Thursday, October 9, 2014

Macro update

So far this week, we've had several pieces of economic news, which have significantly affected the stock market. We had a new CBO deficit projection for the year, a release of minutes from last week's FOMC meeting, and new unemployment numbers today. This month will also likely see the completion of the so called "taper" of the Fed's Quantitative Easing program, meaning that the Fed's net additions of US Treasury and Agency Mortgage-Backed Securities to its System Open Market Account portfolio will go to zero after October 31. The stock markets and financial media have been all over the map in interpreting this information, with a triple digit loss on the Dow on Tuesday, followed by a triple digit gain on Wednesday, and another triple digit fall today.

On the fiscal side, the deficit is the smallest it has been since.....2008--you know, that year we went into a recession. According to CBO, total federal outlays were about the same as last year, but revenues increased by about $200 billion, bringing down the deficit. If we were a country like Germany, which does not spend its own currency, this news might be a reason to celebrate. However, we in the US spend our US dollar, which is our own sovereign, nonconvertible fiat currency. That means that more dollars the US government spends, the more that are added to the economy. Conversely, the more dollars the the US government redeems through taxation, the less dollars that are left to the economy. So for an economy to grow, it needs a constant stream of new dollars added to it--and the only way this happens is through federal "deficits." I put word deficit in quotes, because it is really an inappropriate term for modern public finance. The word deficit comes from 'deficient', which means a running out or lacking of "things." Problem is, since 1933, US dollars have not been materials 'things that can be run out of, because they cannot be consumed or redeemed for anything other than themselves. US dollars are created by decree-- the Fed and Treasury declare them into existence by simply marking up bank accounts, to the tune of billions of dollars a day. So this shrinking deficit represents a shrinking amount of dollars being added to the economy-- not a good thing when we have so many resources, labor and otherwise, still sitting idle in the US.

On the monetary side, we had a release of the minutes from the last meeting of the Fed's FOMC, where we heard members discussing the continuing weakness of the labor market, the lower than expected inflation, and potential continuing need for what they believe is "stimulus." This news of potential stimulus caused the Dow to jump by almost 300 points and wiped out the losses from the previous day. However at this point, policy observers should have serious doubts that the FOMC actually knows what it is doing. Its member's comments and statements have been all over the map...sometimes things are improving and rates may need to go up, sometimes things are weaker than they seem and rates need to stay low (the latter of which we just heard them say). They also still seem to cling on to the belief that low rates and large scale asset purchases (QE) are an economic stiumulus, despite 6 years of contrary evidence. They haven't seem to have caught on to the fact that QE hasn't even succeeded at its ostensible goal of bringing down long term  rates (it has actually done the opposite:)

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To make matters worse, these FOMC statements cause the markets to jolt back and forth based just on reading the tea leaves and trying to guess intentions. Not a good way to make policy in the 21st century.

Its high time that the Fed consider Warren Mosler's thoughts on this: that low interest rates, while doing relatively little to stimulate bank lending, actually cause a drag on the economy, because all the trillions of dollars in outstanding assets and savings produce much lower yields for their owners. These asset holders therefore have much less interest income, which means they have less to spend. This is roughly equivalent to a tax increase on these asset holders. To make matters worse, most of the interest income that the Federal Reserve Banks earn on their increased holdings of Treasuries and MBS, by law, have to be remitted back to the Treasury. These remittances reduce the deficit in the same way as a tax increases reduce the deficit (and therefore the number of dollars in the economy)

So this "tax increase", along with the additional $200 billion collected by the IRS, represents a significant drain on the purchasing power of American citizens. This means that some other entity in the economy ie private sector creditors, have to spend more than their income to offset the federal shrinkage, otherwise X amount of produced goods/services will go unsold. Problem is, this private credit expansion via new originations of mortgage, student, commercial, and auto loans, as well as credit cards, never expanded very rapidly following the financial crisis, and now appears to be tapering off from even these low levels. This leaves foreigners as the only remaining source of net demand via "spending more than their income". But with China and Europe rapidly decelerating in the past few months, export led growth aint happening either.

One bit of recent good news has been the fall in oil prices. If this translates to lower gas prices for US consumers, this means we will have more money left over to spend on other things-- meaning a higher quality of living and more domestic demand. However this good news has a big downside as well. You know all that incredible job growth that states like North Dakota have seen over the past few years? Thats because higher oil prices have finally made the very expensive extraction techniques (fracking, shale, oil sands) that they use more economical. The problem is that these techniques, which have led to the much celebrated US energy boom, are only economical feasible if oil stays above around $78 a barrel. Oil prices are now near 2-year lows and sliding further. This puts many of the US oil operations, and the tens of thousands of jobs that they support, in serious jeopardy.

So I'm not suggesting any sudden collapse a-la-2008. However, there is little reason to expect any significant growth in the coming months. Remember, economic growth does not fall from the sky-- its always a result of policy choices. And the unfortunate reality now is that our policymakers have chosen to remain ignorant of how the economy actually works, and are therefore incapable of implementing any growth-restoring policies.