Ben Bernanke and the Fragile Recovery

Financial FAQs

We know how fragile is the U.S. economic recovery just from the past 48 hours, because both U.S. and Japanese stock prices plummeted, and interest rates jumped on a seemingly offhand remark made by Fed Chairman Bernanke in congressional testimony that a reduction in the Fed’s QE bond purchases could begin as early as June.

Bernanke has said earlier in his testimony that “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

It’s just that such a seemingly offhand shouldn’t upset markets both here and in Japan, if there was confidence that stronger recoveries were in hand. Instead, it seems there is little confidence that the U.S. in particular will maintain its stimulus programs for a long enough period—at least until the unemployment rate drops to the Fed’s stated goal of 6.5 percent from its current 7.5 percent. That would bring the U.S. closer to full employment, though still a long way from the 5 percent rate that is considered to be full employment by most economists.

And prematurely ending government stimulus of any kind after what Paul Krugman calls the Lesser Depression (rather than Great Recession) is a lesson we have learned in the past, then seemingly unlearned when so-called ‘Austerians’, small government conservatives who believe cutting government spending is the way to cure a recession, grab the spotlight.

The ‘greatest’ lesson was learned in 1937, when Roosevelt listened to a newly elected Republican Congress that demanded a balanced budget and end to government spending. The result was the U.S. economy plunged back into what became the Great Depression that lasted until World War II defense spending ended it.

It has also been unlearned in Europe, where today small government Austerians are in control, having slashed government spending, causing unemployment to soar and plunging the euro zone back into recession.

So the danger is that history might repeat itself in the good old U.S. of A., if the minority of Federal Reserve Governors mentioned in the latest release of Federal Open Market Committee minutes get their way that favor an earlier demise of QE purchases.

Graph: Trading Economics

Why is the U.S. recovery still so fragile? It’s not only because 18 million workers either have no job or work part time. It is because prices are not rising. And when companies can’t raise their prices, they don’t hire more employees. That is to say, our inflation rate is too low and continuing to fall.

The danger of falling prices is the other lesson ‘unlearned’ that has been experienced by Japan over the past 2 decades. Japan has been in a deflationary spiral where wages as well as prices have been falling, the result of prematurely ending its own stimulus programs. The result is the Japanese standard of living has fallen as its economy has been shrinking.

Graph: Trading Economics

Only now under new Prime Minister Shinzō Abe is Japan practicing Quantitative Easing, or the purchasing of its own securities by its Central Bank. Paul Krugman says those in Europe and the U.S. who continually call for less government intervention during weak recoveries believe in what he calls the “confidence fairies”, magical beings who instill confidence in future economic growth only when government budgets are balanced and inflation is low.

But that means they have unlearned the lessons of our past. For such ideal conditions only happen after an economy has recovered and government has the means to pay down its debt, which means fully employing its citizens.

Harlan Green © 2013

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What is Pent-up Demand?

Financial FQs

We are now hearing that pent up demand is growing as the economic recovery takes its time. What is it, and what would it mean for an earlier recovery? Fed Chairman Bernanke mentioned that ‘demand’ could grow in a recent speech to South Carolina’s legislators.

“While the support to economic activity from stimulative fiscal policies and firms' restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth…In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment.”

Demand usually refers to aggregate demand, a key concept of Keynesian economic theory. The theory being that if consumers, businesses and governments have growing incomes/revenues, then their ‘demand’ for more goods and services will increase. Pent-up demand is comprised of the elements that must grow to stimulate aggregate demand.  This might seem obvious to anyone who has taken Economics 101, but how to measure aggregate demand is not so obvious.

We know several factors that can stimulate demand. For instance, the 2010 Harvard Joint Housing Taskforce Study estimates that 15 million new households will be formed over the next decade, including immigrants. Yet new home growth has slowed drastically. And there are maybe 1 million surplus existing homes, due to the housing collapse. Yet even with the overhang, the demand for housing is bound to grow exponentially over the next decade.

New home sales in June actually rebounded 23.6 percent after plunging a revised 36.7 percent in May. The June pace recovered to an annualized 330,000 from a revised 267,000 for May and revised 422,000 for April. While the comeback is welcome, the bad news is that May's record drop was revised down notably from the initial estimate of a 33.0 percent decline. The latest figure is down 16.7 percent on a year-ago basis.

Another factor that suppresses demand is surprise, deflation. We are now in a deflationary environment, and studies show that consumers hold back from purchases if they believe prices can fall further—which creates a self-fulfilling prophecy. So rising prices also will signal increasing demand.

For instance, the just released second quarter Gross Domestic Product report showed falling prices. Though economy-wide inflation accelerated in the second quarter as the GDP price index rose an annualized 1.8 percent, following a 1.0 percent in the first quarter.

The acceleration in prices was due to the impact from higher imports—which signals greater domestic demand. But the price index for gross domestic purchases, which measures prices paid by U.S. residents, increased a bare 0.1 percent annualized in the second quarter, following a 2.1 percent boost in the first quarter. The core rate excluding food and energy prices increased just 0.9 percent in the second quarter, compared with a rise of 1.6 percent in the previous quarter.

So despite all of the doomsayers, the recovery continued in the second quarter but at a moderate pace. Yes, growth is still below par but not into a double dip, thanks mainly to the TARP and ARRA programs’ stimulus spending. Second quarter GDP came in at an annualized 2.4 percent growth, following a revised first quarter gain of 3.7 percent.

The latest quarter was led by a rebound in residential investment, a jump in investment in equipment & software, and by inventories. Personal Consumption Expenditures also posted a moderate gain along with government purchases.

In fact, the best measure of pent-up demand, is what is called the “output gap”.  The San Francisco Federal Reserve puts out that calculation. It was minus 6.1 percent in Q1 2009, but would have been as high as 19 percent without the TARP and ARRA stimulus spending, says the Center for Budget and Policy Priorities (CBPP), a non-partisan think tank.

The output gap measures how far the economy is from its full employment or "potential" level that depends on supply-side factors of the economy: the supply of workers and their productivity. During a boom, economic activity may for a time rise above this potential level and the output gap is positive. During a recession, the economy drops below its potential level and the output gap is negative. In theory, the output gap can play a central role in monetary policy deliberations and strategy.

In fact, one of the goals of the Federal Reserve is to maintain full employment, which corresponds to an output gap of zero. And it is the employment rate that best determines output, so we know that the Fed isn’t going to begin to raise interest rates, until the unemployment rate declines substantially, which means that pent-up demand will begin to kick in.

Was Bernanke being too optimistic? We don’t think so, nor does the stock market, which continues to rally.

Harlan Green © 2010

The Debt Fallacy

Financial FAQs

The European debt crisis has re-triggered the debate over budget deficits, and even whether Europe’s problems could trigger a ‘double-dip’ return to recession in our own economy. The contention is that Europe will be burdened with debt for years to come, which slows their economic growth.

What has Europe to do with our own economy? It is mainly the relationship between currencies. When the euro is high, then our exports are cheaper, helping manufacturing employment in particular. So the reverse case boosts European exports and reduces ours. And the euro’s value has plunged as investors fled to dollar denominated investments.

But a more general debate is whether governments should incur additional debts to cure such financial crises as we are now weathering. Keynesian economists say that government stimulus spending is crucial to any recovery, since it boosts demand for new products and services. But that only happens if it is directed to consumers—who account for up to 70 percent of economic activity.

So-called supply-side policies boost the producers by giving tax cuts directly to investors and businesses, in the hopes that it will induce businesses to expand and create more jobs. However, that didn’t happen during the last recovery. The 5 million jobs created from 2000-08 was the lowest total since WWII.

Nobelist and New York Times columnist Paul Krugman came up with an interesting conclusion on just that subject. Were we better off under the supply-side policies of President Reagan in the 1980s who wanted to funnel more money to the supply-side, or of Clinton in the 1990s who wanted it to go to consumers, was his question.

“Here’s what I think,” said Krugman, “inflation did have to be brought down — and Paul Volcker, not Reagan, did what was necessary. But the rest — slashing taxes on the rich, breaking the unions, letting inflation erode the minimum wage — wasn’t necessary at all. We could have gone on with a more progressive tax system, a stronger labor movement, and so on.”

The stimulus spending is definitely working. The Congressional Budget Office reported the latest results of the $787 billion American Recovery and Reinvestment Act (ARRA) under this headline:

New CBO Report Finds ARRA has Preserved or Created up to 2.8 Million Jobs

While the report focuses primarily on the first quarter of 2010, CBO also includes new projections of the Recovery Act’s jobs impact through 2012. It finds that in the current quarter (the second quarter of 2010), there are 1.4 million to 3.4 million more jobs in the economy because of ARRA, and it predicts that ARRA’s jobs impact will peak this fall, when there will be 1.4 million to 3.7 million more jobs because of the legislation.

This is in line with the latest unemployment report, which showed 290,000 payroll jobs created in April, following a revised 230,000 advance in March, and 39,000 rise in February. April's boost topped the market estimate for a 200,000 gain. Net combined revisions for March and February were up a 121,000-including turning February from negative to positive. But the key number is private payrolls as Census hiring added 66,000 to April's jobs, compared to adding 48,000 the prior month. Private nonfarm employment increased 231,000, following a 174,000 rise in March.

The real key to refuting the ‘debt fallacy’ is the benefit government stimulus does for consumers’ pocketbooks, and that is also looking better. Consumers are getting healthier— at least financially, as income gains enable them to spend and save more, with inflation almost non-existent. The headline PCE price index was unchanged in April-easing from up 0.1 percent in March. The core rate also was soft, gaining only 0.1 percent and matching both March and the consensus forecast.

Personal income posted a solid 0.4 percent increase for April, matching the gain the month before. The April figure came in slightly lower than the market forecast for a 0.5 percent boost. Importantly, the latest increase is in what really counts as the wages & salaries component advanced 0.4 percent after rising 0.3 percent in March.

The good news is that consumers are finding more greenbacks in their wallets and this should support additional spending and the recovery. The consumer on average is now pulling its weight in the recovery, while inflation remains benign.

What about paying back the $11 trillion in public debt? We can follow the post-WW II scenario, when it was 120 percent of GDP. That debt was paid down quickly in the post-war recovery. Today it is approaching 90 percent, because this was the worst downturn since the Great Depression. So once again the key to a recovery is keeping consumers healthy with more jobs and higher incomes.

Among ARRA’s most effective provisions for saving and creating jobs, according to CBO’s estimates, are direct purchases of goods and services by the federal government, transfer payments to states (such as extra Medicaid funding), and transfer payments to individuals (such as increased food stamp benefits and additional weeks of unemployment benefits). CBO’s estimates indicate that tax cuts are less effective job producers, and tax cuts for higher-income people and corporations have very low bang for the buck.

Harlan Green © 2010

THE 'REAL' KEYNESIAN ECONOMICS

The debate has only begun on whether the various stimulus packages are enough to kick-start the economy. Of great help will be Animal Spirits, a new book by two well-known behavioral economists who study the psychological and sociological aspects of financial markets—Nobelist George Akerlof and author Robert Shiller. Professor Shiller is best-known for coining the term “irrational exuberance” in his book of the same name, which predicted the dot-com bubble bursting.

Get Reaganomics off our backs!—translated into layman’s terms, that’s how Akerlof and Shiller begin Animal Spirits (Princeton U. Press, 2009. It is an inquiry into the role of human psychology in economic behavior. The small-government, laissez-faire outlook that Reagan helped popularize has severely damaged the financial system. “Now, three decades after the elections of Margaret Thatcher and Ronald Reagan, we see the troubles it can spawn. No limits were set to the excesses of Wall Street. It got wildly drunk. And now the world must face the consequences.”

What in fact the Obama Administration is trying to do is not only stimulate job formation and retention that will in itself grow demand for more goods and services, but raise the confidence level of consumers and business as well. This is also at the core of British Lord Keynes economic theory. Keynes believed that the Great Depression was caused by a pervading loss of confidence in both business and government to correct the economic malaise of that time.

Animal Spirits cites the crash of 1929, for instance, when speculative exuberance and the narrative of a “new era” of continually appreciating stocks suddenly evaporated, while technical factors such as central bank protection of the gold standard worsened unemployment by causing a deflationary price spiral.

As Keynes pointed out, the fundamental problem was that bankers were too scared to loan, because they thought they would lose their money—sound familiar? And since none of the deficit spending was on a scale needed to stimulate demand, self-perpetuating hopelessness set in. Only with the emergency mobilization of World War II did the shattered national mood, and narrative, begin to change.

Might some parts of President Obama’s stimulus measure not work? Of course. Some economists, including Nobelist Paul Krugman, fear that not enough is being done to give it an immediate boost this time, either. Just put more money in people’s pockets, whether via rebates or tax cuts, say some. But history shows that doesn’t provide much bang for the buck. It doesn’t necessarily get consumers spending again, for instance.

Much of the stimulus spending focuses on increasing productivity and nurturing research and innovation in future technologies. Another part focuses on improving our educational and health care systems. The Congressional Budget Office predicts that the economy may need a boost through 2011, so the stimulus package is aimed at promoting a sustainable recovery, not a quick fix.

After touring through this grim history, our contemporary problems, as severe as they may be, don’t look quite so bad. Profs Akerlof and Shiller end on a reassuring note: “Yet we are currently not really in a crisis for capitalism. We must merely recognize that capitalism must live within certain rules.” And we must take into account that irrational behavior has a real effect on demand, necessitating government intervention.

Harlan Green © 2009

WHAT IS DEFLATION RISK?

Why the urgency of putting so much money into the various stimulus plans? Treasury Secretary Geithner’s addition to TARP, a mix of public and private investments, could cost as much as $1.5 trillion. The congressional stimulus bill, called the American Recovery and Reinvestment Plan or ARRP, will cost approximately $790 billion, while the Federal Reserve could be lending and/or guaranteeing more than $1 trillion in debt, and so on.

The recent plan unveiled by Treasury Secretary Geithner highlighted the difficulty of getting banks to lend again. Its centerpiece was a public/private proposal to relieve banks of their toxic—or nonperforming—assets. But if there is no market for these assets, then banks have no idea what they are worth. This is the main reason they are hoarding their monies—bailout funds included.

And so some kind of government guarantee is needed to bolster their value(s). Otherwise, as Citibank Chairman Vikram Pandit said, they would be irresponsible to unload these assets at today’s fire sale prices. Actually, should banks do so, they might very well reveal themselves to be insolvent.

The result is a stalemate, which is causing wages and prices to begin to spiral downward. Hence the urgency of the various plans. Such a deflationary spiral is the most debilitating form of a recession. In fact, that is when a recession becomes an actual depression, as it did in Japan during the 1990s and our Great Depression.

Most Americans have no experience of one, therefore cannot conceive of its damage—when wages as well as prices are in a prolonged slump. This leads to the opposite of the wage-price stagflationary spiral experienced in the 1970s that drove the inflation rate to 14 percent—and unemployment rate above 8 percent.

Nobelist Paul Krugman is one of those sounding the alarm. He maintains that we could see a real 3 percent drop in prices if the so-called ‘output gap’, or difference between normal Gross Domestic Product growth and the negative growth during a recession/depression, is as high as the Congressional Budget Office predicts.

That is why so much money is being thrown at the deflation problem. The ARRP stimulus is targeted at creating jobs, whether by directly subsidizing industry, or indirectly with tax cuts. The Treasury plan is designed to heal the banks’ balance sheets so they will lend again. Both plans have to work before our economy will be able to recover.

Harlan Green © 2009