Hoisington Calls for Recession in 2012

By Van R. Hoisington and Lacy H. Hunt, Ph.D.

High Debt Leads to Recession

As the U.S. economy enters 2012, the gross government debt to GDP ratio stands near 100% (Chart 1). Nominal GDP in the fourth quarter was an estimated $15.3 trillion, approximately equal to debt outstanding by the federal government. In an exhaustive historical study of high debt level economies around the world, (National Bureau of Economic Research Working Paper No. 15639 of January 2010, Growth in the Time of Debt), Professors Kenneth Rogoff and Carmen Reinhart econometrically demonstrated that when a country's gross government debt rises above 90% of GDP, "the median growth rates fall by one percent, and average growth falls considerably more." This study sheds considerable light on recent developments in the United States. After suffering the most serious recession since the 1930s, the U.S. has recorded an economic growth rate of only 2.4%. Subtracting 1% from this meager expansion suggests that the economy should expand no faster than 1.4% in real terms on a trend basis going forward, which is virtually identical with the economy's expansion in the past twelve months.

In highly indebted countries, governments have expansively taken resources from the private sector through taxing and borrowing. This leaves the private sector with less vigor to produce jobs and increase productivity, and subsequently wealth for its fellow citizens. This theory, which dates back to David Hume's essay, Of Public Credit published in 1752, is now being played out in real time in the United States. We judge that when an economy is expanding in such a meager fashion it is exposed to an increasing frequency of recessions. We expect such a recessionary event to emerge in 2012.

Contractionary Fiscal Policy

It would be difficult to devise a more horrendous set of fiscal policy parameters to spur economic growth than currently exist. Real federal government purchases of goods and services, which comprise 8% of real GDP, will decline by about 1% if the impartial projection of the Congressional Budget Office (CBO) for a fiscal 2012 deficit of about $1.3 trillion is in the ballpark. Defense spending will bear most of the decline in federal expenditures, but non-defense spending will, at best, be flat. In spite of record deficits since the spring quarter of 2009, real federal government purchases of goods and services have risen at an anemic 1.5% annual rate, confirmation that only a small amount of exploding expenditures went for infrastructure projects. The scant growth rate in the economy suggests a negative outlay multiplier.
Contrary to common belief, the massive deficits of recent years will actually reduce economic growth in 2012 through a subtle, but nevertheless credible channel consistent with the preponderance of economic research. Studies suggest the government expenditure multiplier is zero to slightly negative. Increased deficit spending does appear to provide a modest lift to GDP for three to five quarters, depending upon the initial conditions of the economy. However, following this small, transitory gain, deficit spending actually retards GDP growth and the economy returns to its starting point at the end of about twelve quarters. Based on our interpretation of these studies, the U.S. economy is now on the backside of the string of record deficits, and this will be a drag in 2012. Despite the massive spending, all that is left is an economy saddled with a higher level of debt, with more of its productive resources diverted to paying the non-productive elevated level of interest payments. According to the CBO, gross federal debt will rise to at least 103% by the end of 2013. However, if the FICA tax reduction is extended for the full year, and/or a recession ensues, as we expect, revenues and expenditure estimates by the CBO will prove to be too optimistic. Under current circumstances, no viable way exists to remove the increasing federal debt burden from the economy's growth trajectory. As such, the federal fiscal constraint is operative for the foreseeable future.
In the past three fiscal years, the budget deficit averaged 9.3% of GDP (Chart 2), the highest since 1943-45. Federal outlays were almost 25% of GDP (Chart 3), and also the highest since the final three years of WWII. Dr. Barry Eichengreen of the University of California at Berkeley, author of Exorbitant Privilage,estimates that after 2015 this outlay figure is headed to 40% over the next quarter century without major structural reforms in Social Security and Medicare. For Dr. Eichengreen this means that the current law cannot remain unchanged in spite of the lack of political will to deal with the issue. Dr. Eichengreen states: "The United States will suffer the kind of crisis that Europe experienced in 2010, but magnified. These events will not happen tomorrow. But Europe's experience reminds us that we probably have less time than commonly supposed to take the steps needed to avert them. Doing so will require a combination of tax increases and expenditure cuts." He goes on to point out that, "At 19 percent of GDP, federal revenues are far below those raised by central governments in other advanced economies with spending on items other than health care, Social Security, and defense and interest on the debt having shrunk from 14 percent of GDP in the 1970s to 10 percent today, there is essentially no non-defense discretionary spending left to cut. One can imagine finding small savings within that 10 percent, but not cutting it by half or more in order to close the fiscal gap."


Consistent with this analysis, the Trustees of Social Security and Medicare have calculated that the present value of unfunded liabilities of these two programs totals $59.1 trillion. Additionally, there have been tabulations that all federal government liabilities, including those of Medicaid, veterans and other defense obligations, pension liabilities of government employees, and additional federal programs total $200 trillion at present cost.
These massive unfunded liabilities, when coupled with our present trillion dollar deficit, point to the stark reality that significant revenue increases and serious cuts in all programs will be shortly forthcoming. If these readjustments take advantage of current knowledge regarding tax and spending multipliers, the economic implications should not be severe. Clearly the only solution for our present predicament is to have a vigorous and rapidly expanding private sector and a shrinking public sector. As an investor concentrated solely in Treasury securities, our maturity structure will depend greatly upon the timely resolution of the country's present deficits.
State and local purchases of goods and services (10.9% of real GDP) has fallen at a 2.1% annual rate since mid 2009, and is poised to decline further in 2012. The fiscal condition of these levels of government has improved due to rising tax revenues and expenditure cuts. However, about one half of the states still face deficits in the final half of the current fiscal year and/or in the new fiscal year that begins in July 2012. Also, these budgets do not reflect the unfunded liabilities of their pension funds that are experiencing another year of investment returns that are considerably less than their actuarial assumptions. Further, a number of states enacted temporary tax increases that expire. Thus, state and local governments must continue to either cut spending or renew the taxes that politicians promised were temporary. The seeming improvement in state and local finance is an illusion, and this drag on economic activity will continue.

QE2 Will Be Either A Small Or Massive Failure

In his latest letter Van Hoisington cuts through the bullshit and asks the number one question (rhetorically): why are bank excess reserves (aka the ugly, liability side of Quantitative Easing) still so high. He answers: "Either the banks: 1) are not in a position to put additional capital at risk because their balance sheets are shaky; 2) are continuing to experience large write-downs on commercial and residential mortgages, as well as on a wide variety of other loans; or 3) customers may not have the balance sheet capacity or the need to take on additional debt. They could also see no expansionary prospects, or fear an uncertain regulatory future. In other words, no viable outlets exist for banks to loan funds." Which leads him to conclude quite simply that while risk assets may hit all time highs courtesy of free liquidity, the economy, also known as the middle class, will be stuck exactly where it was before QE2... and QE1. Van also looks at that other critical variable: velocity of money - "Velocity is primarily determined by the following: 1) financial innovation; 2) leverage, provided that the debt is for worthwhile projects and the borrowing is not of the Ponzi finance variety; and 3) numerous volatile short-term considerations." As an uptick in velocity is critical for any wholesale reflation (as opposed to merely hyperinflation) plan to work, this is one metric Van is unhappy with. Lastly, Hoisington also looks at the fiscal headwinds facing the country (which more so than anything terrify the Goldman economics team), and presents his vision on the bond-bubble argument.
Still Vulnerable
Hoisington Investment Management
By Lacy Hunt and Van HoisingtonOctober 8, 2010
Despite extreme economic intervention by federal authorities, real GDP has increased by a paltry 3% since the recession ended in June 2009, less than half the 6.6% average growth in the comparable periods of the prior ten recoveries.

Inventory investment, a trendless component of GDP, has accounted for nearly two-thirds of the entire rebound in economic activity from the worst economic contraction since World War II. Over the past four quarters, inventory investment has moved from contracting real GDP at a 5% annual rate to boosting it at a 2% annual rate. Real final sales (GDP less inventory investment) grew at a very meager pace of 1.1%, less than one-fourth the average 4.5% rate of increase in the comparable rebounds. Whether measured by GDP or final sales, economic growth needs to expand at least at the pace of population growth to sustain a steady standard of living. In this rebound, per capita real final sales grew by 0.2%, much lower than the earlier ten postwar expansions when the growth in real per capita sales was a robust 3.2%. Thus, the U.S. standard of living has remained stagnant at a very depressed level. The upward inventory thrust is complete, and probably over-extended (Chart 1).

Going forward, the only hope for economic growth is through proper monetary and fiscal policy. Unfortunately, monetary and fiscal policy has yet to contribute to sustainable growth. The greatest probability is that new monetary and fiscal policies will not prove any more successful than prior ones. Instead, unintended consequences will negatively impact output. Thus, our view is that economic conditions will remain depressed, with the probability of a relapse to negative growth of greater than 50%. Moreover, policy makers are proposing actions that have never been tested, complicated by the fact that current economic circumstances have not existed for eight decades.

Another Failed Attempt--QE2

The flaccid nature of this business recovery should serve notice that economic conditions are far more precarious than generally understood. Federal Reserve forecasts were obviously flawed and have now been significantly lowered since they placed great emphasis on the presumed stimulative power of massive deficit spending and numerous aggressive monetary actions. The Fed is contemplating another round of quantitative easing (QE2) because the weakness of the economy has surprised them. They are feeling the political pressure to act, even though the problems facing the economy are not related to monetary policies.

The Fed’s position seems to be that more of the same economic policies are needed, even though they have failed to produce the advertised results. As microeconomist Steven Levitt (author of Freakonomics) documented, conventional wisdom is generally flawed since it fails to ask the right question about economic problems. We view the Fed's econometric model as the personification of conventional wisdom.

For instance, as a result of QE1 the banks are holding close to $1 trillion of excess reserves. The important question is why are banks unwilling to put these essentially zero earning reserves to work. Either the banks: 1) are not in a position to put additional capital at risk because their balance sheets are shaky; 2) are continuing to experience large write-downs on commercial and residential mortgages, as well as on a wide variety of other loans; or 3) customers may not have the balance sheet capacity or the need to take on additional debt. They could also see no expansionary prospects, or fear an uncertain regulatory future. In other words, no viable outlets exist for banks to loan funds.

A parallel situation exists in the corporate sector. Non-bank corporations are sitting on huge cash reserves. In the past two quarters liquid assets amounted to 7% of total assets, the highest level since 1963 (Chart 2). This cash reflects a lack of compelling uses for the funds, as well as the need to hedge against risks, including those of dealing with potential vulnerable counter-parties. The fact that substantial bank and corporate funds remain idle is a strong signal that U.S. economic problems exist outside the monetary sphere.

The problem with the U.S. economy is fourfold: 1) The economy is grossly overleveraged, with many asset prices falling; 2) fiscal policy is counter-productive and debilitating to economic growth as government expenditure multipliers are near zero; 3) proposed tax increases are already curtailing economic activity and tax multipliers approach -3%; and 4) increased bureaucracy with many new and yet unwritten regulations from the Dodd-Frank bill, along with health care regulations, make business planning nearly impossible.

With existing excess liquidity in banks and companies, and the above-mentioned key economic problems, it should be clear that QE2 and the purchases of additional assets by the Fed will, like previous purchases in QE1, serve only to bloat excess reserves without advancing income, spending, or jobs. From this point in the cycle, for QE2 to generate expansion, money growth and therefore debt levels would have to rise.

According to economist Hyman Minsky, there are three phases of credit extension: hedge finance, speculative finance, and Ponzi finance. In view of the extremely leveraged conditions, additional credit would be almost exclusively of the Ponzi finance variety – loans with no reasonable prospect of repayment. Indeed, Ponzi finance appears to typify the bulk of the loans being made by the Federal Housing Authority to unqualified home buyers, replicating the practices underwritten by FNMA and Freddie Mac during the heyday of the sub-prime lending extravaganza whose consequences linger. But, for the purpose of argument let’s assume that with additional excess reserves the banks lend to other potential Ponzi-like borrowers. This could lead to an increase in the money supply, but the net result may still not stimulate faster growth in GDP because velocity would fall, as it did from 1997 to 2007 (Chart 3).

The Velocity Impediment

For a rise in excess reserves to boost GDP, two conditions must be met. First, the money multiplier must become stable. Second, the velocity of money must not decline. The second condition is not likely in view of the theory and history of velocity. Velocity is primarily determined by the following: 1) financial innovation; 2) leverage, provided that the debt is for worthwhile projects and the borrowing is not of the Ponzi finance variety; and 3) numerous volatile short-term considerations.

Since 1900, M2 velocity has averaged 1.67, and has demonstrated distinct mean reverting tendencies (Chart 3). Velocity has been declining irregularly since Ponzi finance took over in the late 1990s. For leverage to lead to an expansion of velocity the loans must meet the requirement of hedge finance, i.e., where there is a reasonable expectation that the borrower can repay both principal and interest.

Fundamentally, the secular prospects for velocity have not improved even though velocity recovered by 2.1% in the past four quarters. This marginal uptick in velocity reflected an assist in federal spending along with the unparalleled recovery in inventory investment discussed previously. Without the gain in these two GDP components, velocity was unchanged over the past four quarters (Table 1).

Unintended Consequences

The Fed's adoption of QE2 may lead to severe unintended consequences. There are two possibilities: 1) QE2 does manage to temporarily improve GDP via continued overleveraging of the economy with non-repayable loans, 2) QE2 goes into the history’s dustbin of failed projects, along with QE1, cash for clunkers, tax credits for first time home buyers, and other numerous failed attempts to boost the economy with rebate checks.

For QE2 to work, a renewed borrowing and lending cycle must take place, resulting in a further leveraging of the already highly overleveraged U.S. economy. Such additional leverage would not be beneficial since increasing indebtedness from these levels ultimately leads to economic deterioration, systemic risk, and in the normative case, deflation, as documented by Rinehart and Rogoff in their book, This Time Is Different. Therefore, at best QE2 can be nothing more than a short-term panacea exacerbating the serious structural problems already facing the United States.

A Branch of Congress

More important, however, is that by implementing QE2 the Fed could eventually lose its historical independence. The Fed is facing some economic headwinds over which they have no control, and thrusting itself into situations with enormous potential for unintended consequences. If the Fed takes additional actions that are as ineffectual as they have been previously, this could lead Congress to assume that the Fed should be given more direct instructions regarding the purchase of financial assets. Congress might assume that QE1 and QE2 were unsuccessful because they were too small, not that they are fundamentally flawed concepts. On such a path, monetary policy could then become a mere branch of fiscal policy--a road to economic perdition.

Fiscal Headwinds

As an example of the headwind the Fed faces, consider present fiscal policy. Between the taxes in the 2010 medical reform law and the sunsetting on the 2001 and 2003 tax cuts, several credible researchers calculate that taxes will rise about $3 trillion over the ten-year period starting in January ($1 trillion of medical law tax increases and $2 trillion of increases resulting from the sunsetting of the 2001 and 2003 tax cuts). The vast range of tax increases include rising marginal rates for all tax brackets: the return of a marriage penalty, a 50% reduction in child tax credit, lower dependent care, adoption tax credits, return of death tax to 55%, rising capital gains and dividend taxes, elimination of health savings accounts, special needs tax caps, return of alternative minimum tax impacting twenty eight million families, shifting of expensing by small businesses, elimination of charitable contributions from IRAs, and inclusion of employer-paid health insurance on individual W2s.

A tax multiplier in the mid range of estimates (-2) is a contractionary force of $6 trillion, or $600 billion per year on average for the next decade. For an economy that grew only $500 billion in the past four quarters (including the aforementioned inventory surge), this tax blow is too large for such a fragile economy to absorb, and beyond the scope of any monetary policy. In addition, a new array of bureaucrats necessitated by new regulations have increased uncertainties and problems, making planning by businesses nearly impossible, and paralyzing commerce. This lagging business regulatory environment is typical. As socio-economist Robert Prechter points out, the Glass-Steagall Act, which separated banking and investment activities, was enacted in 1933 after the worst of the depression, only to be repealed in 1999. Its repeal helped to facilitate the Ponzi financing boom of the 2000s. Thus, changes in regulations only appear after the proverbial "horse is out of the barn", and do little except to inhibit business activity.

Thus, we believe that QE2 is an ill advised program that offers little prospect of boosting economic activity. If the program achieves success, any gains in economic activity will be for a very limited period of time with major risks that any short-term gain will be swamped by incalculably high costs in the future. These unknown, questionable experiments in monetary policy are being made to correct problems that are clearly of a non-monetary nature.

A Treasury Bond Market Bubble?

Over the past several months a number of articles have surfaced emphasizing the theme that the Treasury bond market is in a bubble. The implication of these articles is that yields are so low that they can only go higher, with the result of substantial capital loss to those owning the Treasury paper. It is true that psychology drives markets in the short run making anything possible, so rates may rise or fall, regardless of long-term fundamentals.

A bubble, however, refers to an asset with a price that is substantially beyond the asset’s fundamental or intrinsic value. This immediately raises the question as to what determines these values. A lucid description of this requirement is given by Dr. Seiji S. C. Steimetz in The Concise Encyclopedia of Economics. In his article entitled "Bubbles", Dr. Steimetz defines the fundamental value of an asset as the present value of the stream of cash flows that its holder expects to receive, which includes the series of payments that the asset is expected to generate, and the expected price of the asset when it is sold.

Immediately, the Steimetz definition reveals a distinct delineation between stocks and bonds. The stream of cash flows for stocks, (i.e. dividends) is far less certain than the stream of semi-annual Treasury coupon payments guaranteed by the full faith and credit of the government of the largest economy in the world. In his article on asset bubbles Dr. Steinmetz gives no example of Treasury securities in a bubble, mentioning only common stocks and other types of assets. At maturity, the U.S. government also guarantees the par value of the Treasury bond. No such guarantee or maturity exists for commodities, real estate, common stock, or currencies in the hands of foreign holders.

Charles P. Kindleberger in his breakthrough book, Manias, Panics, and Crashes – A history of Financial Crises, is very explicit. He states, “ A mania involves increases in the prices of real estate or stocks or currency or a commodity in the present and near future that are not consistent with the prices of the same real estate or stocks in the distant future.” There is no mention of Treasury securities. Continuing, he adds “The term ‘bubble’ is a generic term for the increases in asset prices in the mania phase of the cycle.”

Determining Value For Treasuries

Investors are interested in the real or inflation adjusted present value of the stream of earnings from an asset, as well as the real value of the asset when it is sold. This is exactly the approach that Irving Fisher took in The Theory of Interest, published in 1930. According to the Fisher equation, one of the most tested and documented pillars of economics, the long risk-free yield (or the nominal yield) equals the real rate on long Treasury bonds plus the expected rate of inflation. Robert Loring Allen, in his 1993 biography on Fisher wrote: “Fisher’s theory of interest has assumed an honored position in the pantheon of explanations of the formation of interest rates, and indeed, in the functioning of the whole economy. No serious discussion of capital and interest can occur without considering it. If anything, over the years it has grown in importance.”

The real rate is very volatile and not predictable over the short-run. However, it averaged 2.1% over the long run and is mean reverting. Over time the long Treasury bond yield moves in the direction of inflationary expectations. Inflationary expectations lag actual inflation by a considerable period of time, sometimes more than several years. In addition, inflation is a lagging indicator. If the low point in inflation is well down the road, as cyclical analysis would suggest, then the low in bond yields lies ahead. Long Treasuries thus have substantial fundamental or intrinsic value and do not meet the criteria of an asset in a bubble.

Currently, inflation is tracking at a 1% annual rate and the bond yield is around 3.7%. Thus, the real yield is 2.7%, or 60 basis points above the 140-year mean (Chart 4). If the real yield were considerably below the mean and took place in an environment in which inflation was in the process of moving higher, the intrinsic value of Treasury bonds could be questioned. The real yield has remained above the mean for the past three decades. Thus, the mathematical tendency of a mean reverting series, sans economic theory, shows that the risk is that the real yield is headed below the mean and it could remain there for an extended period. For the Treasury bond market to be on the verge of a bond bubble: 1) the real yield would have to immediately lose its mean reverting characteristics that have held since 1871; 2) inflation would need to switch to a leading from a lagging indicator; and 3) inflationary expectations would need to lead actual inflation. All are unlikely.

Based on the Fisher equation’s superior analytic approach for determining value in the bond market, investors are still able to purchase long-term Treasury securities at prices which do not yet reflect their positive long-run potential.

Van R. Hoisington

Lacy H. Hunt, Ph.D.

Hoisington 2Q Review, Forward Outlook

wSent out by John Mauldin. Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies.

Has the Recession Really Ended?

Real GDP has improved for four consecutive quarters (2nd qtr. est.), albeit at a substandard pace following the steep decline in economic activity of the previous year and a half. An impressive recovery in business sales and industrial production has occurred. The responsibility for dating contractions and expansions in the U.S. economy rests with the cycle dating committee of the National Bureau of Economic Research (NBER). Thus far, the NBER has been unwilling to proclaim an end to the recession that started in late 2007. This may partially reflect the fact that the ratio of people employed to our total population has fallen from 62.7% in December 2007 to 58.5% today. Although the recent low in this measure was 58.2%, touched just a couple of months ago, our present level is no higher than it was in 1983. This measure is a proximate indication of our country's overall standard of living and interestingly over the last twenty years has declined as the U.S. economy has become more indebted (Chart 1). Although the four coincident indicators that the NBER utilizes in judging recession troughs have turned positive, two of them (income less transfer payments and employment) have only marginally shifted upwards and are subject to significant revisions. Thus, history may come to judge that the NBER was very wise to hold off making this end of recession call. Four major considerations suggest that the past several quarters may be nothing more than an interlude in a more sustained economic downturn, with further negative quarters still ahead. Such an outcome will suppress inflation further and quite possibly lead to deflation.

Four Major Impediments to Economic Normalcy

Deficit Spending
First, deficit spending is not conducive to sustained economic growth. Substantial scientific research from both U.S. and foreign countries indicates that the government expenditure multiplier is considerably less than one and quite possibly close to zero. This means that if an economy starts with real GDP of $14.3 trillion (i.e. the level for 2009), and it is shocked by a surge in deficit spending, such as has been the case in the U.S., GDP will grow, but the economy will then eventually return to essentially where it began. However, the deficit spending shock leaves the economy in a more precarious overall condition because the same sized economy must now support a higher level of debt. Additionally, the private sector's share, which was 79.4% in 2009, will be reduced in favor of a larger governmental share, which was 20.6% in 2009.
This situation is graphically illustrated in Chart 2. The U.S. economy is depicted in a pie chart that expands initially (arrow A, Chart 2) in response to the deficit spending but then as resources are transferred from the private to the government sector, the economy ends where it started (arrow B, Chart 2). However, the government share of economic activity will be greater than the 20.6% share where it started (arrow C, Chart 2). The Office of Management and Budget (OMB) projects that the ratio of government debt to GDP will jump from 53% currently to 77.2% in 2020 (Chart 3). Based on this substantially elevated level of debt, the government share of total GDP could exceed 25% of GDP within five years followed by even higher levels thereafter, a dramatic difference from the share in 2009. The government share of GDP has been moving higher since the 2001 recession as the Government/Debt to GDP ratio has advanced (Chart 2). At the same time that the government share of GDP has risen, the private sector share of GDP has fallen. This period of extreme underperformance of the private sector since 2001 combined with higher relative levels of government debt constitutes a clear sign that the U.S. is following the path toward economic stagnation and a lower standard of living.


Going forward, the diminished private sector must generate the resources (i.e. the funds) to service and/ or repay the increased level of debt. If the private sector is not successful in generating the additional resources needed, the government sector must either go deeper into debt or impose additional taxes on the already stressed private sector. Considerable evidence suggests that this self-defeating process has already resulted in transfers of resources from the private sector to the government sector (Chart 4). In the past four quarters, total debt has dropped by a record $789 billion even though federal debt has surged by an outsized $1.45 trillion. The reconciling factor was a record $2.235 trillion contraction in private debt outstanding.

Higher Taxes
Second, the other side of fiscal policy – taxes – also poses another major obstacle to a return to sustained economic growth. The scientific work indicates that the government tax multiplier has a negative impact on economic growth. Academicians estimate that the drag on the overall economy from a $1 increase in taxes is between $1 to $3 over time. Thus the multiplier is -1 to -3. According to the administration's figures, the sunsetting tax cuts of 2001 and 2003 will result in a $1.5 trillion increase in taxes over the ten year period beginning in January 2011. Some have estimated that the health care reform legislation will raise taxes another $0.5 trillion, while adding to the budget deficit at the same time. Using a mid-range tax multiplier of -2, the contractionary force on the U.S. economy over the upcoming ten years would be $4 trillion, or approximately an average of $400 billion a year. This amount happens to be almost as much as the entire gain in GDP in the past four quarters. Clearly, a very vulnerable economy will not be able to absorb such higher taxes easily and the response may well be a renewed business contraction.
Massive Over-Indebtedness
Third, the U.S. economy remains extremely over-indebted. In the first quarter, the total debt to GDP ratio was 357%, 100 percentage points higher than in 1998. The best scholarly work indicates that the process of over indulging on debt ends badly – economic deterioration, systematic risk and in the normative case deflation. The private sector has deleveraged slightly either due to conditions imposed by the capital markets or their own choice. Nevertheless, the private sector remains massively over-leveraged.
Another aspect of the debt problem must be considered. The debt was used to acquire a large number of things that are no longer needed in the sense that they are not viable in view of current economic circumstances. Accordingly, the very reasonable risk is that individual private sector borrowers will not have the resources to make timely payments for debt service and amortization. The high debt ratio reflects vast amounts of unused factory capacity, office space, warehouses, retail space, and other facilities.
The seen and shadow supply of vacant homes is not only large, but also probably unknowable. After two costly home buyer tax credits, the housing industry is no healthier now than it was before the additional deficit spending was incurred. The homebuyer tax credit produced the same outcome as the cash for clunkers program, which added to the deficit without providing a sustained lift to vehicle sales. These individual programs, regardless of whether one thinks they were meritorious or not, are still constrained by the very great likelihood that the government expenditure multiplier is close to zero.
This long list of excess capacity serves to undermine the demand for labor. The U.S. must work through this redundant capital stock before longer working hours will be made available to the existing work force. Even more time will be needed before longer working hours lead to increasing demand for new hires.
It is estimated that 125,000 new hires per month are required to provide jobs for our growing labor force. If the economy is to re-employ the 8 million plus individuals thrown out of work over the past year and a half, another 240,000 new jobs per month will be required. If we are to reach full employment status over the next three years our monthly payroll gains should be about 365,000 per month. This prospect seems quite unlikely.
An Impotent Fed
Fourth, monetary policy is not working in spite of the widespread contention that the Fed is wildly printing money. The line of reasoning by many observers is that the Fed's actions will soon lead to faster economic activity but with rapid inflation. The rationale seems to rely on the work of Nobel Laureate Milton Friedman, the world's leading researcher on money and its role in the determination of economic activity, inflation, interest rates and employment. Friedman's transition mechanism from money to either inflation or deflation appears to be poorly understood by those who assume that increases in the Federal Reserve's balance sheet are tantamount to inflation. To understand the fallacy of these arguments, first consider what constitutes money.

Money and Its Functions

Money can mean different things to different people and therefore defies a simple, rigid definition. But, Friedman and other leading scholars generally do agree that money, by definition, should be widely, if not completely, acceptable in exchange for all goods and services or paying off debts. Thus, money is valued because it can, with ease, be passed on to others without dispute that proper value is received. To understand Friedman's interpretation of money and its role, it is best to read Monetary Statistics of the United States: Estimates, Sources, Methods, (Columbia University Press for the National Bureau of Economic Research (NBER), 1970).
Money has three principal functions: a medium of exchange, a unit of account or standard of value and a store of value. First, money can be a tangible item, such as a dollar bill, that is accepted as payment for other tangible items or for services rendered. In this way, it serves as a medium of exchange in transactions. When an asset serves as a medium of exchange, it is completely liquid, as when the dollar bill is exchanged, without delays, for a hamburger.
Second, money can also serve as a unit of account or standard of value, in that it can be fashioned to define very precisely the value of particular goods or services. For example, U.S. gross domestic product (GDP) is reported in dollars, just as firms report their sales and profits.
Third, money can serve as a store for future use. According to Friedman, money, in this capacity, serves as "a temporary abode of purchasing power." You may store your wealth in a variety of places. Although gold coins were once used, gold is so illiquid that it is not even considered to be a form of near money--though it is still widely thought of as a store of value. Since its price can fluctuate widely and unpredictably, it no longer serves well as a medium of exchange or as a unit of account. Also, storage, insurance and conversion costs for gold may arise.

The Monetary Base is Not Money

The monetary base, bank reserves plus currency, does not fulfill these functions and hence does not constitute money. To paraphrase Friedman and Schwartz, the base, which is also known as highpowered money (currency in the hands of the public and assets of banks held in the form of vault cash or deposits at Federal Reserve Banks) cannot meet these criteria. The nonbank public – nonfinancial corporations, state and local governments and households - cannot use deposits at the Federal Reserve Bank to effectuate transactions. Moreover, currency is not sufficiently broad to be considered a temporary abode of purchasing power. For Friedman, high-powered money can be properly regarded as assets of some individuals and liabilities of none. So, let us be clear on this subject. In 2008, when the fed purchased all manner of securities, to the tune of about $1.2 trillion, the fed was not "printing money". Bank deposits at the fed exploded to the upside, the monetary base rose from $800 billion to $2.1 trillion, yet no money was "printed". Deposits did not rise, loans were not made, income was not lifted, and output did not surge. The fed could further "quantative ease" and purchase another $1 trillion in securities and lift the monetary base by a similar amount yet money would still not be "printed". It is obvious the fed authorities would like to see money, income, and output rise, but they cannot control private sector borrowing. If banks were forced to recognize bad loans and get the depreciated assets into stronger more liquid hands, it could be debated on how much reserves should be in the banking system. Until that cleansing process is completed it will be a slow grind to cure the one factor which makes the fed "impotent" and unable to "print money"....overindebtedness.
Friedman and Schwartz give very specific definitions of money, definitions that are consistent with the way that M1 and M2 are currently tabulated by the Board of Governors of the Federal Reserve. The Federal Reserve calls the stock of money represented mainly by currency and checkable deposits M1.
M1 is the narrowest measure of the money supply, including only money that can be spent directly. Broader measures of money include not only all of the spendable balances in M1 but certain additional assets termed near monies. Near monies cannot be spent as readily as currency or checking account money but they can be turned into spendable balances with very little effort or cost. Near monies include what is in savings accounts and money-market mutual funds. The broader category of money that embraces all of these other assets is called M2. M2 is M1 plus relatively liquid consumer time deposits and time deposits owned by corporations, savings and other accounts at the depository institutions, and shares of money market mutual funds held by individuals. Thus, M2 is: M1 plus very liquid near monies.
Money can encompass even more than M2, including such big-ticket savings instruments as certificates of deposit whose worth exceeds $100,000 plus certain additional money-market funds and Eurodollars. The Fed no longer publishes this broader measure of money, which was called M3. M3 was M2 plus relatively less liquid consumer and corporate time deposits, savings accounts and other such accounts at depository institutions, and money market mutual fund shares held by institutions. A working definition for M3 was: M2 plus relatively less liquid near monies. Thus, the Fed, following the standards set by Friedman and Schwartz, has established money definitions that fulfill its three functions: unit of account, transaction mechanism and a store of value. The monetary base, however, does not achieve these functions and therefore is not considered money.

Excess Money equals Inflation;
Insufficient Money equals Deflation

Building on the fallacious assumption that the monetary base constitutes money, some authors have seized on Friedman's quote that "inflation is always and everywhere a monetary phenomenon." These articles imply incorrectly that Friedman said that any increase in the quantity of money causes inflation, a proposition made even worse since Friedman actually rejected such a simple concept. According to Friedman, the inflation/deflation outcomes hinged on whether money increases are excessive or insufficient.
Early in his essay entitled The Optimum Quantity of Money Friedman wrote: "The real quantity of money has important effects on the efficiency of operation of the economic mechanism ... Yet only recently has much thought been given to what the optimum quantity of money is, and more important, to how the community can be induced to hold that quantity of money. ... it turns out to be intimately related to a number of topics ...(1) the optimum behavior of the price level; the (2) the optimum rate of interest; and (3) the optimum stock of capital; and (4) the optimum structure of capital."
As this passage reveals, for Friedman, an optimum quantity of money exists. Moreover, due to repeated Federal Reserve policy error, the nominal quantity of money has intermittently fluctuated wildly, forcing the nonbank sector to realign spending with the optimum level of desired money balances. By such policy actions, the Fed accentuated the volatility of the business cycle, which is why Friedman often advocated the FOMC be replaced by a monetary rule (i.e. with money growth fixed within a narrow band).
The evidence unambiguously indicates that current growth in the quantity of money is exhibiting a strongly deficient trend. In the latest twelve months, M2 has inched ahead by just 1.7%, the slowest pace in fifteen years, less than one-third the average annual gain in M2 of the past 110 years. Although the Fed no longer calculates M3, economist John Williams does, with his numbers registering the most severe contraction since the end of World War II. Hence, Friedman's monetary analysis is consistent with deflation not inflation.

Prelude to Deflation?

With the GDP deflator up less than 1% in the past four quarters and the core CPI in a similar range, the trend in inflation remains down. The risk, if not the probability, is that deflation lies ahead. Under a neutral velocity assumption, nominal GDP might be expected to improve a mere 1.7% in the next four quarters, the same as the previous four quarter rise in M2 (Chart 5). If this were split between inflation and growth, this would result in sub 1% numbers for both real GDP and inflation. Velocity (V2), however, is more likely to fall. V2 is mean reverting, a bad sign since it has been above the mean since the early 1980s. Moreover, velocity historically has declined when the private nonbank sector is deleveraging, as is the case currently. This condition is partially the result of the heavier government absorption of the pool of available credit. Also, there is a reduced incentive to take risks in an environment of substantially higher taxes. Thus, inflation and real GDP could both post surprisingly meager readings.
Long term Treasury bond and zero coupon bonds will perform well in this environment. Collapsing inflationary expectations (or should we say rising deflationary expectations) will drive the bond yields lower; perhaps even into the range of prior historical lows. In this environment, holdings of long Treasury paper will serve not only as a safe haven but an asset whose value will appreciate significantly.
Van R. Hoisington
Lacy H. Hunt, Ph.D.