Patience warranted

It has been some time since I wrote my last blog for Economicious. Do not fear, however, as I will return within few days (at least, I hope).

A lot has happened since my November 3 post in the world of economics (not in chronological order):

• harsh criticism on QE2;
• sovereign debt concerns in the Eurozone periphery;
• Trichet under pressure and ECB bond buying;
• the rescue of Ireland (and will Portugal, Spain, Belgium, Italy and even France be next???);
• talk on the collapse of the Euro;
• emerging markets still growing strongly, just like Germany;
• the US is growing still and showing better than expected data for some time, but worse than expected unemployment data last Friday;
• some experts still believe the US will enter a second recession in 2011 although the tax cut will be extended for 2 more years for even the wealthiest Americans;
• etc.
• etc.

So I am just contemplating what my next topic will be...

QE2 could boost growth, but it will not

Below, I will spend some time explaining how the programme that the Fed will announce in a few hours could boost the U.S. economy, and why it will not do this.

With already more than two months since the Fed started talking about a new programme of money-printing (the economics word for it is quantitative easing, 2nd version, also: QE2), the list of opponents to QE2 is growing larger, and the list includes ever more renowed names. Examples: Volcker, Greenspan, Stiglitz, PIMCO's Gross, etc. All of them warn for medium- to long-term inflation dangers that will be a huge cost of the quantitative easing programme, whereas benefits are minor - that is, if they are there.

Nevertheless, the Fed will announce its QE2 programme today. Probably with monthly asset purchases of $100 billion, after each injection of cash reconsidering its next step dependent on the economy's progress. The Fed is hardly paying attention to the warnings, so it seems. Or actually, most members of the FOMC are 'not hearing evil, not seeing evil'. But yet, the Fed has never been so divided over what to do next. How come? The upcoming package of QE is unprecedented; there is no evidence of the effects of such programmes. All that Boom-Boom Bernanke is now seeing is that the Fed's dual mandate is out of sight. At least, when you look at the numbers superficially (more on that later). One mandate, an annual inflation rate between 1.7 and 2% is being missed. The other mandate, achieving close to full employment, is even further out of sight with a current unemployment rate of 9.6%, with risks of rising further as the government's austerity programme probably kicks in by 2011. Hence, the two targets are not being reached.

But there's more to this dual mandate. First of all, they are intertwined. The historically high current output gap that partly exists because firms are not hiring (thus, low employment), so capacity is not being used. This causes deflationary pressures. Get employment up, and inflation rises. Secondly, it is doubtfull that unemployment is cyclical and can be reduced by loose monetary policy (that is why it seems that the second target is being missed, but actually the mandate concerns cyclical employment as there is always some structural unemployment). As the U.S. economy is somewhat recovering, many people do not have the skills required by the sectors that are recovering, as they have been trained to work in sectors that are now declining. Looser monetary policy will do nothing to change this. Rather, retraining of workers, more flexible labour markets and changed legislation are needed. This argument has been advanced some speeches by Dallas Fed president Richard Fisher, who strongly opposes QE2.

So is the achievement of the dual mandate in the Fed's reach? Probably not, given current conditions.

However, the logic of Bernanke is the following (he, obviously, does think QE2 will help - somehwat): asset purchases lower interest rates, lower the cost of borrowing and create a wealth effect as firms and households see their balance sheets improve due to rising asset prices, whereas lower borrowing costs induce them to borrow more; hence, to spend more. This will create a domestic-demand-driven positive growth cycle. Companies will start to hire again once they see consumer spending restored.

But there are some crucial steps that need to be taken for this QE2 programme to succeed, which makes the plan weak. Some problems related to QE2:

• Interest rates are already very low. Even if the real interest rates get pushed down even lower, why would this now all of a sudden induce the consumer and business owner to start borrowing?
• Financial institutions are reluctant to lend. The normal transmission channel of monetary policy is broken. Lowering interest rates further does not automatically get credit in the economy up.
• As banks do not lend, they sit on a lot of cash that needs to go somewhere, so they invest it in higher-yielding (hence: riskier) assets. These high-risk yields get depressed as well, as can be seen already today, because of these capital flows into emerging market (EM) stocks and equities. This could lead to risks being significantly mispriced again, which was one of the causes of the recent crisis.
• It takes time to recover from a debt crisis. Consumers and firms took a blow as they saw their balance sheets destroyed. They are now reluctant to spend, and are seeking to deleverage. They just want to get rid of the debts! They do not want to invest; they want to save.
• Bernanke assumes that lower borrowing costs can get consumers/firms to borrow more (due to the substitution effect). However, lower borrowing costs imply lower returns from savings. Therefore, consumers/firms need to save even more to achieve the same return from their savings. It might well be that this income effect outweighs the substitution effect, by a lot. This is a big point. If it is true (I think it is), interest rates need to go up, not down, to get people to safe less.
• Following from the previous argument: As long as interest rates remain low, wealth gets shifted from consumers that save to financial institutions that borrow, whereas the consumers should be the ones to carry the recovery. Now they get deprived of returns to savings, whereas financial institutions that are actually doing pretty badly get to continue their operations. Higher interest rates would get less-efficient firms and financial institutions out of business. Keep borrowing costs low, and overall economic productivity stays low.
• Lastly, if the so-called 'wealth effect' is to take place, consumers/firms would have to genuinely believe in the restoration of their balance sheets from the increase in asset prices. If they think that higher asset prices are caused by the money-printing instead of asset prices rising from demand-supply forces, they will not start to borrow more againts their assets. In other words: if they think their houses etc. do not truly become worth more, they will also not lend against higher house prices, because they will foresee a new burst of the asset bubble.

And in the end, if these problems persist, and the Fed does not quickly undo the injection of money into the economy, inflation will be upon us.

This is a long list of negative effects and problems related to QE2. Monetary easing cannot lift the economy out of the doldrums. It is far too uncertain that QE2 will do any good, because of the hurdles discussed above, while the unintended consequences are possible enormous.

QE2 distracts people from the true problem, which is the unsustainable level of debts in 'advanced economies'. This problem should be recognised and attacked. However, given that the Fed proceeds with its nonsense QE2 programma, I hope the markets can get fooled. If not, QE2 will have no effect and the next (debt) crisis will be seriously damaging.

Current growth-thinking, and what is just plain wrong with it.

Alternatively, the title of this blog could be: the myth of GDP growth.

What is bothering me for some time now, is the focus on GDP growth, while often, people do not realise what this growth actually constitutes, and what the reasons for the rise in GDP are. So I have made the chart below, which should make it clear (perhaps some clarification is needed).

The light blue part of the bars is U.S. public debt. The orange part of the bars is nominal U.S. GDP excluding public (federal) debt. Strikingly, the share of nominal GDP excluding federal debt as a part of total GDP is becoming smaller and smaller.

The dark blue line indicates the percentage change (yearly) in nominal GDP excluding debt. This share is falling since somewhere halfway of 2007.

The U.S. debt as a percentage of GDP is nearly 90, but this is when you include only the general government debt. It becomes worse when you include household debt:

By the way, the picture is even bleaker when taking account of financial sector debt. Total debts are 350% of GDP!

Obviously, if one would subtract household and government debts from U.S. GDP, one should conclude that the U.S. owes far more to its creditors than it generates every year. How does it plan on paying off this debt? Question: it does not.

Now the thing is: GDP might be growing by 1.5% on a yearly basis, debts are growing even faster. Apparently, the only way the U.S. economy can sustain a growing economy is by financing this growth by taking on debt. No, actually it is worse. The statistical decline of the economy is prevented by the accumulation of debt.

It is like I would produce paintings, and every year the paintings are getting worth less and less, but I can still say that their value is increasing year on year (because I have taken on a debt that I add to the value of the paintings).

So if we were being honest, we would admit that GDP is declining. In the U.S., but in many other advanced countries as well.

And then there is the issue of all the future liabilities that are not taken into account yet.

Given all the implicit liabilities of the U.S. for healthcare, ageing, etc., it becomes very difficult to imagine how these debts are ever goint to be paid off (again, the U.S. is an example, as the same goes for other countries). Estimates of the implicit future liabilities are seriously shocking. In some estimates for the U.S., they amount to 4 times the size of the economy.

The U.S. has some options left: restructure debts/plain default, inflate debts away, and structurally reform the economy to make it efficient and flexible again in order to boost GDP. The first two options seem impossible given the size of the U.S. debt market. U.S. creditors will not like it, to say the least. But that is another issue. The last option is just insufficient. Now, this is of course a very big problem, and that is an understatement. It seems to me that there is not an easy way out for the U.S., and sooner or later, these problems will have to be recognised, preferably before the bond market recognises it and the U.S. office of debt management faces Greek-style financing conditions.

For now, the problems are being ignored and even made worse by the accumulation of deficits, in order to continue living in a myth of a growing economy.