This is an appendix to our earlier post, “Banking Buffoonery, Modeling Mysticism and Why Krugman Should Be Sweatin’ Bullets.” We discuss the Bank of England report and IS-LM model in more detail, using a Q&A format.
Technical Notes for ‘Banking Buffoonery’
Banking Buffoonery, Modeling Mysticism and Why Paul Krugman Should Be Sweatin’ Bullets
We have a few things to say about the recent debunking of established monetary theories.
In case you missed it, the Bank of England issued a report in March explaining that standard textbooks get money and banking all wrong.
The authors point out that banks don’t wait for deposits before making loans, as often claimed by academics. It’s the other way around. Banks create new deposits when loans are made, for this is how loan proceeds are delivered to the ultimate recipients. The fact that deposits then slosh around from bank to bank has no bearing on future loan issuance, which is always matched with newly-created, not old, deposits.
Moreover, the role of bank reserves is badly botched by academics. Central banks don’t use the monetary base (currency plus reserves) as a tool to constrain lending, contrary to textbook descriptions of the so-called money multiplier. Rather, bank reserves are supplied by central banks “on demand”. The authors explain that policymakers normally don’t “fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”
The media conveyed these points with unusual excitement for such a bland topic. But the bigger story goes beyond banking fallacies to a between-the-lines message about economic modeling.
Technical Notes for ‘3 Underappreciated Indicators’
This is an appendix for our earlier post, “3 Underappreciated Indicators to Guide You through a Debt-Saturated Economy.” We’ll share a few extra charts and describe our use of the Fed’s flow of funds data, in Q&A format.
3 Underappreciated Indicators to Guide You through a Debt-Saturated Economy
If you’re my generation or older, you may remember taking the original Pepsi Challenge – the Coke versus Pepsi taste testing booths that you would find at sporting events, fairs and similar venues. I took the Challenge and stuck with Coke. The majority of people went the other way, as confirmed by even Coke’s private tests. Nowadays, though, I’m guessing the public version of a Challenge booth would bring heckling from the nutrition-conscious folks at the Just Juice stand. The bigger challenges for Coke and Pepsi are health risks linked to their flagship products. Researchers are zeroing in on a handful of ingredients that may be harmful, such as sodium benzoate and phosphoric acid.
We have nothing to add to the soda studies, but they somehow seem similar to our research on debt. Like soft drinks, you can think of debt as having different ingredients, some benign and others risky. At the highest level, here are the ingredients that everyone should be aware of (hereafter, we’ll call them funding sources):
- Funding from outside the U.S.
- Funding from the Federal Reserve system
- Funding from private banks
- Funding from non-money savings
Over any period, we can examine the total amount of borrowing and divide it among these sources with only a small residual. Here’s a breakdown for the last 60 years:
Is This What a Credit Bubble Looks Like?
There’s been some buzz recently about a pick-up in business lending. The six largest banks increased business loans at an average annual rate of 8.5% in the first quarter, according to a Wall Street Journal report last week. Other first quarter data reported by the Fed shows commercial and industrial loans jumping 12% from last year. Charles Schwab’s chief strategist went so far as to call a chart depicting the Fed’s broader lending data “the most important chart in the world.”
Unlike some pundits, though, we’re not convinced that a surge in business credit is such a good thing. We don’t doubt that more lending to small businesses, in particular, might do some good if it doesn’t go too far. Lending to large corporations, on the other hand, is a different story. Corporations are already borrowing at a pace that’s only before been seen near cyclical peaks:
Bulls vs. Bears: Some Profit Margin Stories Are Better Than Others
[M]argins have been rising smartly–faster than Greenspan can ever recall. His only explanation: productivity… Greenspan argues that the U.S. is undergoing a productivity revolution not seen since early this century… In the longer term, he’s betting that as the world moves into the 21st century and the New Economy takes root, more of the old economic rules will fall apart.
- From “Alan Greenspan’s Brave New World,” Business Week, July 13, 1997
I caught up recently on a debate about S&P 500 valuation involving GMO, Hussman Funds and their assorted critics (see here or here, for example).
As you may know, GMO and Hussman take the position that stocks are expensive, citing a variety of indicators and arguing that profit margins should “mean revert” from record highs. On the other side, market bulls dispute the indicators and propose that fat margins are no big deal – they might just remain at record highs indefinitely.
“High margins reflect a long-term structural change, not a short-term cyclical one,” according to one account of a popular position. Also: “It’s a mistake to think that margins will revert to a long-term mean just for the sake of reverting to a mean.”
The message seems to be that mean reversion is for losers. This is a new era, or it’s a new economy, or whatever. I’m paraphrasing, but the story sounds a lot like the capital letter New Economy of the late 1990s. There’s even a technology angle once again, along with huge confidence in monetary policy and recession-free growth. Above all, there’s a notion that the world might be different.
Needless to say, the new, new economy story comes with plenty of red flags. But let’s not dismiss it just because it didn’t pan out the last time around. If we’re not buying the story, we should at least have a clear rationale and not just assume mean reversion “for the sake of reverting to a mean,” as noted above. I’ll take a shot at providing such a rationale. Or, as Brad Katsuyama might say: “Let’s do this.”
Message to the Fed: Here Are a Few Things That You Can’t Do
[A]sset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.
-March 19 FOMC statement
The excerpt above or some variation has appeared in every one of the Fed’s post-FOMC meeting statements since the beginning of QE3 in September 2012.
Unfortunately, it doesn’t give us much comfort. We don’t see evidence of the Fed’s economists accurately gauging QE’s “efficacy and costs,” notwithstanding its oh-so-slow wind down. On the contrary, history shows that these economists have an inflated view of what they can achieve with monetary policy.
Take the link between QE and jobs, for example. We were struck by the following question, asked recently by commenter “liongterm investor”:
How does a dollar (or trillion dollars) added to the Fed balance sheet create a job? This is a serious question; I am not trying to bait someone into an argument … What I do understand about QE is how money the ends up [in] excess reserves earning interest from the Fed larger than what my deposits or short term treasuries earn. I also understand how the money can end up driving up equity prices. But job creation??
We don’t doubt that “liongterm investor” is aware of “wealth effects” – the idea that a booming stock market encourages happy investors to buy an extra luxury item or two, and this might eventually create a few positions at, say, Tiffany. But it’s not a very powerful effect, is it? Nor can we be sure that it won’t come back to bite us, for reasons we’ve written about in the past (see here, here, here or here).
What’s more, questions of what the Fed can and can’t achieve go beyond QE. We touched on the limitations of monetary intervention in recent research on where the economy stands today:
- “What Needs to Happen Before We See a Big Recovery?”
- “Corporate Capex Fallacies and Why You Shouldn’t Rely on CNBC”
We’ll build on that research below with a handful of charts showing that there are many things the Fed can’t do when it comes to manipulating the economy.
Corporate Capex Fallacies and Why You Shouldn’t Rely on CNBC
We get experts on everything that sound like they’re scientific experts … They’ll sit at a typewriter and make up all this stuff as if it’s science and then become an expert … Now, I might be quite wrong, maybe they do know all these things. But I don’t think I’m wrong. You see I have the advantage of having found out how hard it is to get to really know something … how easy it is to make mistakes and fool yourself. I know what it means to know something. And therefore, I see how they get their information and I can’t believe that they know it. They haven’t done the work necessary. They haven’t done the checks necessary. They haven’t done the care necessary … and they’re intimidating people.
-Richard Feynman, Nobel Prize-winning physicist
The excerpt is from a 1981 BBC documentary about Richard Feynman that was linked in a Zero Hedge post several years ago. Unfortunately, Feynman passed away in 1988 and never had the chance to watch the “experts” on financial television. We would have particularly liked to hear the great physicist’s thoughts on economics punditry.
To understand economics experts in Feynman’s absence, the best analogy that we can think of is to the methods of a magician. Magicians operate by showing their audience a small window on reality, and then tricking people into mentally filling in the rest incorrectly. Because the economy has so many moving parts, a similar approach also works in economics. Pundits can draw our attention to a couple of indicators, ignore everything else, and make claims that sound realistic even though they make little sense in the bigger picture. One difference between economists and magicians, though, is that economists are often unaware of their trickery because they fool themselves before fooling others.
To be clear, we don’t claim to be immune to such deceptions, but we do try to root them out as best we can and will do that here.
We’ll look at capital expenditures (capex), in particular. You can’t take in much media commentary today before finding someone arguing that capex is lower than it should be. Crystal ball gazers predict a capex resurgence that lifts the economy into a robust recovery, while pundits with an activist bent implore businesses (and public officials) to ramp up their investments.
There’s usually some combination of four pieces to what we’ll call the “CNBC” story:
- Corporate cash is high
- Net investment is low
- Bond yields are low
- Corporate profits are high
These four observations are said to demonstrate that businesses are behaving irrationally or improperly by not pushing capex higher. And the story may sound reasonable on the surface, but is it really that simple?
Did Today’s Flow of Funds Report Predict the Fed’s Next Confession?
In return for speaking fees reported to be “at least” $250,000, Ben Bernanke confessed a few of the Fed’s missteps while speaking to guests of the National Bank of Abu Dhabi on Tuesday:
- “Bernanke says he underestimated impact of subprime problem.”
- “This is going to sound very obvious but the first thing we learned is that the U.S. is not invulnerable to financial crises,” Bernanke said.
- “Bernanke says he thought slowdown would be ‘moderate’.”
Bernanke’s gentle mea culpas had us wondering what kind of confessions we may hear next. It’s probably not surprising that we didn’t have to wait long for clues.
Consider this chart created from the household balance sheet in today’s Flow of Funds report:
What Needs to Happen Before We See a Big Recovery?
In a Bloomberg article last May, Caroline Baum summed up the economy nicely in a single question:
Four-and-a-half years of an overnight rate near zero and aggressive securities purchases by the Fed have succeeded in raising asset prices. The question is whether higher asset prices will deliver jobs and economic growth before they become destabilizing.
In other words, will the real economy mend before excessive financial risk-taking kills the patient?
Baum called it a “horse race.”
With 2013′s economic data mostly complete, let’s have a look at where the race stands.