As expected the Federal Reserve this week expanded its quantitative easing by shifting the $45 billion in long term government securities currently being financed by selling short term securities on the Fed’s balance sheet to outright purchases. The Fed is now buying roughly $1 trillion (yes, I said billion last week. Sorry, but thanks for reading) in new government securities at an annual rate, effectively financing the entire federal deficit. As we explained last week, we do not really see this as much of a change in monetary policy. The $45 billion a month in short term securities being sold were a virtual gift from the Fed to the financial markets. They were snapped up at the near zero interest rates they offered, because most investors are happy holding cash (currency or near equivalents) even at deeply negative real interest rates rather than taking any chances in this soft global economy. As noted last week, we argue that when a central bank is quantitatively easing, what it is really doing is printing money and giving it directly to the government – which in turn is using it to sustain nominal incomes via safety net programs. The impact is immediately inflationary – but given this occurs in a deeply deflationary period it results in little measured inflation.
If you accept my view about balance sheet expansion as currency, just how inflationary has the Fed – and, in fact, all central banks — been since they started quantitative easing? The Federal Reserve’s balance sheet has risen a tad under $2 trillion from just before Lehman ($900 billion) to now ($2.8 trillion). That $1.9 trillion represents roughly 12% of the $16 trillion nominal annual GDP generated on average during the past thirteen quarters – or roughly 4% inflation a year, double the rate of reported inflation. For all the big central banks, their balance sheets have risen about $10 trillion since early 2007, or about the same 4% a year for their part of global GDP. Bottom line, printing money has accounted for virtually all of the nominal increase in GDP since the start of the recessionary period (even before Lehman). Without money printing, the US and the rest of the developed world would look like Greece (or Iceland before it), with imploding real and nominal growth and exploding interest rates due to a lack of trust.
Why more implied inflation than what is reported? Because deleveraging reduces the velocity of money, since currency (or electronic currency held as reserves) turns over more slowly in an economy than bank deposits. Banks have a financial incentive to earn on their deposits even when they cannot find borrowers. They lend it out to other banks that might be in need through the federal funds market – increasing its effectiveness or velocity. Currently, there are so many excess reserves in the system that the rate would be zero if not for the Federal Reserve’s 25 basis point rate for holding reserves – which, as we noted earlier is a subsidy to the money market industry to preserve the commercial paper market. As financial intermediation declines due to lack of trust, money sits in zero rate deposits (electronic currency) at fortress balance sheet corporations. These firms see no potential for growth, so they don’t invest or hire – so there is no growth. Catch-22.
Asset values go up in this environment, not because of inflation, but because the value of existing streams of cash flow are more valuable. Note that equity values are rising, but there is little new equity issuance. Listed equities’ growing earning power is more from buying market share as they gather up the most successful small businesses and throttle the rest through competition than it is from overall economic growth. Even allowing for faster growth in revenues earned overseas, listed earnings growth is faster than global GDP. No wonder the NFIB fell out of bed following Obama’s re-election and small businesses recognition that their already tough position vis a vis bigger corporate competitors was about to get much worse. As we have noted in earlier missives, increasing market concentration is one of the invisible hands ways of reducing the efficiency of capital to bring the current excess supply back in line with diminished demand.
How much money can a government print before it becomes inflationary? That depends on how underutilized resources are in the economy when the money printing starts. Theory tells us that Money x Velocity = Price x Transactions. If you print money when an economy is near full effective use of its resources – so that it is hard to increase transactions – you get pure inflation. However, if printing money helps resources become better employed, you get a mix. In the case of Germany from 1933-1937, the money supply was effectively doubled during that period by the issuance of MEFO notes – a quasi-currency that was directly convertible into Reich marks. The increased money supply funded the German armaments industry – which generated incredibly more efficient use of initially very underutilized resources (in part, due to totalitarian rules such as the one that required bakers to move from Munich to Bremen if there was a need!) The German fourfold increase in buying power in Eastern Germany at reunification in 1990 was more inflationary, but also resulted in a sharp rise in real economic output across Europe as much of the region was operating below potential (especially the UK, which entered the ERM in 1990 for that reason.) Indeed, it was excessive German tightening after that modest inflation threat that led to weak European growth throughout the 1990s. Conversely, US money printing — initially to finance Vietnam and the Great Society — started when the economy was already near full employment and coming off a government financed technology boom, so it was quite inflationary. At present, resources are heavily underutilized, so the inflation threat seems remote.
Nor is it likely that resources will suddenly become much more efficiently utilized – leading to higher growth and real interest rates — without a rebuilding of trust in the US banking sector. When capital is narrowly held, as it is in the US and around the world these days, society needs a deep well functioning system of financial intermediation to move control of resources from those that own them to those who can utilize them the best. True, wealth became narrowly held because the owners of capital were highly efficient users of those resources — but pre-Lehman their best use was often the lending out of those resources through the financial intermediaries. With the old strategy undermined, many new alternatives offer opportunities for better allocation. Hedge funds replacing banks to allow direct ownership or deep pocket lending is one successful strategy, but it results in market concentration and capital destruction in the aggregate. Government reallocation via expropriation (taxes or nationalization) is well down almost all private sector participants wish list. Financial repression, where central banks hold real rates negative, is a more palatable form of wealth taxation — for politicians. We believe allowing de novo banks in the US, which would prosper in part by taking out old banks, would eventually be a winning strategy – but government is protecting the status quo.
Ultimately, the path of least resistance seems to be for capital to move to the emerging markets where growth opportunities – primarily from converging to global best practices – are the highest. Some of this movement will be through growth in their banking systems. Some will be from development of higher forms of financial intermediation, much of which does not yet exist in the emerging markets. However, in the short run, most will be from existing international players in those markets expanding their operations. New entrants will come as well, but the learning curve is high in the EM so success is more likely among existing players. Ownership of multi-national corporations and commodities producers seem the best near term ways to benefit from this trend. As the recession in the developed world recedes, investment in capital goods exporting economies should again become a successful strategy. We see it as many years before a rising tide raises all boats, so sitting in a zero yield position may be safer than many decidedly risky investments in the EM, but that strategy is still likely to result in slowly declining buying power relative to the world’s wage earners – especially EM workers. Look to the early 1900s or 1950s for similar periods of growth. It should be slow (and not necessarily steady) growth, with low inflation, and a redistribution of income toward labor and the emerging markets, plus increased government regulation and taxes. It will be a much tougher world for investors than the Reagan to Lehman heyday – but those that adapt soonest and best will benefit as others follow their investment trends.
Free to Choose?
One question which arose in our minds as Bernanke answered questions about the new “Evans Rule” was whether his mentor Milton Friedman was rolling over in his grave? It is not because Bernanke indicated that the Fed would now consider both an inflation target and an unemployment target. After all, whether monetarists like it or not, that is actually the mandate imposed on the Federal Reserve. The Evans rule merely quantified the goals, in line with Bernanke’s desire for a more open Fed. It was Bernanke’s observation that the Fed might hold interest rates at zero even if unemployment rate reached 6.5% — if the reason for the decline in the unemployment rate was due primarily to shrinkage in the workforce. This seems like a very palatable political statement – especially given President Obama’s re-election and the majority of Congresses focus on jobs (read votes) – and consistent with the Fed mandate for maximum employment. However, as an economist it struck us as dangerous.
Workers who are offered a market wage for their labor can decide whether to accept or not. Some will decide to work and keep looking for a better job (the reservation wage in the academic literature). Some will opt to remain unemployed – not working, but looking for a job. Some stay out of the labor force — to raise families, or go to school, or retire. The presence of alternative forms of income – whether from government support, or community support or family support – will affect the acceptable wage. A government imposed minimum wage may keep them out of the labor force, but they may still potentially work in the grey market. Bottom line, unless someone is forcing workers to leave the labor force, non-participation is as legitimate an economic decision as whether to borrow money from a bank at a specific interest rate. Is Bernanke indicating that he knows better than the market the proper wage rate for all workers? Is he suggesting he would use monetary policy to subsidize corporations via lower interest rates so that they could pay a wage above the market rate? If Obamacare depresses wages at small businesses and reduces labor force growth further will he remain very accommodative? Or was he just being nice during the holiday season to show workers that the Fed has their best interests at heart? We do not know, but we think it matters — a lot. At the current rate of decline with roughly 150,000 new workers a month and slow growth in the labor force – in part due to very slow growth in average hourly earnings – the unemployment rate could reach 6.5% by the end of 2013. That is well ahead of the time line being suggested by the Fed. If Bernanke wants to be clear about the Fed’s intentions, then the markets need a more specific explanation of how “maximum employment”, the unemployment rate and monetary policy will interact.