Mid-Year Macroeconomic Review: History Repeating Itself

In mid 2006, I wrote that the Fed’s financial obligations ratios suggested that the federal deficit had gotten too small to sustain the kind of growth we’d been seeing, and that aggregate demand would moderate until the economy got weak enough to get the federal deficit to probably about 5% of GDP as had been the case in most previous cycles.

And, at the same time, rising crude prices due to monopoly pricing power would drive up CPI.

I had also thought the Fed would keep rates steady or increase them as inflation expectations rose, and that the higher interest rates would further drive up CPI and support incomes through the interest income channel as the non government sectors are large (equal to the size of the outstanding Treasury securities) net savers.

GDP growth did start declining and CPI did start climbing, as did inflation expectations. However, I was wrong about the Fed’s reaction as they cut rates long before CPI peaked.

Ironically for the Fed, events seemed to support that notion I have long suggested that rate cuts are in fact deflationary, working through the 'cost channel' as well as the 'income channel' as the rate cuts removed interest income from the non government sector and contributed to the decline in aggregate demand. The $170 billion Q2 08 fiscal package more than offset that, however, and real GDP remained positive for the first half of 08.

The end of that fiscal package coincided with what I termed the 'Great Mike Masters Inventory Liquidation' which was even more severe than I had imagined, lasting to year end, and driving down GDP in the process.

By year end the rapid increase in unemployment and the decline in tax revenues combined to increase the federal deficit to over 5% of GDP, boosting the $US net financial equity of the monetary system by that same amount (federal deficits add directly to non government savings of financial assets) and slowing the decline of personal income to the point of ending the inventory liquidation by the end of q4 and reversing the decline in the rate GDP some time during Q1.

Q2 GDP is currently looking to be somewhere near flat and maybe positive as the proactive fiscal measures begin to kick in, and with international inventories starting from extremely low levels.

My proposals for fiscal policy, once the inventory liquidation was in progress, included the payroll tax holiday (the Treasury would make all payments for employees and employers), $300 billion of revenue sharing for the states on a per capita basis, and funding a job for anyone willing and able to work that included health care.

This would have eliminated the need for unemployment to rise and GDP to fall as the means of restoring the federal budget deficit to level necessary to sustain output and employment. And all with the caveat that energy prices would resume their climb as soon as stability was restored if there was not a credible plan in place to immediately cut US domestic crude oil consumption.

Rather than something like my 'bottom up' approach to restoring aggregate demand and restoring the ability to make mortgage and car payments, our government instead took a 'top down' approach, with both the Treasury and the Fed buying only financial assets - a policy that does nothing for aggregate demand, and only prolongs the agony of waiting for the automatic stabilizers work to restore aggregate demand through the most ugly process of rising unemployment and falling tax revenues.

The Obama-boom is now underway due to the ‘automatic stabilizers’ described above, and the additional fiscal adjustments that began in April. Unfortunately, because there was no fiscal response, we got here that ugly way, via rising unemployment and falling taxable incomes- a real and tragic cost. Sadly, those real losses are water under the bridge, never to be 'recovered.'

And, unfortunately, our crude consumption has dropped only modestly and is already increasing as GDP stabilizes, even at current levels of unemployment. As a consequence, crude prices are headed north again, and will support headline and eventually core CPI through the cost structure, as cost push ‘inflation’ resumes after pausing for last year's massive inventory liquidation.

While off of last year’s highs, food prices are now rising from levels that are about double those of a few years ago and crude prices nearly triple earlier levels.

The US fiscal expansion is also likely to drive imports, with rising crude prices increasing the US import bill as well. This keeps a lid on domestic employment, and as unemployment remains high and real wages stagnate, increases in real consumption and wealth due to productivity increases and (some) employment gains necessarily flow to the ‘top’ in what could be the largest upward flow of real wealth we've ever experienced.

It also means US dollars will be ‘easier to get’ overseas which puts downward pressure on the USD. The Fed and Administration are prone to look at this as a ‘good thing’ as they view increased ‘competitiveness' that drives increased exports ‘necessary’ to ‘balance the trade account.’

For the real economy, however, rising prices of imports while nominal wages are contained decreases real standards of living as workers use up their take home pay on food and energy, exporting a greater share of their output rather than consuming it. This is what happens with an administration that doesn’t understand that exports are real costs and imports real benefits.

The Fed will soon be looking at sub trend GDP, unacceptably high unemployment, a falling dollar, rising headline CPI and rising inflation expectations. And while recent history says they will keep rates low as long as they perceive an continuing output gap, they are also keenly aware of severe mainstream criticisms of the former chairman for keeping rates too low too long. And I do expect the mainstream to define away a large chunk of the output gap by raising the 'natural rate of unemployment' as CPI and inflation expectations escalate.

Meanwhile, the administration will see the same data and be hesitant to blame the Fed for inflation, for fear of triggering higher interest rates.

Ironically, this disturbing scenario is, historically, a near ideal environment for nominal equity prices, so the administration may soon be presiding over a period of increasing wealth in the financial sectors, the senior management level, and in the investor classes in general, while pondering what to do about unemployment in the face of rising inflation and what is perceived as a too high budget deficit.

This makes the major risk to equity valuations the potential political responses rather than the fundamental economic forces. These could include higher corporate (as well as personal) taxes on both earnings and dividends, and excess profits taxes should energy prices move back towards last year's highs. The recent attack on the $190 billion of 'corporate loopholes' may be indicative of where the administration is looking regarding the presumed need for tax revenues.

Comments

[Missing_Link:]

The market can jump, but it cannot fly.

Your comment reminded me of a quote from JS Kim's insightful article at seekingalpha.com/artic...

"Since most citizens don’t understand the extreme fragility of the bubbles the financial oligarchs create and instead interpret the bubbles as bull markets that cannot end [...]"

On May 10 03:48 PM Cetin Hakimoglu wrote:

> Buying toxic financial assets improves investor & business confidence.
> The banking system was seizing, and the efforts of Bernanke, Geithner,
> Palson, Geroge W. bush, and Obama fixed it by bailing out the too
> big to fail. Now the stock market is surging and the economy is turning
> around. It seems the bailouts and stimulus accomplished their intended
> goals.

May 10 04:06 PM

[Market Sniper:]

Same argument. That you can borrow your way to wealth and print your way to prosperity. These are recipes for disaster and will accomplish neither. Read some history. Old road, well traveled, ending in a bad place.

May 10 05:05 PM

[UbuTranscen...:]

Warren,

Washington is, after all, first and foremost, a political arena and has never let logic or sensibility significantly interfere in the exercise of power or allocation of the nation's wealth.

The 'bottom-up' proposals for economic stimulus that you made last October were logical, sensible and comprehensible. They almost certainly would have benefited the American public and strengthened the economy far more than the course of action actually chosen by the wholly-owned Washington subsidiary of Goldman Sachs now managed by Mr. Geithner.

Your proposals would not, however, have been nearly as beneficial as our present course has been for the GS parent company.

Thus, in retrospect, we can now see how wrong-headed your proposals were. In the future, before distracting the public with merely great ideas, and logic only appropriate on the planet Vulcan, please consider first the meager needs of the downtrodden, impoverished, maligned and abused true heroes of Wall Street: banks.

In parting, I note that the US Mint has leaked that an inspiring phrase will be printed on the new $1000 bill coming into circulation soon. (Soda machines are already being reprogrammed to accept it as exact change for a 20oz Coke.)

I simply can't wait to get a new G-note in change at McDonald's and read those words of comfort:

"What's good for Goldman Sachs, is good for the Nation."

Ubu.

May 10 08:01 PM

[Warren B. M...:]

On May 10 03:48 PM Cetin Hakimoglu wrote:

> Buying toxic financial assets improves investor & business confidence.
> The banking system was seizing, and the efforts of Bernanke, Geithner,
> Palson, Geroge W. bush, and Obama fixed it by bailing out the too
> big to fail.

They didn't fix it by doing that, as in any case the FDIC was there to support continued operations.

The performed an alternative 'fix' to the normal FDIC channel which could have done what functionally would have been nearly identical.

Now the stock market is surging and the economy is turning
> around. It seems the bailouts and stimulus accomplished their intended
> goals.

As per my article, the turn came after the deficit poked through 5% of gdp and got large enough to support income and 'savings' of financial assets.

>
> --------------------
> Rather than something like my 'bottom up' approach to restoring aggregate
> demand and restoring the ability to make mortgage and car payments,
> our government instead took a 'top down' approach, with both the
> Treasury and the Fed buying only financial assets - a policy that
> does nothing for aggregate demand, and only prolongs the agony of
> waiting for the automatic stabilizers work to restore aggregate demand
> through the most ugly process of rising unemployment and falling
> tax revenues.

May 11 10:55 AM

[Warren B. M...:]

The funds to pay taxes come (only) from govt spending and/or govt lending with a non convertible currency.

If govt doesn't spend enough to cover the tax liability and any residual 'savings desires' the evidence is excess capacity/unemployment.

see 'Soft Currency Economics' at
moslereconomics.com


On May 10 05:05 PM Market Sniper wrote:

> Same argument. That you can borrow your way to wealth and print your
> way to prosperity. These are recipes for disaster and will accomplish
> neither. Read some history. Old road, well traveled, ending in a
> bad place.

May 11 10:57 AM

[Warren B. M...:]

The funds to pay taxes come (only) from govt spending and or govt lending

If the govt doesn't spend enough to cover the tax bill and any residual savings desires for financial assets the evidence is excess capacity/unemployment.

see 'Soft Currency Economics' at
moslereconomic.com

and mosler2012.com


On May 10 05:05 PM Market Sniper wrote:

> Same argument. That you can borrow your way to wealth and print your
> way to prosperity. These are recipes for disaster and will accomplish
> neither. Read some history. Old road, well traveled, ending in a
> bad place.

May 11 11:03 AM

[User 411717:]

On May 10 08:01 PM UbuTranscendent wrote:

> Warren,
>
> Washington is, after all, first and foremost, a political arena and
> has never let logic or sensibility significantly interfere in the
> exercise of power or allocation of the nation's wealth.
>
> The 'bottom-up' proposals for economic stimulus that you made last
> October were logical, sensible and comprehensible. They almost certainly
> would have benefited the American public and strengthened the economy
> far more than the course of action actually chosen by the wholly-owned
> Washington subsidiary of Goldman Sachs now managed by Mr. Geithner.

Thanks!

>
>
> Your proposals would not, however, have been nearly as beneficial
> as our present course has been for the GS parent company.
>
> Thus, in retrospect, we can now see how wrong-headed your proposals
> were.

Don't confuse a proposal with a forecast!

In the future, before distracting the public with merely great
> ideas, and logic only appropriate on the planet Vulcan, please consider
> first the meager needs of the downtrodden, impoverished, maligned
> and abused true heroes of Wall Street: banks.

I'm holding a walk-a-thon to help them out. Want to contribute $1 a mile?


>
> In parting, I note that the US Mint has leaked that an inspiring
> phrase will be printed on the new $1000 bill coming into circulation
> soon. (Soda machines are already being reprogrammed to accept it
> as exact change for a 20oz Coke.)
>
> I simply can't wait to get a new G-note in change at McDonald's and
> read those words of comfort:
>
> "What's good for Goldman Sachs, is good for the Nation."

(From an arb point of view, the currency is at least worth its BTU value)


>
> Ubu.
>

May 11 11:29 AM

[31October:]

If buying toxic assets is a good idea, then I have a lot to sell to you.


On May 10 03:48 PM Cetin Hakimoglu wrote:

> Buying toxic financial assets improves investor & business confidence.
> The banking system was seizing, and the efforts of Bernanke, Geithner,
> Palson, Geroge W. bush, and Obama fixed it by bailing out the too
> big to fail. Now the stock market is surging and the economy is turning
> around. ...

May 11 03:18 PM

[Warren B. M...:]

my first proposal for the financial crisis back in July/August was a full payroll tax holiday where the tsy makes all the soc sec and med payments for us.

once incomes are restored to the extent borrowers can afford their payments the toxic asset issues fades rapidly.

And car sales pick up as well, etc.

May 11 04:00 PM