After several weeks of decline in the stock market, we finally staged a significant rally on Monday. The Dow (DIA) was up 1.65%. The S&P 500 (SPY) and the Nasdaq Composite (QQQ) were up 2.21%. We were arguably due for a little rebound, but if the fundamentals matter at all, it won't last. The three charts featured in this article lay out part of that fundamental case.
Since QE3 was announced, and a week or two prior to that, I have presented my views on why monetary and fiscal policy is just not working to revive an economy that remains bloated with excess leverage four years after the credit bubble crisis. Some have listened, but I'm not sure very many really understood.
Our recent focus has been on the economic impact of the scheduled spending cuts and tax hikes. The assumption is that some kind of "Grand Bargain" will work to avoid recession in 2013. I don't think many really believe that, but I am reasonably sure few really grasp the magnitude of the dilemma Congress is faced with.
As Chairman Bernanke pointed out on Tuesday, Congress dealt with the debt ceiling and the deficit spending issue in 2011. Back then, Congress agreed -- in exchange for a debt ceiling hike -- to attack the massive deficits by implementing the "sequestration cuts" and allowing the Bush tax cuts to expire. A few days later, Standard & Poor's issued a credit downgrade in spite of the resolution to the debt ceiling dilemma. The credit downgrade fueled a mini market collapse.
Today -- 15 months later -- we are once again pondering a way to renege on another commitment to deal with the debt and deficit. The truth is the "fiscal cliff" issues just don't matter. Whatever Congress comes up with will not work. Our economic recovery -- if one wants to call it that, and I don't -- was built entirely on the back of a massive and unprecedented acceleration of public debt.
The inconvenient truth is that absent massive public spending, we would have completed the deleveraging process that was started in 2008 and interrupted with monetary and fiscal stimulus. It can be argued that this borrow and spend policy has done nothing to affect a legitimate economic recovery and in fact, at this point, it is simply adding to the problem.
I have selected three charts as the focus of this article. All three are long-term charts, and demonstrate why our economic dilemma is dramatically different and much more serious than in times past. Let's start with the Labor Participation Rate chart:
This chart goes back to 1983. It presents a picture very seldom considered when we look at weekly and monthly jobs data figures. When we look at the shorter-term charts, we tend to get a distorted view of the really serious nature of the unemployment picture. The bottom line -- labor participation is at a 30-year low, and in spite of that lack of participation, we remain -- four years after the recession ended -- at 14.6% unemployment using the U6 figure.
The U6 unemployment number in January 2009 was 14.2%. Last month, the number was 14.6%. We have made no gains at all since President Obama took office in 2009 based on that metric. In January 2009, the participation rate was 65.7%. In October 2012, the participation rate was 63.6% -- a drop of 2.1%.
The net takeaway from these numbers is that the U6 number would be even worse than it is if the participation rate had remained at 2009 levels. Consider that the BLS doesn't take into account those workers who have simply given up. If those representing the 2.1% drop in participation rate were included in the number, the U6 figure would be even larger than 14.6%.
$7 trillion in borrowed money and almost $3 trillion in monetary stimulus has accomplished nothing to date to improve the unemployment situation. At what point do we accept reality? Government stimulus is not helping to resolve the problem and is, in fact, going to make it that much worse when natural market forces outweigh all other forces and we enter into a protracted recession.
It is true that fiscal stimulus has worked to keep GDP in positive territory over the last four years, but what happens going forward? Are we going to just keep the life support system hooked up by borrowing $1 trillion-plus per year to pay those workers who no longer have a job? One wonders how long we can do that before we are forced to reckon with the reality of our predicament.
Moving on, let's look at the next chart. The chart below shows excess reserves in the nation's banking system. The hockey stick appearance of the chart reflects the massive amounts of liquidity that the Federal Reserve has injected into the banking system since 2009.
Many traders and investors see this as proof that the Federal Reserve is doing their job as it relates to M2 expansion. It is this misunderstanding of how our monetary policy and fractional banking system really works that has served to drive asset prices higher.
As a side note, it is important for gold investors to understand the reason why gold did not move higher after QE3. The reason is that liquidity injections into a banking system that is already bloated with untapped excess reserves is not inflationary.
The sharp spike in excess reserves is indeed the result of the Fed's quantitative easing initiatives. The problem is these injections of liquidity by the Fed are still sitting on the books of banks as excess reserves. That is not what the Fed wants to see, and is the best way I have to prove my point that QE is a failed policy.
The huge spike in excess reserves is reflected as an asset of the bank, not the depositors. Why is that relevant? It is relevant because the banks don't spend that money for automobiles, computers, food, gasoline or anything else that adds to GDP.
Excess reserves are simply idle funds, and they do nothing to drive GDP or unemployment in the desired direction. It just sits there. It is only when the banks use that money to make loans to businesses and individuals that the cash on the bank's balance sheet moves into a depositor's account. At that point, this money is at least in a position to drive GDP growth.
This situation is discussed in Keynesian economic theory. It is the classic Keynesian "liquidity trap." "Liquidity traps" are the result of fear and apprehension. People and businesses -- for whatever reason -- are afraid to borrow. They elect, instead, to pay down debt and increase savings.
This is a huge deal and validates my argument that QE won't work to drive assets higher. It is an increase in M2, but practically speaking, it shouldn't even be considered as M2 until it moves into a depositor's account. QE3 -- the most recent addition to the QE initiatives -- will add another $40 billion a month to M2, but just like the other QE initiatives, it will do absolutely nothing to expand GDP or induce inflation.
Those who get this point should see it as a serious problem. It demonstrates a massive and unprecedented failed effort to shock our economy back into growth mode. Consider that this chart goes back 50 years.
The sheer magnitude of the injections expands the scale on the chart to such a degree that it gives the impression the Fed has never injected liquidity into the bank system before. Of course, that is not true, but the amounts are imperceptible on the chart above due to the need to expand the scale to encompass the massive money infusions the Fed has made in the last four years.
That brings us to my last chart -- M2 velocity. The chart below should help to connect the dots and allow you to come away with an epiphany moment. Money velocity is simply the number of times a single unit of money -- let's say a dollar -- is spent in the economy.
Let's consider an example of how this might work. If you spend money at the supermarket for food, the owner of that supermarket might take that money and use a portion of it to replenish his inventory. In turn, the supermarket's vendor might use it to pay an employee, and that employee might use it to buy food from his own local supermarket.
In the example here, money was turned over four times, and it created $3 in GDP. It went from you to the supermarket ($1 GDP) to the vendor ($2) to the employee and back to the supermarket ($3). The impact of the money velocity example above is that $1 created $3 in GDP.
What's significant here is that the chart above shows money velocity to be at a 50-year low, and the lower the money velocity, the lower the GDP. Once again, these aren't normal times, and any attempt to draw a parallel to our situation today with any of the recessions we have experienced in the last 50 years is flawed. We have never seen anything that remotely parallels the situation we are in today, as these long-term charts clearly demonstrate.
Now, let's connect the dots. Money velocity is at a 50-year low at 1.56. Money velocity is the ratio of M2 to GDP. The reason money velocity is so low is that a significant portion of M2 is locked up in excess reserves, and is doing nothing to drive GDP growth.
From a practical point of view, M2 should be reduced by the amount of excess reserves to see what impact QE has had on money supply. The reason is simple enough -- excess reserve balances cannot be used to drive GDP.
The most recent number for excess reserves is $1.418 trillion. If we subtract that from current M2, we end up with the amount of M2 that is actually available for use. That number is $8.873 trillion. At the end of December, 2008 M2 was $8.212 trillion.
The takeaway here is that the very modest real increase in M2 (M2 - trapped reserves) has been negligible and explains why inflation and GDP growth have both remained constant for the last four years at 2%. In fact, inflation must be taken into account in the roughly 2% increase in GDP, and when that inflation is factored out of GDP, we have had zero real growth.
As we ponder the issue of the "fiscal cliff" and the upcoming debt ceiling debate, one wonders what our political leaders are thinking. The focus is on the tax hikes and spending cuts that are scheduled to take place in 2013. Virtually everyone knows that if these spending cuts and tax hikes are implemented as current law provides, we are going into a recession. But in the end, we are going into recession anyway.
The preposterous idea that a resolution to the "fiscal cliff" prevents recession certainly ignores the data set forth by these charts. There is no question that fiscal stimulus has served to prop up the economy for the last four years. There is also no question that monetary stimulus -- provided through QE -- has done virtually nothing.
Why do so many cling to the belief that the Fed is simply a "money printing" machine and will eventually print enough money to get us moving in the right direction? It hasn't happened despite unprecedented levels of liquidity infusion into the banking system, and there is simply no reason to think that when we wake up tomorrow morning, that will change.
These are different times than any of us have ever encountered. We can bury our heads in the sand and deny the truth or we can, once and for all, accept reality and deal with the consequence of the government excess that has brought us to this point. Simply solving the "fiscal cliff" issue will do nothing to solve the real problem. It is time to accept that truth.
The severity of our economic dilemma is unprecedented, and there is no viable solution other than a completion of the deleveraging process that began with the credit bubble crisis and interrupted -- by a government in denial -- with massive stimulus. This is not the talk of a "doomsday" prophet -- it is the talk of a realist.