.S. econ­omy has a long way to go before the eco­nomic recov­ery will be either sus­tain­able or robust.  Mon­e­tary indi­ca­tors don’t look good and are once again get­ting worse.  I am con­cerned that the finan­cial sys­tem hasn’t recov­ered enough for the Fed­eral Reserve to with­draw from its pro­gram of quan­ti­ta­tive eas­ing. 

    While most of the large finan­cial insti­tu­tions seem to be cur­rently sta­ble, abet with hun­dreds of bil­lions of dol­lars of gov­ern­ment invest­ment and sup­port, they aren’t strong enough to ser­vice the needs of Main Street.  Almost all of the mon­e­tary and finan­cial indi­ca­tors point to shrink­ing lend­ing and con­strained credit.  The part of the bank­ing sec­tor that sup­ports busi­ness and con­sumer isn’t work­ing and, in many ways, is get­ting worse.  And, the shadow bank­ing sys­tem is con­tin­u­ing to dis­ap­pear and can’t be counted on to pick up the slack of banks. 

   Until the charts pre­sented below start to point up, I don’t think there is going to be a real eco­nomic recov­ery (as con­trasted with tech­ni­cal bounces from inven­tory adjust­ments and changes in pop­u­la­tion). 

   All of the data sug­gests that the U.S. remains in the grips of a liq­uid­ity trap, i.e., a period of time when inter­est rates are at or near 0% but yet tra­di­tional mon­e­tary pol­icy is inef­fec­tive.  The Obama admin­is­tra­tion needs to reex­am­ine its cau­tious approach to the big banks and think about whether or not the largest banks are sap­ping the eco­nomic strength of the rest of the econ­omy. 

   Money Sup­ply and Bank Lend­ing Charts — Impor­tant Note — Each chart is a link to a full page view of the chart.  Sorry I am not bet­ter at pre­sent­ing graphics. 

   The below chart indi­cates that, con­trary to pop­u­lar belief, money sup­ply is some­where between stag­nant to shrink­ing.  A grow­ing econ­omy requires an increas­ing money sup­ply and an increas­ing money sup­ply is a sign of a grow­ing econ­omy. 

   

   The veloc­ity of money, i.e., the num­ber of times a year money is spent and re-spent, con­tin­ues to fall (which is very bad).  Sus­tain­able eco­nomic recov­ery can’t hap­pen until the veloc­ity of money starts to rise.  The cur­rent veloc­ity of money is sig­nal­ing money hoard­ing by banks, busi­nesses and indi­vid­u­als.  Hoard­ing is a type of sav­ings in cash and cash equiv­a­lents that is moti­vated by fear rather nor­mal sav­ings that sig­ni­fies a desire to invest in the future because tomor­row will be bet­ter than today.

   

   The money mul­ti­plier is below 1x which means that as bank­ing reserves are cre­ated, money sup­ply is actu­ally shrink­ing.  I think that this is the first time in my life time that the money mul­ti­plier is less than 1x.  The money mul­ti­plier has fallen below 1x despite the Fed­eral Reserve’s quan­ti­ta­tive eas­ing pro­gram.  One way to think of the money mul­ti­plier is as a sort of eco­nomic ther­mome­ter.  As long as the money mul­ti­plier is below 1x then the bank­ing sys­tem (includ­ing the effects of Fed­eral Reserve quan­ti­ta­tive eas­ing) is sick.  With­out Fed­eral Reserve emer­gency mea­sures the dis­eased bank­ing sys­tem would prob­a­bly have been sick enough to kill the rest of the econ­omy.  Sick banks shrink, delever­age and cut back on loans (which are riskier than own­ing Trea­sury secu­ri­ties and cash equiv­a­lents).  The money mul­ti­plier needs to be well above 1x for the bank­ing sys­tem to be able to sup­port eco­nomic growth. 

   

   All of the most com­monly watched mea­sures of bank lend­ing are trend­ing down (except for the pur­chase by banks of invest­ment secu­ri­ties which includes gov­ern­ment secu­ri­ties and cash equiv­a­lent secu­ri­ties).  The lend­ing trends are bad and sus­tained eco­nomic recov­ery isn’t hap­pen­ing until they start to look bet­ter.  More­over, non-financial com­mer­cial paper (a mea­sure of the shadow bank­ing sys­tem) isn’t look­ing very healthy either. 

   For those read­ers who aren’t con­ver­sant in Fed jar­gon, some of the below charts refer to MZM which is M2 minus small-denomination time deposits plus insti­tu­tional money mar­ket mutual funds. 

   All of the charts were com­piled by the St. Louis Fed­eral Reserve which has a great research web site and series of pub­li­ca­tions. 

2. What If The Fed’s Isn’t Printing Money Like A Drunken Sailor?

   June 12, 2009 2:48 pm 1 Comment

   What if con­ven­tional wis­dom about the Fed is wrong and it isn’t print­ing money like a drunken sailor? Well…that would make most of the media cov­er­age of the bond mar­ket and the econ­omy wildly off the mark.

   As it turns out while media talk­ing heads were rant­ing about how the Fed was run­ning their print­ing presses over­time to push up money sup­ply the facts were very dif­fer­ent. M1 has actu­ally declined since the mid­dle of Decem­ber, 2008. Dur­ing the same six month period M2 has only risen by a lit­tle less than 3%.

   For some rea­son that I can’t explain most finan­cial, eco­nomic and media experts don’t bother to read the Fed­eral Reserve’s weekly money sup­ply data before writ­ing author­i­ta­tive arti­cles or spout­ing off on TV about money sup­ply and its implications.

   Of course, M3 fol­low­ers argue that M1 and M2 are bad money sup­ply indi­ca­tors because they are too nar­row and that only M3 should be used to mea­sure the growth in money sup­ply. Unfor­tu­nately, the Fed stopped pub­lish­ing M3 a few years ago (because they said it was irrel­e­vant) which started a club of M3 con­spir­acy the­o­rists, i.e., peo­ple that believe the Fed stopped pub­lish­ing M3 as part of a con­spir­acy to hide irre­spon­si­ble mon­e­tary policy.

   How­ever, even with­out M3 being specif­i­cally pub­lished we know that broader mea­sures of money sup­ply, like M3, haven’t mate­ri­ally risen in 2009.

   M3 fol­low­ers can get a very rough idea of what M3 would have been, if it were pub­lished, by look­ing at the Fed­eral Reserve quar­terly Flow of Funds Accounts of the United States which was dis­trib­uted yes­ter­day. As it turns out, total net bor­row­ing of the United States (pri­vate and pub­lic) dropped approx­i­mately $255 bil­lion in the first quar­ter and other indi­ca­tors of M3 fell or are about flat (on a net basis). The Flow of Funds Accounts data is incon­sis­tent with a large rise in M3 (or a large rise in any money sup­ply mea­sure). By the way, this data sup­ports Brad Setser’s the­ory that the fall in pri­vate bor­row­ing is more than off­set­ting the rise in gov­ern­ment bor­row­ing and there­fore, at least for the time being, financ­ing the deficit isn’t a problem.

   And, I have a sug­ges­tion for the M3 con­spir­acy the­o­rists; get a life. Wor­ry­ing about a Fed­eral Reserve con­spir­acy isn’t worth your time and effort.

   Set forth below is a chart that was com­piled from weekly Fed­eral Reserve data that illus­trates money sup­ply growth, sea­son­ally adjusted, since the week end­ing Decem­ber 15, 2008. The data sug­gests that the Fed is hardly “out of con­trol” or a drunken sailor.

   

   To those read­ers who want to flame me for not accus­ing Bernanke & Com­pany of ruin­ing the econ­omy because of the growth in the Fed’s bal­ance sheet, just hang in there. You will get your chance soon enough. Over the week­end I am going to write about the “irre­spon­si­ble” expan­sion of the Fed­eral Reserve bal­ance sheet (or maybe why it wasn’t irre­spon­si­ble at all).

3. 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.

4. Sunshine Travel Log Blog – I Went Fishing And The Fed Slowed Money Supply Growth

   January 27, 2009 8:00 am Leave a Comment

   Last week­end I went fish­ing in Tokyo harbor.

   The below pic­ture is my friend Masura Ono with a really big fish that he caught on his boat. Ono-san is a famous lawyer in Tokyo. He is a senior part­ner at the largest law firm in Japan as well as a law pro­fes­sor at the Uni­ver­sity of Tokyo. But, most week­ends, Ono lives his dream which is to be the best fish­er­man in Japan.

    

   OK…so we didn’t catch that fish when we went out last week­end. But we could have if we tried (I guess).

   Instead, we went out on Ono-san’s boat (see below) and went on an eat­ing and drink­ing extravaganza.

   

   

   Below are some pic­tures of the foods that we ate at lunch. The raw squid def­i­nitely reminded me of “Squid­ward” from Sponge Bob Square Pants.

   

    

    

    

    

    

    

    

   

   

   While I was off in Tokyo boat­ing and fish­ing, the Fed­eral Reserve was qui­etly cut­ting back on the pace of mon­e­tary stim­u­lus. The rate of increase in money sup­ply growth (as mea­sured by sea­son­ally adjusted M1 and M2) has notice­ably slowed and a rough mea­sure of the Fed­eral Reserve’s bal­ance sheet has actu­ally shown shrink­age in recent weeks. The size of the Fed­eral Reserve bal­ance sheet is a proxy for qual­i­ta­tive eas­ing while the rate of growth in money sup­ply is a proxy for quan­ti­ta­tive easing.

   It isn’t sur­pris­ing that the Fed­eral Reserve is slow­ing down given the tor­rid pace of mon­e­tary eas­ing that took place from Sep­tem­ber through Decem­ber. The Fed­eral Reserve has to walk a mon­e­tary tightrope; too lit­tle eas­ing and the US could tum­ble into uncon­trolled defla­tion and a depres­sion while too much eas­ing will result in hyper­in­fla­tion and the destruc­tion of the Dollar’s posi­tion as the world’s reserve currency.

   Set forth below are some graphs that illus­trate the slow­down in mon­e­tary eas­ing by the Fed­eral Reserve. The source for all data was the Fed­eral Reserve’s weekly reports (Fac­tors Affect­ing Reserve Bal­ances – H.4.1 and Money Stock Mea­sures – H.6).

   As the below graphs illus­trates, while I was off gal­li­vant­ing in Asia, the Fed­eral Reserve stopped increas­ing M1 and actu­ally caused the amount of money (as mea­sured by M1) to drop. M1 is the Fed­eral Reserve’s most nar­rowly defined mea­sure of money sup­ply and is basi­cally cash and near cash equivalents.

    

   The pace of growth of M2 (a more broadly defined mea­sure of money sup­ply that includes most types of bank deposits) slowed to a more nor­mal pace of mon­e­tary eas­ing in January.

   

   

   And, the size of the Fed­eral Reserve’s bal­ance sheet actu­ally shrank in early 2009.

   

   The mon­e­tary data indi­cates a pause in the fre­netic pace of Fed­eral Reserve activity.

   Such pause doesn’t indi­cate restric­tive mon­e­tary pol­icy; quite the con­trary, mon­e­tary pol­icy con­tin­ues to be extremely accom­moda­tive and expan­sion­ary. The pause prob­a­bly indi­cates that the cur­rent phase of mon­e­tary stim­u­lus ran its course and the Fed­eral Reserve needs to reassess its cur­rent posi­tion and the effect of the stim­u­lus that it injected into the finan­cial sys­tem before doing more.

5. Money Supply And Economic Data Weekly Watch — How the Fed is Making Banks Lend

   December 19, 2008 8:04 pm 2 Comments

   The Fed­eral Reserve is forc­ing banks to lend or face finan­cial dis­as­ter. The Fed’s lat­est strat­egy gives banks the stark choice of lend­ing or los­ing a lot of money from oper­a­tions. Every­one knows the Fed cut its tar­get Fed­eral Funds rate to the bone this week. In a less obvi­ous move, the Fed is also forc­ing down rates on Trea­sury bonds and other secu­ri­ties. As a result, banks have the choice of buy­ing bonds that yield less than their cost of funds or lend­ing. Any bank that decides not to lend will suf­fer losses. Cash is trash and if banks don’t recy­cle it, they will slowly bleed to death.

   The Fed­eral Reserve is return­ing banks back to the lend­ing busi­ness in two ways.

   First, the Fed is pro­vid­ing banks with cash to lend by dra­mat­i­cally increas­ing money sup­ply. Newly cre­ated money becomes new deposits in banks. For the last 3 months, money sup­ply as mea­sured by M1 increased by an aston­ish­ing annual rate of 37.6%. The largest com­po­nents of M1 are cash deposits at banks and those com­po­nents are grow­ing very rapidly. The Fed is mak­ing sure that banks get A LOT of new cash to lend.

   In nor­mal times, banks gather cash by accept­ing deposits and then recy­cle their cash into loans. But, these aren’t nor­mal times and banks aren’t react­ing the way they have in the past. Instead of recy­cling cash into loans, banks have tried to avoid risk by recy­cling their cash into low risk bonds that are like cash equiv­a­lents. So, mon­e­tary eas­ing didn’t really do any­thing for the econ­omy because cash was recy­cled into cash look alike instru­ments rather than into loans. The bank­ing sector’s huge demand for cash equiv­a­lent invest­ments caused yields on short term Trea­sury and gov­ern­ment secu­ri­ties to drop to almost 0% (and was even neg­a­tive for brief peri­ods of time).

   This led the Fed to its sec­ond, less obvi­ous, strat­egy. The Fed has start­ing pur­chas­ing the cash equiv­a­lent invest­ments that banks are buy­ing and in the process dri­ving down yields. Banks are los­ing money on their for­merly safe invest­ments because their all-in cost of deposits is higher than the yield they are earn­ing from cash equiv­a­lent invest­ments. This is sim­i­lar to a retailer buy­ing inven­tory for $100 and then sell­ing it for $95. It isn’t a good busi­ness strat­egy. To make a pos­i­tive net inter­est spread between their all-in cost of deposits and their invest­ments, banks are being forced to lend. Loans to busi­nesses and con­sumers have high enough yields for banks to make a profit.

   Even when banks pay 0% inter­est to depos­i­tors if they don’t lend money they will lose money. Banks have a mar­ginal cost of hold­ing deposits that is much higher than the inter­est cost of 0%. Bank deposit costs include: oper­at­ing expenses, FDIC insur­ance, cost of equity and reg­u­la­tory com­pli­ance costs. These costs are gen­er­ally between 1% and 3%. And if banks accept deposits that are CD’s which have an inter­est rate of between 1.5% and 4.5%, their all-in cost of funds gets even higher.

   The types of invest­ments that the Fed is ini­tially tar­get­ing to drive down yields include Trea­sury secu­ri­ties, Fed­eral Funds, Agency bonds and Agency and gov­ern­ment guar­an­teed mort­gage backed secu­ri­ties. These invest­ments have his­tor­i­cally been con­sid­ered low to no risk invest­ments that are as good as cash. One by one, the Fed­eral Reserve is going to take away the hid­ing places that banks have used to avoid lending.

   While yields on low risk cash equiv­a­lent invest­ments are around 0%, the rate of inter­est that “real” bor­row­ers need to pay for new loans has remained high. Most real mea­sures of loan avail­abil­ity for busi­nesses and con­sumers indi­cate a con­tin­u­ing credit cri­sis, incred­i­ble risk aver­sion and a rel­a­tively high cost of bor­row­ing. It is into this lend­ing void that the Fed is dri­ving banks.

   How­ever, if banks con­tinue to avoid lend­ing to busi­nesses and con­sumers, the Fed is mak­ing sure that they will feel a lot of finan­cial pain. The Fed­eral Reserve has put banks between a rock and a hard place. Either they lend, or destroy their insti­tu­tion with a neg­a­tive inter­est spread and risk reg­u­la­tory dis­ci­pline. The Fed­eral Reserve has mor­phed the strat­egy of hoard­ing cash equiv­a­lent invest­ments into a very risky decision.

   The Fed’s inno­v­a­tive approach goes far beyond the “qual­i­ta­tive eas­ing” that bankers and econ­o­mists were expect­ing. Some­time in the next few weeks, after cor­po­rate plan­ning staffs and con­sul­tants grind out mod­els and analy­sis, it is going to dawn on bankers that they have to par­tic­i­pate in the eco­nomic recov­ery by lend­ing. The Fed’s two-pronged strat­egy will get banks lend­ing again. And, with fis­cal stim­u­lus from the new Obama Admin­is­tra­tion, the econ­omy will respond sooner than most peo­ple expect.

6. Money Supply And Economic Data Weekly Watch – Living in the Twilight Zone

   December 15, 2008 8:26 am Leave a Comment

   We’ve entered the twi­light zone. This week’s money sup­ply and eco­nomic data is surreal.

   Money sup­ply is grow­ing at an unbe­liev­able pace. As mea­sured by sea­son­ally adjusted M1 and M2, the Fed announced that money sup­ply set new all time records. The quick rate of growth for money sup­ply is actu­ally accel­er­at­ing. Over the last 13 weeks, sea­son­ally adjusted M1 has grown at a 25.3% annual rate, while sea­son­ally adjusted M2 has grown at a 10.5% annual rate. If the econ­omy wasn’t already suf­fer­ing from defla­tion, a liq­uid­ity trap and a poten­tial depres­sion, money sup­ply growth would have already caused rag­ing infla­tion. Instead, money sup­ply growth is dis­tort­ing invest­ment deci­sions as demon­strated by Trea­sury secu­ri­ties trad­ing at bizarre neg­a­tive inter­est rates.

   Qui­etly, the Fed­eral Reserve enlarged its bal­ance sheet by more than $123 bil­lion last week. A few months ago, this news would have made the head­lines and could have trig­gered Con­gres­sional Hear­ings and rit­ual sui­cide by infla­tion hawks. Instead, no one seems to have noticed or cared.

   Fed­eral Funds traded as low as 0.1% despite a tar­get rate of 1.00%. While no one knows what the tar­get Fed­eral Funds Rate means any­more, every­one expects the Fed to lower its tar­get again at its meet­ing this week.

   Almost all of last week’s data was bad except for retail sales, which tem­porar­ily halted its down­ward spi­ral. This indi­cates that sooner or later peo­ple will buy things when the Fed pushes money at them.

   While the auto­mo­bile bailout deal died in the Sen­ate and the entire world is on Big 3 death watch, that news was pushed off the front page by the hor­rific losses cre­ated by Marc Dreier and Bernie Mad­off. I am hop­ing that as long as I live noth­ing will top these frauds. With global ram­i­fi­ca­tions, Mad­off announced that he evap­o­rated more than $50 bil­lion of value. As the Mad­off losses rip­ple through the global econ­omy, what lit­tle con­fi­dence remains in the finan­cial sys­tem will dissolve.

   The once in a cen­tury grand prize for incom­pe­tence goes to Chris Cox and the SEC. It is the pri­mary reg­u­la­tor of Mad­off Secu­ri­ties and some­how didn’t notice that $50 bil­lion of secu­ri­ties were miss­ing. If the SEC can miss the Mad­off fraud in an entity that they closely reg­u­late, what sort of fraud will they catch? What do they do with their time and budget?

   I wish I could over­state how bad I think last week’s news was, but I can’t. The defla­tion can­cer con­tin­ues to grow and the side effect of the cure appears to be hyper inflation.

   I remain skep­ti­cal of Fed and Trea­sury state­ments that this econ­omy is dif­fer­ent from the Depres­sion. These are the same pub­lic offi­cials that told us just before Bear Stearns folded that all was well. They have been behind the curve for the last 18 months and I don’t see any sign of them catch­ing up. Pres­i­dent Elect Obama takes office soon and hope­fully his admin­is­tra­tion will pro­vide the lead­er­ship, plan­ning and com­mon sense that have been miss­ing in recent years.

   Vice Pres­i­dent Cheney summed it up best when he said to Con­gres­sional Repub­li­cans that it’s “Her­bert Hoover time”.

   Yes, we’re liv­ing in the twi­light zone.

7. Money Supply And Economic Data Weekly Watch – Deflation Hurts The Economy Like Hydrochloric Acid Burns Through Steel

   December 6, 2008 4:12 pm 1 Comment

   Defla­tion hurts the econ­omy like hydrochlo­ric acid burns through steel. Falling prices destroy cor­po­rate and house­hold bal­ance sheets and make it impos­si­ble for the finan­cial sec­tor to func­tion nor­mally. Demand is destroyed by defla­tion which in turn leads to more defla­tion. The weak­est sec­tors are hurt first, but defla­tion quickly burns through healthy indus­tries. This week’s eco­nomic news is a real life les­son in what defla­tion will do to the econ­omy and why it must be stopped at all costs by the Fed­eral Reserve and the incom­ing Obama administration.

   The morning’s busi­ness head­lines stated “10 Per­cent of U.S. Homes in Finan­cial Jeop­ardy”. The fall in hous­ing prices, i.e., hous­ing defla­tion, destroyed the bal­ance sheets of mil­lions of house­holds which in turn caused mort­gage delin­quen­cies and defaults. The cat­a­strophic losses in the bank­ing sec­tor are a rip­ple effect of hous­ing defla­tion. While house­holds were finan­cially over-extended and should have had less mort­gage debt, deflation’s first vic­tims are always the weak­est and sub-prime bor­row­ers are by def­i­n­i­tion on the eco­nomic fringe of sol­vency. Con­sumer demand was destroyed by falling home prices which hurt fam­ily wealth and made indi­vid­u­als unable or unwill­ing to con­tinue spending.

   The rip­ple effect of hous­ing defla­tion hit the over­lever­aged finan­cial sec­tor like an eco­nomic tsunami. Even with high delin­quen­cies and defaults, if house prices hadn’t declined, lend­ing losses would have been much lower because lenders would have recov­ered most of their invest­ment when they sold fore­closed homes. Home price defla­tion made fore­clo­sure a los­ing propo­si­tion and made the losses big­ger. The bank­ing sector’s past year would have been a bad dream if hous­ing defla­tion hadn’t occurred.

   The Big 3 auto­mo­bile man­u­fac­tur­ers’ prob­lems are a “rip­ple effect” of the hous­ing cri­sis and falling con­sumer demand. Of course decades of mis­man­age­ment made the Big 3 vul­ner­a­ble. But, even with­out their well doc­u­mented short­com­ings, the Big 3 would be in big trou­ble. Auto­mo­bile man­u­fac­tur­ers have large fixed costs and can’t sur­vive the 35% drop in sales (domes­tic and imported) that has occurred. With­out sales to off­set fixed over­head costs, it is inevitable that the Big 3 will fail sooner or later. In fact, few man­u­fac­tur­ing com­pa­nies can sur­vive both col­laps­ing sales and falling prices. If the trend con­tin­ues, the next “shoes to drop” will be sup­pli­ers to the auto­mo­bile indus­try includ­ing logis­tics com­pa­nies, parts sup­pli­ers and raw mate­ri­als producers.

   Retail­ers are drop­ping like flies after the first frost. Novem­ber retail sales were posted this week and showed the biggest monthly drop in 30 years. Falling retail sales are evi­dence of col­laps­ing con­sumer demand that started with hous­ing defla­tion. Prices are falling and traf­fic is down at most retail­ers. If retail sales don’t pick up in the near future, many more retail bank­rupt­cies will occur. Retail bank­rupt­cies will destroy other indus­tries such as com­mer­cial real estate, logis­tics, man­u­fac­tur­ing, adver­tis­ing, media and pack­ag­ing. And, of course, the bank­ing sec­tor will face more losses as retail­ers go broke and lay off workers.

   Oil prices closed the week at around $40 per bar­rel which is a 4 year low. Assum­ing the cur­rent trends con­tinue, soon bank­rupt­cies are going to start in energy and energy related indus­tries. And, since many farm com­mod­ity prices are tied to energy prices, large scale busi­ness fail­ures in the food sup­ply chain are likely. This week’s bank­ruptcy of Pilgrim’s Pride, a poul­try grower, is an exam­ple of what hap­pens when prices and demand col­lapse. Pilgrim’s Pride paid for feed dur­ing the sum­mer at record prices and then when it tried to sell its chick­ens and turkeys in the late fall it was ham­mered by falling prices and col­laps­ing demand. Every turkey that Pilgrim’s Pride sold this thanks­giv­ing was prob­a­bly sold at a loss. Of course Pilgrim’s Pride was finan­cially weaker than its com­peti­tors, but that is how defla­tion works; it picks off the weak­est first as it burns its way through the economy.

   Other sec­tors of the econ­omy that are being destroyed by falling prices and weak demand include edu­ca­tion, leisure, trans­porta­tion and any­thing relat­ing to dis­cre­tionary spend­ing. It won’t be long before every­one feels the cor­ro­sive effects of the defla­tion­ary spiral.

   The prob­lem is that defla­tion tends to cre­ate a self per­pet­u­at­ing and rein­forc­ing cycle. As new rounds of bank­rupt­cies and busi­ness fail­ures occur wealth is ruined, work­ers are laid off and demand for goods and ser­vices are destroyed. Falling demand causes falling prices which starts a new round of bank­rupt­cies and busi­ness failures.

   The Fed­eral Reserve is work­ing over­time to break the cycle and stop defla­tion. They are increas­ing money sup­ply at a very rapid pace as sea­son­ally adjusted mea­sures of money sup­ply (both M1 and M2) hit new all time records. For the last 13 weeks sea­son­ally adjusted M1 increased at the blis­ter­ing pace of 22.6% and sea­son­ally adjusted M2 increased by an amaz­ing 9.2%. Nor­mally, this rate of money sup­ply growth would cre­ate hyper demand, hyper growth and hyper infla­tion. How­ever, the econ­omy is in reces­sion because banks and house­holds are hoard­ing cash. Demand for goods and ser­vices is falling, growth is neg­a­tive and defla­tion is accelerating.

   The cure for the defla­tion­ary spi­ral is large scale spend­ing by gov­ern­ment. The Fed­eral Reserve by itself can’t stop the hoard­ing of money and can­not force demand to increase. Bernanke needs the Pres­i­dent to be his part­ner by stim­u­lat­ing the econ­omy through Fed­eral spend­ing. The spend­ing needs to be tar­geted at increas­ing demand by hav­ing gov­ern­ment pur­chase goods and ser­vices and doing it quickly. Soon we will find out if the Obama Admin­is­tra­tion is going to rise to the chal­lenge and be the part­ner that the Fed needs to stop the cor­ro­sive effects of deflation.