The US economy has been in crisis since
2008 and despite optimistic statements by officials and commentators there are
no fundamental signs that the crisis will end in the foreseeable future. Current economic data suggests a number of
diverging and unsustainable trends. The US economy has suffered a real estate collapse,
a stock market crash, a banking crisis, a near systemic collapse on a global
scale, a credit crisis, the worst economic downturn in the US since the Great Depression, and
an unprecedented global recession. Following
two sequential economic bubbles, the dot-com bubble and the real estate bubble,
no one has yet correctly called either the bottom for the US economy or the start of a US economic
recovery. Nonetheless, each day, news
reports, articles and statements by officials and commentators reveal new
economic data and offer new analysis. Unfortunately,
both the economic data and the interpretations offered by officials and
commentators are contradictory.
It appears that both
inflation and deflation are occurring at the same time; that the US gross
domestic product and consumer spending are declining while stock prices are
rising; that government spending is rising while tax revenues are falling; that
consumers are deleveraging and that the flow of credit has slowed while the total
of debts and liabilities in the US economy continues to rise; that the US
dollar is falling while price inflation remains nominal; that interest rates
are near zero for banks but rising for consumers. The seemingly contradictory facts indicate economic
distortions and therefore developing systemic instabilities. What ties all of the economic data together is
the US dollar. Rather than considering
what impact unsustainable economic distortions might eventually have on the US
dollar, could the developing systemic instabilities instead be the symptoms of
a currency crisis already in progress?
The debate over inflation
versus deflation in the US
economy tends to overlook the fact that both inflation and deflation are occurring
at the same time but in different areas of the economy. The policies of the US government and Federal Reserve are
inflationary but there are vast deflationary pressures with no apparent relief
in sight. Inflation, of course, is
simply an increase in the money supply rather than rising prices, which is one
of the effects of inflation. Deflation
is simply a reduction in the money supply rather than falling prices, which are
one of the effects of deflation.
Nonetheless, the effects of inflation can always be seen in the long run
in consumer prices, i.e., the dollar looses value as a function of monetary inflation
thus prices tend to rise.
Faced with the imminent
collapse of the US baking system in 2008, averting a deflationary depression,
such as the Great Depression, was obviously desirable but whether the radical
inflationary policies of Federal Reserve Chairman Ben Bernanke combined with US
government bailouts can ultimately save US banks remains to be seen. An inflationary outcome and a corresponding
fall in the value of the US dollar could ultimately be as destructive to the US economy as a
deflationary collapse would have been. At
the same time, monetary inflation in the financial system is a technical fix
that does not address the deflation in the broad US economy. The broad US
economy has continued to decline since 2008 despite having saved the banking
system and despite massive Keynesian interventions by the US government (deficit spending and
stimulus programs).
The relationship between the
banking system and the broad US
economy hinges on the levels of debt in the economy. Since the mechanism of money creation is debt,
the broad money supply cannot be inflated without increasing debt levels
outside the banking system. It is primarily
debt defaults that create deflation via bank losses and failures while the
engine of inflation (the issuance of new debt) has been separated from the broad
US economy and is now concentrated in the banking system and in US government
debt rather than being distributed over consumers and non financial businesses. This fundamental change may signal the end of
US
economic expansion characterized by debt levels rising faster than economic
output. Since consumers and non
financial businesses remain unable to take on new debt, deflationary pressures
continue to stress US banks.
According to the Federal
Reserve Bank of St. Louis,
the monetary base (MB) has approximately doubled in roughly the past 12
months. The increase appears to
contradict the fact that deflationary pressures impacting US banks continued
virtually unabated. Mortgage and credit
card defaults have resulted in 170 US bank failures since 2007. A recent Bloomberg article
indicated that the number of lenders that cannot collect on 20% or more of
their loans hit an 18-year high, signaling more bank failures ahead. Evidently, fewer bank failures have taken
place than would have occurred otherwise had it not been for the massive
interventions of the US
government and the Federal Reserve.
The MB data reflect increases
in bank reserves partly attributable to the Federal Reserve's Term Asset-Backed
Securities Loan Facility (TALF) program.
Whether banks can successfully borrow their way past their losses
depends not only on the magnitude of the losses relative to their revenues,
reserves and balance sheets but on future business performance. The strategy cannot work as long as the US economy
continues to contract, thus shoring up reserves with zero interest loans from
the Federal Reserve is only a short-term fix.
In any case, while new money has flowed into banks, it cannot filter out
into the broad US
economy which continues to decline.
The dramatic increase in MB is
not apparent in more broad measures of the money supply such as M3. M3 includes currency in circulation and all
types of deposit and money market accounts as well as other liquid assets. Although the Federal Reserve ceased
publication of the M3 monetary aggregate in March 2006, it is still calculated
by John Williams of Shadow Government
Statistics. M3 has been in a sharp
decline since 2008 and there is no indication that the rate of decline is
slowing. The M3 data reflect monetary deflation
in the broad US
economy.
Economic recovery cannot take
place in a deflationary environment simply because money is less available to
individuals and non financial businesses.
In particular, small businesses provide roughly 2/3 of all jobs in the US
economy and the flow of credit to small businesses has been sharply curtailed. The reduced availability of credit to
consumers and non financial businesses has had a strong dampening effect on the
broad US
economy. At the same time, consumer credit
card interest rates have gone up sharply in advance of the US
consumer-protection law slated to go into effect in February 2010 despite a
prime rate near zero. Consumers are
deleveraging (paying off debt) and non financial businesses, hesitant to borrow
in the face of declining revenues and economic uncertainty, are cutting costs
as well as jobs. Unless banks issue new
loans, deleveraging is, in effect, a deflationary force in the broad US economy
outside of the banking system.
The effects of the credit
crisis can be seen most clearly in the velocity of money (MZM) which shows that
spending on the part of consumers and non financial businesses has slowed dramatically.
MZM is the average frequency with which
a unit of money is spent in a specific period of time. Saving and deleveraging on the part of
consumers (as opposed to financing consumption via credit), reduced borrowing
on the part of non financial businesses, and unemployment all contribute to
falling MZM.
As deflation makes money more
scarce (falling M3), consumer and business spending slows down (falling MZM) exacerbating
falling business revenues, business failures, and unemployment, which in turn
put additional stress on US banks. This
is the short formula for a deflationary depression. Comparing the present situation to the Great
Depression, the main difference is that deflation due to bank failures is being
prevented, or at least slowed down, by a combination of bailouts (TARP and
PPIP) and FDIC insurance, and by radical interventions by the Federal Reserve
and the US Department of The Treasury, such as the TALF program and the
suspension of the Financial Accounting Standards Board (FASB) mark-to-market
rule. Unfortunately, saving US banks has
not prevented the decline of the broad US economy.
Another interesting difference
in the present situation compared to the Great Depression is that stock prices no
longer appear to accurately reflect business performance, e.g., the S&P 500
average price-to-earnings (P/E ) ratio is currently a multiple of the overall historical
average.
Source: Chart of the Day
(http://www.chartoftheday.com/)
Unsustainable P/E ratios are
typically the result of a stock price bubble.
However, in the present situation they reflect that widening gap between
the US banking system and
the broad US
economy. The trend in stock prices is
pulling away from indicators that more closely reflect the broad US
economy. Although deflation in the banking
system as well as in financial markets appears to have been held in check by
various interventions, economic recovery cannot take place unless and until
deflation in the broad US
economy can be reversed.
The current policy framework
of the Federal Reserve (and the view of modern economics in general) is that
monetary inflation not only supports economic growth by expanding the money
supply but stimulates economic activity (boosting M3 and MZM), thus inflation stimulates
economic growth. As a result, there is a
theoretical optimum level of inflation that can not only maximize economic
output by matching the supply of money to demand, i.e., to maintain a stable
currency value, but also a level that can maximize economic growth. Since inflation is the result of debt there
must also be an optimum or "healthy" level of debt for an economy relative to
its gross domestic product (GDP). Since
GDP growth is stimulated by inflation and inflation requires increased levels
of debt, maintaining an optimum level of inflation requires debt levels not to increase
disproportionately.
Whether the levels of
inflation required to accommodate normal economic growth, optimize economic
activity, maximize economic growth, and maintain a healthy level of debt in the
economy are the same seems to be a vitally important question. If not, the theory that economic output can
be maximized by manipulating the money supply beyond the scope of supporting
normal economic growth (as opposed to growth linked to inflation resulting in excessive
levels of debt relative to GDP) would in practice systematically create economic
instabilities that would ultimately be unsustainable. If that were the case, then the current
unsustainable economic distortions could be viewed as the inevitable
consequence of inflation characterized by excessive levels of debt relative to
GDP, i.e., excessive inflation.
At a glance, it seems that US
GDP, while in decline, remains near an all-time high in nominal terms. Interestingly, the GDP growth curve mirrors
that of cumulative CPI, which is directly a function of inflation.
Looking at the percent change
in GDP tells a different story. The way
that the US
government measures GDP has changed over time.
John Williams of Shadow Government
Statistics still measures GDP using the pre-Clinton
era formula.
While the rate of decline in
US GDP may be questioned, the fact of decline remains, i.e., the US economy is
in recession. Whether nominal GDP
indicates sustainable economic growth depends on the levels of inflation and
debt in the economy. Specifically, if
nominal GDP growth is accompanied by a disproportionate rise in debt, GDP
growth is unsustainable at best and illusory at worst.
US unemployment data point to
a further contraction of GDP. In an
economy where GDP growth has been associated with rising debt levels and where
consumer spending accounts for roughly 2/3 of GDP, unemployment cannot be
considered a trailing economic indicator and must instead be seen as a leading
indicator.
A further drop in consumer
spending can be expected as a function of rising unemployment. The policy response of the US government has had little effect
in terms of GDP or unemployment.
The key question with respect
to US GDP is whether total debts and liabilities in the US economy are sustainable. If not, new borrowing on the part of consumers
and non financial businesses cannot take place and deflationary pressures will
persist in the broad US
economy. Karl Denninger (The Market Ticker) has published
a number of articles discussing debt levels in the US economy.
US mortgage and consumer debt
levels, as well as asset values, have been in decline since 2008. At the same time, public debt has accelerated
due to a dramatic increase in US
government borrowing. Unfortunately, government
spending on behalf of consumers and non financial businesses cannot offset
deflation or halt the overall slowdown of the broad US economy. While Keynesian intervention (government
stimulus) may be effective in the short run to offset a mild recession, the theory
does not account for severe or prolonged declines or systemic instabilities. Japan's "lost decade", for example,
can be viewed as a failure of Keynesian intervention.
A closer look at debt levels
in the US
economy suggests that debt levels may not be sustainable and that points to
further bank failures ahead. When
discussing debt levels in the US
economy, it may be difficult for those outside of banking or economics to
understand what the numbers mean, but simple calculations can paint with a
broad brush where the US
economy stands today. According to data
published by the US Debt Clock
Organization:
- The current US national debt is roughly
$11,813,000,000,000 (equal to roughly 90% of official GDP) or $38,400 for
every citizen (excepting approximately 11 million illegal aliens).
- US household debt (mortgages, credit cards, student
loans, etc.) is roughly $7,523,000,000,000 or approximately $24,500 for
every citizen.
- Unfunded US government liabilities are roughly
$59,000,000,000,000 or approximately $192,300 for every citizen.
- According to Neil M. Barofsky, Special Inspector
General for the Troubled Asset Relief Program ("SIGTARP"), bank
bailouts, loans and guarantees related to the financial crisis total $23,700,000,000,000
(based on government data), or $77,126 for every citizen.
Federal and household debts
and liabilities for the entire US
economy, not including commercial debt, total $332,326 per citizen. Since there are approximately 2.6 persons per
household, according to the US Census Bureau,
debts and liabilities total approximately $862,000 per household. According to the Social Security Administration,
the national average annual wage is $40,405, thus the average citizen would work
roughly 21 years without pay to equal their theoretical share of total non
commercial US
debts and liabilities. For a household
with one income, the wage earner would work roughly 63 years to pay their
household's theoretical share of total non commercial US debts and
liabilities. While such estimates include
current debt and other liabilities and do not account for changes in wages or
the value of the US dollar, they clearly suggest a sobering reality: debt
levels in the US
economy are not sustainable.
Excessive debt levels in the US economy
point to excessive inflation in the past and suggest that GDP growth, having
been over-stimulated, will contract more severely than expected. Similarly, bank balance sheets must contract
for debt levels to return to sustainable levels.
Consumer debt, however, is
not the main problem. As unfunded
liabilities come due, the US
public debt will rise and servicing the public debt will grow significantly compared
to tax revenues. Fiscal 2009 federal tax
revenues were approximately $1.6 trillion, while spending was roughly $3
trillion. Interest on the US public debt
was roughly $361 billion, thus the cost of servicing the public debt
represented roughly 25% of tax revenues.
At the same time, federal tax revenues have been in decline.
Considering a scenario where
the US
public debt doubles, as is planned by the current administration, servicing the
public debt could result in a situation where it is impossible to balance the
federal budget and where the public debt will necessarily increase purely as a
function of mandatory spending. The
eventual default of the US
government and a corresponding crash of the US dollar would be inevitable.
While it may be interesting
to conceptualize debt levels in terms of individual or household liability and
to consider whether tax revenues will be sufficient to service a far larger
public debt, what is most important is how debt levels relate to GDP.
According to data from the
Federal Reserve and the US
government, the rise in debt levels has been pulling away from GDP growth at an
accelerating rate since the mid 1990s.
With GDP in decline, or in sharp decline as measured using pre-Clinton
era methods, the ratio of total debts and liabilities in the US economy to
GDP is unsustainable under any realistic GDP growth scenario.
Unsustainable debt levels are
the root cause of deflationary pressures in the broad US economy. There are only two ways to eliminate
excessive levels of debt: deflation and inflation. The policy response of the US government and Federal Reserve
has made clear that deflation will be prevented as far as it is possible to do
so, i.e., to avoid a deflationary depression.
The largest banks have been preserved under the "too big to fail" theory
and the US government, as has been demonstrated in the past year, stands ready
not only to borrow and spend whatever amount of money may be necessary without
regard for the public debt or future tax or budgetary consequences, but also to
take on virtually unlimited liabilities.
The question is: will it work?
The current policy response might
work if the US dollar were devalued significantly since that would reduce the
value of debts in real terms after prices, wages and asset values rose to
accommodate the reduced purchasing power of the dollar. The US government could manage a far larger
public debt if each future dollar used to service the debt were comparable, for
example, to $0.33 today. With a lower
value for the US dollar it might be possible to preserve bank balance sheets
and at the same time bring the ratio of total debts and liabilities, measured
in real terms, in the US
economy closer to a sustainable level relative to GDP. In other words, the process of monetary
inflation would have to be greatly accelerated.
Whether accelerated inflation
would be more unstable or more destructive than deflation is unclear. The obvious risk is that the US Federal Reserve
could miscalculate the rate of inflation, as it now appears they may have done
in the past, and loose control crashing the US dollar along with the US economy.
In any case, it appears the US dollar is
headed for a significant decline if not an outright crash under the current
policy response. The risk of
hyperinflation in the future seems insignificant compared to past levels of
inflation and the resulting levels of debt currently in the US
economy. It even seems possible that
"hyperinflation", meaning prolonged excess levels of inflation (perhaps
characterized by a series of asset price bubbles) has already occurred and that
what is taking place now is only the result.
Although the US dollar
rallied in 2008 as the global financial crisis brought world economies to a
precipice, the US dollar in 2009 appears much less attractive.
Setting aside the US dollar
inflation of past decades associated with the excessive levels of debt in the US economy today, a rapidly expanding Federal
Reserve balance sheet and quantitative easing ("money printing") are directly
weakening the US dollar while foreign appetite for US debt is waning. On a global basis, there is a growing shift
away from the US dollar both as a reserve currency and as an international
medium of exchange, as well as a developing US dollar carry trade threatening
to put additional pressure on the dollar.
In theory, the slide of the
US dollar can be stopped simply by reducing federal spending and raising interest
rates. However, a rise in interest rates
would bring about loan defaults in all categories and result in deflation due
to greatly increased bank failures. Raising
interest rates would accelerate, as compared with drawing out, the inevitable process
of purging excessive levels of debt from the US economy, thus paving the way for
a return to stable economic growth. Of
course, the idea of attempting a managed deflation is heresy to current US economic
policy.
The ongoing inflationary
policies currently helping to maintain the balance sheets of US banks mean that the total of debts and
liabilities in the US
economy remain excessively high relative to GDP, preventing genuine economic
recovery. Bank balance sheets can be
expected to continue slowly crumbling as mortgage, credit card and other loan
defaults continue while the recession drags on for what looks to be a period of
years. It seems unlikely that mortgage
backed securities, regardless of how they are valued for accounting purposes, will
not become liquid in the foreseeable future, thus US banks will remain in a
state of decay. In other words, it does
not appear that the policy response will work in the long run.
The apparent choice between
inflation and deflation may itself be illusory because both assume the US
dollar can survive the developing systemic instabilities in the US
economy and growing pressure on the dollar.
The US policy
response does not address the root cause of the problems in the US
economy: excess levels of debt. Since
monetary inflation is tied in lock-step to debt levels, an inflationary policy
response at this point can only produce unsustainable economic
distortions. The fact that managed
deflation was rejected as a policy option from the start suggests a failure to
recognize the root cause of the problems in the US economy. At this point, it is too late to put the
inflation genie back in the bottle, thus there is no fundamental way to stop
the slide of the US dollar in the long run.
Posted
Oct 11 2009, 01:45 AM
by
Ron Hera