Tag: finance

The contrast of the past week has been telling. In the U.S., you’ve had the yawn-fest otherwise known as the debt ceiling debate. All too predictably, the Republicans caved because their politicians will be up for re-election soon enough whereas Obama won’t be (he can only serve two terms). It wasn’t hard to work out the endgame in advance, despite all the hoopla, and the markets nailed it from day one.

What’s received far less attention is the rise of the Chinese yuan to a 20-year high versus the U.S. dollar. That’s big news, comparable to the U.S. debt ceiling resolution. And it may have a hugely beneficial impact not only on China, but the rest of the world.

The reason for this is that significant yuan undervaluation was one of the key drivers behind the 2008 financial crisis. It allowed China to become an exporting powerhouse. For that to happen though, China needed willing consumers for its exported goods and it found them in developed markets, particularly the U.S. Given stagnant real incomes, American consumers were only too happy to rack up debts to pay for these goods. And those debts eventually brought the U.S., and the world, unstuck.

Now China is actively pursuing a strong yuan policy. The reason that it’s doing this is because the country’s exporters are strong enough to withstand a higher yuan. And more importantly, China knows that it needs to re-balance its economy, which has been over-reliant on exports at the expense of consumption. A stronger currency promotes consumption as it allows the Chinese to import cheaper foreign goods and enjoy less expensive overseas holidays.

A rising yuan is not only good for China though. It also goes a long way to removing a central problem in global trade: that of a significant trade imbalance between China and America.

Today I’m going to further explore why a rising yuan is such a big deal. But also why it isn’t a cure-all for China’s problems, or the world’s for that matter. The development should be welcomed though as genuinely good news in an otherwise downbeat global economic environment.

Economic fault lines

At the outset, I must confess something: I’ve developed a bit of a man-crush. It’s embarrassing because I’m not naturally inclined to put people up on a pedestal. But India’s new central bank chief Raghuram Rajan deserves many of the accolades which he’s already received.

Rajan is relevant to the discussion because of his book, Fault Lines, published in 2011. Reading through the book this week, it does a great job of outlining the underlying issues which caused the financial crisis and remain threats to the world economy today.

For those that don’t know, Rajan is famous for warning of impending economic problems at the glamorous (at least by economist standards) Jackson Hole conference in 2005. His speech went down like a lead balloon then as Alan Greenspan was still at the height of his powers and the world could seemingly do no wrong. Or at least that’s what everyone thought, bar Rajan.

Anyhow, the book details a number of the key threads from the 2005 speech. It suggests that there were four primary causes for the 2008 crisis:

• Rising inequality and the push for housing credit in the U.S.
• Export-led growth and dependency of several countries including China, Japan and Germany.
• A clash of cultures between developed and developing countries.
• U.S central bank policy pandering to political considerations by focusing on jobs and inflation at any cost.

The first cause is fascinating as it’s one that few people have focused on. Rajan suggests that rising income inequality in America created the political pressure to push easy credit conditions. Everyone knows of the increasing inequality in the U.S. but Rajan has a unique take on it, placing the blame on a poor education system and inadequate social safety nets.

Technological progress has meant that the labor force requires ever-greater skills which the U.S. education system has been unable to provide. That’s resulted in stagnant paychecks for the middle class and growing job insecurity. Politicians have felt the pain of their constituents but fixing the education system is a long-term solution which they’ve been unwilling to promote. Instead, they’ve opted for short-term fixes. Namely, they created the conditions for easier credit so their constituents could afford things via debt which they couldn’t afford via their own incomes. That ultimately contributed to the subprime and housing crisis.

This brings us to the second cause for the 2008 meltdown: the export-led growth of several countries including China. Normally, debt-fueled consumption in the likes of the U.S. would push up prices and inflation there. Then the central bank would have to raise rates to stem the consumption.

But what happened prior to 2008 was that increased U.S. household consumption was met by exporters from abroad. China, Japan and Germany needed other countries to consume their excess supply of goods and the U.S. came to the party. It was a win for the exporters and a win for the U.S. as it kept a lid on inflation. That is until high household indebtedness in the U.S. limited further demand growth and everything eventually unraveled.

Rajan describes the third cause of the crisis as a “clash of systems”. Here, he examines what pushed many developing countries towards export-oriented economic models. And he suggests the 1997 Asian crisis played a key role.

Prior to the this crisis, Asian countries weren’t net exporters. Yes, they produced exports sold overseas. But their strong growth entailed substantial investment in machin
ery and equipment, often imported from the likes of Germany. That meant they often ran trade deficits, having to partially fund their investments via borrowing from abroad.

The financing for the investment mainly came from the developed world. Given the lack of transparency in many Asian countries, these financiers were only willing to lend on a short-term basis. When trouble hit, that short-term financing evaporated. And the Asian crisis ensued.

Due to the crisis, Asian countries decided to cut back on debt-fueled investment. Instead, they focused on boosting exports by maintaining undervalued currencies. In other words, they went from being net importers to substantial net exporters, thereby creating the conditions for a global glut in goods.

Finally to the fourth cause of the 2008 downturn. Rajan says U.S. central bank policy poured fuel on the flames. The bank pandered to politicians wishes by keeping interest rates too low for too long. They did this to maintain high employment, one of the bank’s two central mandates. Note that keeping people in jobs was critical to assuage the masses given the stagnant incomes and inadequate social safety nets in the U.S. But low interest rates, ably aided by greedy financiers, helped create the credit bubble.

Rajan believes the four underlying causes for the 2008 crisis are still with us today and they need to be addressed if we’re to avoid further trouble.

Let’s now draw the discussion back to the significance of a rising yuan.

The impact on China

The undervaluation of the Chinese yuan didn’t only contribute to the global problems which precipitated 2008. It also created enormous issues within China itself, many of which are still with us.

I’ve argued previously that China’s 50% devaluation of the yuan in 1994 was a critical event in recent economic history. It was one of several devaluations and resulted in a significantly undervalued yuan. That undoubtedly aided in China becoming the world’s largest exporter. The country’s entry into the World Trade Organisation in 2001 also kicked things along.

But an undervalued yuan created a long list of problems for China, including:

1. An over-reliance on investment and exports at the expense of consumption. An undervalued yuan meant more expensive imports and more expensive overseas holidays, among other things.
2. Negative real interest rates. Keeping an undervalued currency via a peg to the dollar meant sterilising excess yuan creation and maintaining rates below the dollar interest rate in order to avoid huge losses on dollar reserves. That pushed people out of low-yield bank deposits into stocks and property, creating bubbles in these areas.
3. A side effect from the policies was that state-owned banks tended to lend mainly to state-own businesses as they were deemed less risky. This starved the private sector of funds and ultimately made them less competitive. It also led to alternative financing, such as the recent phenomenon of “wealth management” products.

These issues haven’t disappeared. Far from it. But the underlying issue – an undervalued yuan – is being addressed.

Welcoming a rising yuan

The above provides some context to the yuan rising to 20-year highs versus the U.S. dollar over the past week. It represents a dramatic change in Chinese policy. The country’s leaders know that the export-led economic model which has powered China over the past two decades isn’t sustainable. A stronger yuan will help re-balance the economy, with consumption becoming a larger contributor to growth.

Chinese leaders are also in the process of addressing other related issues. You should to see more on this at a key meeting of Communist Party leaders next month.

As I outlined in a previous post, likely reforms at this meeting include:

1. The central government taking over key expenditure functions of local governments, including social security, compulsory education and parts of healthcare. The thinking is that there’s a substantial skew in revenue and expenditures of central and regional governments. Currently, local governments account for 52% of total fiscal revenue but 85% of expenditure. Spending at the local government level has spiked from 46% of total to the current 85%. That’s why these local governments have had to borrow money and why they’ve resorted to off-balance sheet vehicles.
2. Local governments at the provincial level being allowed to issue bonds. And this financing will replace the problematic local government finance vehicle (LGFV).
3. Financial liberalisation – interest rate liberalisation and RMB internationalisation.
4. Hukou (resident-ship reform) being opened to small and medium-sized cities as well as a relaxation of the one-child policy.

A stronger yuan and related reforms can help put China on a more sustainable economic path. But it can also assist the global economy. With China consuming more of its production, that may mean less goods being sent overseas. That could go some way to addressing the current oversupply in goods. In other words, it could remove a key impediment to a global economic recovery.

More work to be done

All of this isn’t to suggest that China is out of the woods . It isn’t. For instance, the GDP figures of the past week show that debt-funded investment remains the key driver to growth. That needs to change and further reform is required.

I’m not as optimist
ic as some commentators are that the transition to a new economic model will happen fast enough to prevent serious short-term pain for China. But I’m not as pessimistic as others who suggest China will go the way of Japan, which encountered similar issues as a dominant exporter in the 1980s but failed to re-balance its economy. It’s likely that China still has some time to avoid the fate of Japan.

And though a rising yuan reduces some of the global economic imbalances highlighted by Rajan, significant imbalances still remain. Japan is trying to export its way out of deflation by turning the yen into toilet paper. Germany is also committed to its export-oriented model. That means the global supply glut is unlikely to rapidly diminish, even if Chinese export growth slows from a higher yuan.

At the other end of the spectrum, reform in the U.S. is as elusive as ever. Central bankers there seem determined to reflate debt-driven consumerism. The politicians are happy to go along with this as it placates disgruntled voters, whose real wages haven’t risen over the past 20 years and worry about losing their jobs. The debt ceiling debate largely ignored these inconvenient truths.

In sum, the world’s economic problems remain acute but a stronger yuan is a welcome step forward.

This post was originally published at Asia Confidential:
http://asiaconf.com/2013/10/19/china-is-embracing-bold-reform/

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/0XDNTHksGy4/story01.htm Asia Confidential

Presented with no comment…

 

(h/t @Not_Jim_Cramer)

Source: Compete.com and Mars One Foundation

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/dwuKCdVEQjo/story01.htm Tyler Durden

Presented with no comment…

 

(h/t @Not_Jim_Cramer)

Source: Compete.com and Mars One Foundation

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/dwuKCdVEQjo/story01.htm Tyler Durden

Submitted by Lance Roberts of STA Wealth Management,

 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/rQu3lfzDhrc/story01.htm Tyler Durden

While it has been a stretch to call Bernanke’s post-2009 experiment in “wealth-effect” central planning (where in 2013 the Russell 2000 has outperformed the composite hedge fund by a factor of over 500%!) a “market”, here are some of the latest market thoughts by Goldman’s David Kostin.

US stocks surged to an all-time high of 1745 following the debt accord. The S&P 500 has returned 22% YTD driven almost entirely by P/E multiple expansion rather than higher earnings.

In other words, there has been zero actual bottom line improvement in 2013. Zilch. Nada. All this despite so many loud promises by every pundit in late 2012 that 2013 will be the year of the turn, just wait, you’ll see. It also means there has been zero “fundamental” component to the upside. All of it is multiple expansion. What’s another name for that? Why, “the Fed.”

Bearishly inclined investors will point to the cyclically-adjusted P/E ratio popularized by newly-crowned Nobel laureate Robert Shiller that suggests the S&P 500 is roughly 30% overvalued based on 10-year trailing average reported EPS.

“30% overvalued” by a person who just won the Nobel prize for saying the market is irrational and creates bubbles? You don’t say. Why is a perfect segue into the final Goldman notice:

We forecast the index will climb to 1750 by year-end 2013, a slim advance less than 1% above today’s level. Our year-end 2014 price target remains 1900 or 9% above the current level. S&P 500 trades at 2.6x price/book value. From a valuation perspective, the index level is consistent with the market’s current return on equity (ROE) of 15.5%, and in-line with the 35-year average P/B.

To summarize Goldman:

• All upside is multiple expansion-driven, i.e. relentless Fed pumping of risks as the final bubble grows to unprecedented proportions,
• A market which even tenured economists say is a disaster waiting to happen.
• But hey, the music is still playing so everyone must dance all the way until Goldman’s 2100 target… in 2015.

All of this has come and gone before, but since this time will be different, one can just ignore the recurring past.

And, finally, some charts:

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/iGCUwpbBu0Y/story01.htm Tyler Durden

While it has been a stretch to call Bernanke’s post-2009 experiment in “wealth-effect” central planning (where in 2013 the Russell 2000 has outperformed the composite hedge fund by a factor of over 500%!) a “market”, here are some of the latest market thoughts by Goldman’s David Kostin.

US stocks surged to an all-time high of 1745 following the debt accord. The S&P 500 has returned 22% YTD driven almost entirely by P/E multiple expansion rather than higher earnings.

In other words, there has been zero actual bottom line improvement in 2013. Zilch. Nada. All this despite so many loud promises by every pundit in late 2012 that 2013 will be the year of the turn, just wait, you’ll see. It also means there has been zero “fundamental” component to the upside. All of it is multiple expansion. What’s another name for that? Why, “the Fed.”

Bearishly inclined investors will point to the cyclically-adjusted P/E ratio popularized by newly-crowned Nobel laureate Robert Shiller that suggests the S&P 500 is roughly 30% overvalued based on 10-year trailing average reported EPS.

“30% overvalued” by a person who just won the Nobel prize for saying the market is irrational and creates bubbles? You don’t say. Why is a perfect segue into the final Goldman notice:

We forecast the index will climb to 1750 by year-end 2013, a slim advance less than 1% above today’s level. Our year-end 2014 price target remains 1900 or 9% above the current level. S&P 500 trades at 2.6x price/book value. From a valuation perspective, the index level is consistent with the market’s current return on equity (ROE) of 15.5%, and in-line with the 35-year average P/B.

To summarize Goldman:

• All upside is multiple expansion-driven, i.e. relentless Fed pumping of risks as the final bubble grows to unprecedented proportions,
• A market which even tenured economists say is a disaster waiting to happen.
• But hey, the music is still playing so everyone must dance all the way until Goldman’s 2100 target… in 2015.

All of this has come and gone before, but since this time will be different, one can just ignore the recurring past.

And, finally, some charts:

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/iGCUwpbBu0Y/story01.htm Tyler Durden

Submited by Charles Hugh Smith from Of Two Minds

The Poverty Of Our Political Theater Of The Absurd  

The public sphere has been effectively stripped of everything but corny, irritatingly hammy political theater.

All we have left in the U.S. is a deeply impoverishing Political Theater of the Absurd. Policy, theory and governance have all been reduced to competing stage performances in the Theater of the Absurd. The actors are transparently given to farcical overacting in exaggerated dramas drained of meaning; they proceed through the cliched motions as if the audience hadn’t seen the same charades overplayed dozens of times before.

“Government shutdown” and “debt ceiling” may have engaged audiences starved for entertainment in a bygone age, but now they exemplify a theater that is so impoverished it can only re-stage tired formulaic dramas with a savage appetite for incompetence and buffoonery.

The poverty of this substitution of theater for actual ideas is best displayed by ObamaCare. The entire complex edifice of ObamaCare is not an expression of policy–it is simply the perfection of state complicity with a private cartel that increases its share of the national income regardless of which set of bad actors are on stage.

As for the alternative “policy,” it is nothing but a reversion to the pre-ObamaCare cartel-state arrangement that artlessly combines gross injustice, insensitivity to cost and insane incentives for fraud, skimming, defensive medicine and the pursuit of national chronic ill health as the most profitable state of existence.

That these two variations on state-cartel predation pass for “policy” is a clear indication of the absolute impoverishment of American political/social/economic ideas. We are adrift in a political order that glorifies and rewards overacted farce and punishes policy grounded in actual ideas rather than the theatrical trends of the day.

The public sphere has been effectively stripped of everything but corny, irritatingly hammy political theater. The players, bereft of talent and inspiration, chosen for their blind obedience to those benefiting from the eradication of ideas and the replaying of tiresome charades, are blind to the poverty of their performance and political theatrics.

Will the audience ever tire of this cheesy Theater of the Absurd? It seems the appetite of the American public for this sort of play-acting entertainment is essentially bottomless. As a result, so too is our poverty.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/hWfziOUP5z4/story01.htm Tyler Durden

The re-opening of the US government after a 16-day shutdown sparked a sell-off in the US dollar that has deteriorated the near-term technical outlook.  The combination of setting the stage for a repeat of the brinkmanship in early 2014 and the recognition that the Fed’s long-term asset purchases are unlikely to be slowed this year, provides the fundamental backdrop.  

 

The prospect of unabated asset purchases by the Federal Reserve favor risk assets.  It will likely reinforce the flow into Spanish and Italian assets, and European distressed asset more broadly, including Greek bonds and stocks.   The recovery in emerging markets can continue, even if more selectively.  Here, South Korea, Taiwan and India have stood out in recent weeks. 

 

Another key characteristic of the price action is the continued decline in implied volatility.  The 3-month implied euro volatility has fallen to new six-year lows even as the euro appeared to break out of its month long consolidation range.  Implied yen volatility has fallen below 10% for the first time since January.  It peaked near 16.4% in June.  

 

The implied volatility of the other major currencies is also trending lower.  The implied volatility of sterling is approaching 5-month lows it falls through 7%.   Near 8%, three-month implied Aussie volatility is at the lowest level since mid-May and the 5.5% implied volatility of the Canadian dollar has not been seen since mid-year.  To the extent that risk is defined as volatility, the lower implied currency volatility is conducive to greater risk taking and a reduced need (and cost) to hedge.    

 

The euro is approached the year’s high, set in early February near $1.3711, though stopped just shy of it.  Assuming this is breached next week, the next target is near $1.40.  The main caveat from our technical analysis is that the euro closed above the top of its Bollinger Band (two standard deviations above the 20-day moving average) two consecutive sessions at the end of last week.  

 

Even though the returns in the foreign exchange market are not normally distributed,  arguably undermining the value of such concepts as standard deviations in the first, it is still a rare occurrence. It did take place this year in June and September and although neither time marked a significant high, there was at least a cent pullback.  This would seem to argue against chasing the euro at the start of the week and look for a pullback into the $1.3590-$1.3615 area as a lower risk buying opportunity.  

 

Sterling does not appear as over-extended as the euro, but its gains do not appear to have been confirmed by the Relative Strength Index.  The high set at the start of the month near $1.6260 is the next immediate target, and over the slightly longer term, potential extends toward $1.6400.  We peg initial support near $1.6100 and $1.6060.  

 

The dollar is making a third lower high against the yen since peaking in late-May near JPY103.75.  The dollar briefly poked through JPY99.00 on October 17, then it reversed lower and closed below the previous day’s low.  Follow through selling was seen the next day and the greenback finished the week at six-day lows.  The market appears to be set to re-test the 200-day moving average that had been successfully tested on the October 7-9.  It is found near JPY97.15.  Below there, the JPY96.50-70 band is reasonable near-term objective.   Lending credence to this negative dollar-yen view, the US interest rate premium over Japan has slipped below 200 bp to its lowest level in nearly three weeks.  

 

The price action at the end of last week also negated the bottoming pattern that the dollar had appeared to be carving out.  The low for the year was set on October 3 near CHF0.8970 and although the dollar held just above there before the weekend, near-term potential extends toward CHF0.8880-CHF0.8930.  That said, the Swiss franc many under-perform in the period ahead as some will prefer it as the short-leg of carry positions, especially against the Australian and New Zealand dollars. 

 

The US dollar posted an outside up-day against the Canadian dollar on Tuesday, only to reverse lower Wednesday and experience follow through selling into the weekend.  Still, the Canadian dollar was the worst performing of the major currencies last week, gaining only 0.6% against the greenback.  A break of the CAD1.0270 area could signal a move toward CAD1.02.  

 

However, the Canadian dollar still looks poised to lag behind the other dollar-bloc currencies.   The other dollar-bloc currencies are in strong uptrends against the Canadian dollar and these moves still appear to have room to run.  The Australian dollar is testing the CAD0.9945 area and, a convincing break, could signal a move toward CAD1.0125.  For its part, the New Zealand dollar is set to test the year’s high near CAD0.8780, which is also an eight-year high.  A convincing break suggests technical potential toward CAD0.9000.  

 

The Australian dollar, like the euro, finished the last week with two consecutive closes above the top of the Bollinger band.    This has not taken place since April and marked an important high.  While this time is seems different, rather than chase the Aussie higher, look for momentum players to buy into a half to a full cent decline.  The next immediate objective is near $0.9715 area, which corresponds to a 50% retracement of the decline since the April high, and then $0.9800.     

 

The Mexican peso has appreciated by about 4.4% against the US dollar since October 3.  However, the inside trading day record on October 18 may suggest a near-term consolidation phase lies ahead.  With a base near MXN12.75, the dollar can rise toward MXN12.93 initially.  The MXN13.00 area may provide a stronger cap.  Expectations of building for a rate cut at the end of next week.  We note that the other two times that the central bank has cut interest rates this year, the peso has rallied in response.  

 

Due to the government shutdown, the Commitment of Traders report on positioning in CME currency futures is still unavailable. 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/dC2wMQ1uHrQ/story01.htm Marc To Market

Authored by Lacy Hunt via Casey Research,

The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation; the Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. In the late 1970s and early 1980s, rampant inflation was again brought under control by a determined and persistent Federal Reserve.

However, when an economy is excessively over-indebted and disinflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness. 

Four considerations suggest the Fed will continue to be unsuccessful in engineering increasing growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP):

• First, the Fed's forecasts have consistently been too optimistic, which indicates that their knowledge of how LSAP operates is flawed. LSAP obviously is not working in the way they had hoped, and they are unable to make needed course corrections.
• Second, debt levels in the U.S. are so excessive that monetary policy's traditional transmission mechanism is broken.
• Third, recent scholarly studies, all employing different rigorous analytical methods, indicate LSAP is ineffective.
• Fourth, the velocity of money has slumped, and that trend will continue—which deprives the Fed of the ability to have a measurable influence on aggregate economic activity and is an alternative way of confirming the validity of the aforementioned academic studies.

1. The Fed does not understand how LSAP operates

If the Fed were consistently getting the economy right, then we could conclude that their understanding of current economic conditions is sound. However, if they regularly err, then it is valid to argue that they are misunderstanding the way their actions affect the economy.

During the current expansion, the Fed's forecasts for real GDP and inflation have been consistently above the actual numbers. Late last year, the midpoint of the Fed's central tendency forecast projected an increase in real GDP of 2.7% for 2013—the way it looks now, this estimate could miss the mark by nearly 50%.

One possible reason why the Fed have consistently erred on the high side in their growth forecasts is that they assume higher stock prices will lead to higher spending via the so-called wealth effect. The Fed's ad hoc analysis on this subject has been wrong and is in conflict with econometric studies. The studies suggest that when wealth rises or falls, consumer spending does not generally respond, or if it does respond, it does so feebly. During the run-up of stock and home prices over the past three years, the year-over-year growth in consumer spending has actually slowed sharply from over 5% in early 2011 to just 2.9% in the four quarters ending Q2.

Reliance on the wealth effect played a major role in the Fed's poor economic forecasts. LSAP has not been able to spur growth and achieve the Fed's forecasts to date, and it certainly undermines the Fed's continued assurances that this time will truly be different.

2. US debt is so high that Fed policies cannot gain traction

Another impediment to LSAP's success is the Fed's failure to consider that excessive debt levels block the main channel of monetary influence on economic activity. Scholarly studies published in the past three years document that economic growth slows when public and private debt exceeds 260% to 275% of GDP. In the U.S., from 1870 until the late 1990s, real GDP grew by 3.7% per year. It was during 2000 that total debt breached the 260% level. Since 2000, growth has averaged a much slower 1.8% per year.

Once total debt moved into this counterproductive zone, other far-reaching and unintended consequences became evident. The standard of living, as measured by real median household income, began to stagnate and now stands at the lowest point since 1995. Additionally, since the start of the current economic expansion, real median household income has fallen 4.3%, which is totally unprecedented. Moreover, both the wealth and income divides in the U.S. have seriously worsened.

Over-indebtedness is the primary reason for slower growth, and unfortunately, so far the Fed's activities have had nothing but negative, unintended consequences.

3. Academic studies indicate the Fed's efforts are ineffectual

Another piece of evidence that points toward monetary ineffectiveness is the academic research indicating that LSAP is a losing proposition. The United States now has had five years to evaluate the efficacy of LSAP, during which time the Fed's balance sheet has increased a record fourfold.

It is undeniable that the Fed has conducted an all-out effort to restore normal economic conditions. However, while monetary policy works with a lag, the LSAP has been in place since 2008 with no measurable benefit. This lapse of time is now far greater than even the longest of the lags measured in the extensive body of scholarly work regarding monetary policy.

Three different studies by respected academicians have independently concluded that indeed these efforts have failed. These studies, employing various approaches, have demonstrated that LSAP cannot shift the Aggregate Demand (AD) Curve. The AD curve intersects the Aggregate Supply Curve to determine the aggregate price level and real GDP and thus nominal GDP. The AD curve is not responding to monetary actions, therefore the price level and real GDP, and thus nominal GDP, are stuck—making the actions of the Fed irrelevant.

The papers I am talking about were presented at the Jackson Hole Monetary Conference in August 2013. The first is by Robert E. Hall, one of the world's leading econometricians and a member of the prestigious NBER Cycle Dating Committee. He wrote, "The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level."

Dr. Hall also wrote the following about the large increase in reserves to finance quantitative easing: "An expansion of reserves contracts the economy." In other words, not only have the Fed not improved matters, they have actually made economic conditions worse with their experiments. Additionally, Dr. Hall presented evidence that forward guidance and GDP targeting both have serious problems and that central bankers should focus on requiring more capital at banks and more rigorous stress testing.

The next paper is by Hyun Song Shin, another outstanding monetary theorist and econometrician and holder of an endowed chair at Princeton University. He looked at the weighted-average effective one-year rate for loans with moderate risk at all commercial banks, the effective Fed Funds rate, and the spread between the two in order to evaluate Dr. Hall's study. He also evaluated comparable figures in Europe. In both the U.S. and Europe these spreads increased, supporting Hall's analysis.

Dr. Shin also examined quantities such as total credit to U.S. non-financial businesses. He found that lending to non-corpora
te businesses, which rely on the banks, has been essentially stagnant. Dr. Shin states, "The trouble is that job creation is done most by new businesses, which tend to be small." Thus, he found "disturbing implications for the effectiveness of central bank asset purchases" and supported Hall's conclusions.

Dr. Shin argued that we should not forget how we got into this mess in the first place when he wrote, "Things were not right in the financial system before the crisis, leverage was too high, and the banking sector had become too large." For us, this insight is highly relevant since aggregate debt levels relative to GDP are greater now than in 2007. Dr. Shin, like Dr. Hall, expressed extreme doubts that forward guidance was effective in bringing down longer-term interest rates.

The last paper is by Arvind Krishnamurthy of Northwestern University and Annette Vissing-Jorgensen of the University of California, Berkeley. They uncovered evidence that the Fed's LSAP program had little "portfolio balance" impact on other interest rates and was not macro-stimulus. A limited benefit did result from mortgage-backed securities purchases due to the announcement effects, but even this small plus may be erased once the still unknown exit costs are included.

Drs. Krishnamurthy and Vissing-Jorgensen also criticized the Fed for not having a clear policy rule or strategy for asset purchases. They argued that the absence of concrete guidance as to the goal of asset purchases, which has been vaguely defined as aimed toward substantial improvement in the outlook for the labor market, neutralizes their impact and complicates an eventual exit. Further, they wrote, "Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound." For Krishnamurthy and Vissing-Jorgensen, this "undercuts the efficacy of policy targeted at long-term asset values."

4. The velocity of money—outside the Fed's control

The last problem the Fed faces in their LSAP program is their inability to control the velocity of money. The AD curve is planned expenditures for nominal GDP. Nominal GDP is equal to the velocity of money (V) multiplied by the stock of money (M), thus GDP = M x V. This is Irving Fisher's equation of exchange, one of the important pillars of macroeconomics.

V peaked in 1997, as private and public debt were quickly approaching the nonproductive zone. Since then it has plunged. The level of velocity in the second quarter is at its lowest level in six decades. By allowing high debt levels to accumulate from the 1990s until 2007, the Fed laid the foundation for rendering monetary policy ineffectual. Thus, Fisher was correct when he argued in 1933 that declining velocity would be a symptom of extreme indebtedness just as much as weak aggregate demand.

Fisher was able to make this connection because he understood Eugen von Böhm-Bawerk's brilliant insight that debt is future consumption denied. Also, we have the benefit of Hyman Minsky's observation that debt must be able to generate an income stream to repay principal and interest, thereby explaining that there is such a thing as good (productive) debt as opposed to bad (non-productive) debt. Therefore, the decline in money velocity when there are very high levels of debt to GDP should not be surprising. Moreover, as debt increases, so does the risk that it will be unable to generate the income stream required to pay principal and interest.

Perhaps well intended, but ill advised

The Fed's relentless buying of massive amounts of securities has produced no positive economic developments, but has had significant negative, unintended consequences.

For example, banks have a limited amount of capital with which to take risks with their portfolio. With this capital, they have two broad options: First, they can confine their portfolio to their historical lower-risk role of commercial banking operations—the making of loans and standard investments. With interest rates at extremely low levels, however, the profit potential from such endeavors is minimal.

Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking.

Perversely, confirming the point made by Dr. Hall, a rise in stock prices generated by excess reserves may sap, rather than supply, funds needed for economic growth.

Incriminating evidence: the money multiplier

It is difficult to determine for sure whether funds are being sapped, but one visible piece of evidence confirms that this is the case: the unprecedented downward trend in the money multiplier.

The money multiplier is the link between the monetary base (high-powered money) and the money supply (M2); it is calculated by dividing the base into M2. Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2.

If reserves created by LSAP were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition.

The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth.

Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high- and low-income households. When policy makers try untested theories, risks are almost impossible to anticipate.

The near-term outlook

Economic growth should be very poor in the final months of 2013. Growth is unlikely to exceed 1%—that is even less than the already anemic 1.6% rate of growth in the past four quarters.

Marked improvement in 2014 is also questionable. Nominal interest rates have increased this year, and real yields have risen even more sharply because the inflation rate has dropped significantly. Due to the recognition and implementation lags, only half of the 2013 tax increase of $275 billion will have been registered by the end of the year, with the remaining impact to come in 2014 and 2015.

Additionally, parts of this year's tax increase could carry a negative multiplier of two to three. Currently, many of the taxes and other cost burdens of the Affordable Care Act are in the process of being shifted from corporations and profitable small businesses to households, thus serving as a de facto tax increase. In such conditions, the broadest measures of inflation, which are barely exceeding 1%, should weaken further. Since LSAP does not constitute macro-stimulus, its continuation is equally meaningless. Therefore, the decision of the Fed not to taper makes no difference for the outlook for economic growth.

 

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College graduates are twice as likely to find employment… but at what cost?

 

 

 

Source: Visual.ly via CreditGuard

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