Hoisington Quarterly Review and Outlook(2)

Monetary Policy

Monetary policy has broad powers, and many of those were wisely used during the financial panic of 2008. Subsequently, however, the exercise of those powers has been counterproductive to the average U.S. citizen. Two rounds of quantitative easing have raised inflation, but the pace of economic growth did not respond and the standard of living of U.S. citizens fell. During QE2 there were transitory increases in stock and commodity prices, but real consumer wealth fell. Money growth surged in both instances of easing, but the velocity of money fell sharply just as Irving Fisher in 1933 indicated would be the outcome in a highly over-indebted economy. In both these actions moderate income households fared the worst, thereby aggravating the divide between the upper and lower income categories. Some have advocated another round of quantitative easing under the assumption that in some unspecified way it might work better than the two previous failed efforts. However, QE3 has actually begun, in stealth form, via the European bailout. Since this program was announced, the price of oil and some other commodities has risen, bringing along the risk of a further drop in the real income of consumers. The unintended negative consequences of Federal Reserve actions appear to be continuing.

Writing in the Wall Street Journal on December 28, 2011, Gerald P. O’Driscoll Jr. of the Cato Institute and a former Dallas Fed Vice President said the Federal Reserve is engaged in a bailout of European banks under the guise of what the Fed terms “a temporary U.S. dollar liquidity swap arrangement.” Dr. O’Driscoll indicates the Fed and ECB are engaged in this roundabout transaction since each needs a “fig leaf” because the Fed does not want it known that the Fed’s balance sheet is being made available to foreign banks. He cites three problems with this approach. “First, the Fed has no authority for a bailout of Europe. …Second, these Federal Reserve swap arrangements foster the moral hazards and distortions that government credit allocation entails. …Third, the nontransparency of the swap arrangements is troublesome in a democracy.”

In addition to these problems, we would add that, in the final analysis, this new program is simply another expansion of the Fed’s balance sheet. This program will make the Fed’s balance sheet even more bloated relative to its mere $54 billion of capital, just 1.9% of total liabilities. Without evidence to the contrary, we fail to see how this cleverly named swap program can achieve any type of satisfactory outcome. In fact, any other balance sheet expansion activities, such as the additional purchases of mortgage-backed securities, will also fail to result in positive GDP expansion. On the contrary, the uncertainty created by untested Fed interventions will inhibit business planning and reduce risk taking, thereby slowing growth. In order to improve business conditions, improve psychology, and create a stable planning environment one approach would be a five year moratorium on all new fed actions and banking regulations, and a settled tax policy. Until that is accomplished, “animal spirits” will be depressed.

Recession in 2012

The interconnectedness of global activity will serve to further destabilize the global financial system in 2012. Although the federal government debt to GDP ratio is surging past 100%, if private indebtedness is included our debt to GDP ratio exceeds 350%. The same calculation reveals a debt ratio of 490% in Japan, 443% in Euro currency countries, and 459% in the United Kingdom. Similar to the U.S., their growth rates are also falling rapidly. In fact, there is compelling evidence that Europe and Japan have already entered recessions. In addition, manufacturing recessions have emerged in China and India, and growth in the Brazilian economy came to a standstill in the third quarter. These contracting growth rates suggest that U.S. exports will contribute to slower growth in 2012.

Exports have been critical to the expansion of the U.S. economy since the end of the last recession. Compared with the tepid rates of expansion in consumer expenditures of 2.1% and overall real GDP of 2.4%, real exports have surged at a 9.7% rate. Thus, the fast rising gain in exports equals slightly more than 48% of the increase in real GDP from the recession low. Considering that exports spur the need for increased non-residential fixed investment, as well as higher inventories, it is clear that without a booming export sector our expansion since 2009 would have been truly dismal. Unfortunately, the negative feedback of a global recession will not only impair the U.S. exports sector, but also will cause a steeper downturn overseas.

For instance, in Germany, the United Kingdom, and Japan exports accounted for 51%, 30%, and 16% respectively of their GDPs in 2011. In France, Italy and Spain exports averaged about 29% of GDP. The loss of exports to the United States will be most detrimental to the European economies, feeding back to a slower export sector in the United States. Thus, the main driver of growth (exports) for this expansion will be sharply diminished in 2012.

Weakened Consumer

Beyond the slowdown in exports, the deteriorating financial circumstance of the U.S. consumer is also contributing to the recessionary conditions this year. First, real consumer net worth (Chart 4) has fallen over the past year as domestic stock prices stagnated, foreign equities and lower quality bond prices fell, and home prices continued to decline. As indicated in Chart 4, a drop in net worth has been associated with the start of each of the past six recessions. The pace of decline in real consumer net worth is heavily influenced by home values. Home prices seemed to stabilize over the summer, but have recently fallen to new cyclical lows. Stubbornly high delinquency rates, sluggish employment, and declining real incomes all suggest a continuing fall in housing, the largest portion of U.S. consumer net worth. Second, consumer incomes in real terms have been falling. In November, real disposable personal income less transfer payments was at the same level as in December 2008 and April 2006. For a time, consumers can sustain spending by reducing their saving or increasing borrowing. The impact of these efforts, however, was to lower the personal saving rate (Chart 5) from 5.8% in 2010 to just 3.5% in November, near the same level that existed at the start of the recession in 2007. We expect that consumer spending will slow to match the existing trend in negative real income. A third restraint on the consumer is rising taxes. At the end of 2010, total federal, state and local taxes accounted for 17.76% of personal income, but by October the effective tax rate was up to 18.20% despite a 2% reduction in the FICA tax rate in 2011. The offset was a rise in state and local taxes last year, and further tax increases are expected in 2012.