Tuesday, September 01, 2015
Something rotten in the state of economics
Low interest rates have resulted in unusual levels of leveraging, so high that even Fed Chairwoman Yellen has recognized their existence, although she claims they sill don't represent a danger. I beg to differ.
Those unusually high levels of leveraging can lead to a rapid unwinding, which is what I think is what may be making investors nervous, that in turn can throw the economy into another recession. We are about due for another downturn of the business cycle anyway, and all factors combined can make this next one another real bad one.
Monetary and fiscal policy have been largely ineffective the last six years. Our economy has entered a new phase that I believe is little understood by economists. Excessive regulation and policy uncertainty are hurting us and for that the only solution is less and better government.
In the meantime there have been excesses even in this anemic recovery and the time has come for a new downturn in the business cycle and correction. I think that is what we are seeing with this latest stock market drop. So tighten your seat belts and hold on tight, we are going down.
At this point I am not sure I trust any of the theories we have been offered. The fact is that with the unprecedented volumes of base money it created for the quantitative easing and the six years of near zero interest rates, the Fed has taken us into completely uncharted territory, and the results have been very poor. The only conclusion one can draw from it is that economics as we've known it no longer works, or at best worked to buffer the downward part of the business cycle, but not to get us back on our feet and running.
To bolster my hypothesis that economics has not helped us get ourselves running again, consider this. Since the crisis started in 2008 we more than quadrupled the monetary base from just under $900 billion to $4 trillion currently. As to fiscal policy, consider that all government deficits are by definition stimulative and that our debt has increased from $10.0 trillion on September 30, 2008, to $18.4 trillion currently, an increase of $8.4 trillion, or there has been a stimulus of that magnitude the last seven years.
And despite those unprecedented levels of monetary and fiscal policy, we are still not growing like we used to after earlier recessions. Something is clearly wrong with our current knowledge of economics.
Economics is like a horse on two legs, only the two legs that can be quantified: how much money the government spends, and the other how much it prints and the price it gives it. The other two, which can't be quantified and are therefore always ignored, are the stranglehold of regulation on the flexibility of the economy, and investor trust in the policies of the government.
The first, regulation, is like the brake pedal on a car. You can step all you want on the gas (spending and printing) but if your foot is also on the brakes you won't go much faster.
The second, policy uncertainty, is like going up a steep mountain without knowing what is on the other side. Investors like some degree of predictability for their investments but currently the future they see is one in which the costs in major sectors affecting the whole economy, principally healthcare and energy, have become hugely unpredictable because of the preferred policies of this president.
There is no science possible in managing these two variables, just beliefs applied under the guise of "rational" intervention. Maybe if we had more trust in Mother Nature and the Invisible Hand, not to mention the entrepreneurial creativity of those Americans who haven't lost their willingness to sacrifice and work hard for a better future, we would be doing better.
There is another explanation for why the Phillips curve may not be producing the expected results and it points to the danger of being hooked to numbers that sound good politically, in this case an unemployment rate of 5.3% currently.
During the current recovery of the business cycle unemployment has gone from a low of 4.4% at the peak of the previous business cycle in January 2007, to the current 5.3%, but during that same period the ratio of employment to population has gone from 63.3% to just 59.3% currently.
Arguably then we are not yet near “the 5% to 5.2% [unemployment] range that Fed officials expect in the long run,” but rather somewhere between 5.3% and a high of 9.3% were the target that a similar percent of the population be employed as were at the peak of the previous business cycle.
The point is that we can throw around all the math, graphs, curves and numbers we want but in the end they are all theoretical constructs that may have little relationship to reality. I don’t doubt that there may be some point where there are not enough workers to keep up with demand and prices will go up, but to say that the politically contrived measure of unemployment adequately measures that point is sheer delusion.
That is particularly true when we have quadrupled the base money supply and thrown unprecedented levels of stimulus at the economy, formulas that textbooks tell us should lead to rampant inflation, yet we haven’t seen any. I suspect something is rotten in the state of economics.
Unfortunately, and as I have been saying for at least three years now, the Fed painted itself into a corner without any obvious good results. While I would raise interest rates somewhat primarily to work out some of the overleverage of balance sheets that resulted from such low interest rates for so long, as the author suggests, I would be very cautious about raising interest too much.
We are about due for another downturn of the business cycle and there is a good chance that the weakness in China plus its effects on emerging economies, coupled with the weakness of some European economies, could push us into a new recession the moment the Fed does start raising interest rates, even if only marginally.
Yeah, I know, I sound contradictory but as I said, the Fed painted itself and us into a corner. At this point I fear that any moves it makes may be strategically unwise, so if it does do something it will have to be for tactical reasons based on better numbers than I have.
Posted by Dan Butcher