Earlier this week, I read an excellent piece from Felix Salmon on "Who's To Blame for the Emerging Market Crisis?" Felix highlights an argument between Paul Krugman and Dani Rodrik on whether the world's developed economies (including the US and the European nations) are to blame for the crises in emerging markets or whether the EM's problems are a result of flawed domestic policies in those nations. Krugman blames the US and Europe for failing to adequately stimulate global demand, while Rodrik blames emerging market nations for embracing pro-globalization policies that expose them to outside risk.
Lost in this debate is the shared set of assumptions between the two economists. Both Krugman and Rodrik appear to agree that heavy government "stimulus" creates real economic growth. Neither question the wisdom of the massive fiscal stimuli in the US or China. Neither offers much in the way of skepticism about the effectiveness of the Federal Reserve's quantitative easing program [commonly known as "QE"]. Neither mentions China's currency peg, nor do either of them allude to China's interest rate controls, which have resulted in a host of distortions.
There have certainly been critics of all these policies, but in mainstream economics circles, it's too often taken for granted that unending streams of government stimuli create real economic growth. This shared lack of skepticism about government stimulus is the true crisis of modern economics.
In this article, I want to take a look at 16 years of stimulus, both fiscal and monetary, in the United States as well as China. Then, I will show why these programs have introduced greater volatility to markets worldwide, and have likely resulted in weaker long-term growth.
The United States and the Perma-Stimulus
In the late 1990's, the United States (NYSEARCA:SPY) initiated what I have termed the "perma-stimulus." It began under the watch of Federal Reserve Chairman Alan Greenspan. Housing prices grew at a modest pace in the US from around 1991 - 1996, with yearly gains consistently ranging in the 0% - 3% territory. Around 1998, that changed and housing prices began to take off.
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The Federal Reserve never responded with an adequate tightening of monetary policy. Why did the Federal Reserve miss this major move? It's a debatable issue, but my personal thesis on the subject is that the Fed officials had been focusing on the wrong data.
In 1983, the Consumer Price Index was altered to remove housing price data and replace it with a concept called "Owners' Equivalent Rent." This might not have seemed like a groundbreaking move at the time, but if you compare Owners' Equivalent Rent with Case-Shiller housing index prices, you quickly see that the two series look absolutely nothing alike.
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The rationale for the 1983 shift was that housing is an investment, not consumption. The logic of this is perfectly acceptable, but the problem is that CPI, along with the synonymous Personal Consumption Expenditures ["PCE"], have traditionally been used as proxies for inflation in the United States. That never changed with the shift. As it turns out, asset prices tend to be one of the first places that inflation manifests itself. By removing housing from CPI, it became more of a lagging indicator for inflation, and hence less useful for decision-making purposes.
You might think that Fed policymakers would understand this connection, but the evidence suggests that Fed officials and many prominent economists have and continue to view CPI as a reasonable proxy for inflation. Once you adjust CPI for housing prices, a radically different picture emerges. You can see that in the chart below that uses a Housing-Adjusted "Alternative CPI" measure and compares it with the Federal Funds Rate.
What's most important here is the spread between the two measures. Prior to the US housing bubble, the Federal Funds Rate tended to be about 200 - 400 basis points higher than CPI. Beginning in the late 90's, this connection totally shifted, with housing-adjusted "Alternative CPI" peaking at over 800 bps above the Federal Funds Rate in 2004.
While I make no claims that my Housing-Adjusted CPI measure is a "precise" measurement of inflation, it nevertheless suggests that monetary policy was extremely loose from 1998 - 2005. On top of this large monetary stimulus, the Bush Administration ran significant budget deficits in 2003, 2004, and 2005 that likely exacerbated the issues; with funding gaps ranging from 2.5% to 3.5% of GDP.
We can term this large monetary stimulus, coupled with a significant fiscal stimulus as the 1st stage of the "perma-stimulus". While it's difficult to quantify the entirety of it, given the major differences between the monetary and fiscal side, needless to say, these dual stimuli helped fuel a housing bubble, with the monetary side clearly being the bigger culprit.
The Tightening and the Next Wave of Stimulus
It took till around 2004 and 2005 (6-7 years into the housing bubble) before the Federal Reserve began to significantly tighten rates. Ironically, part of the reason behind the tightening likely had to do with surging commodity prices, which were being driven more by new demand from China and emerging markets, than policies in the United States. Because energy prices are a substantial element in CPI, this may have caused the Federal Reserve to pursue too aggressive tightening around 2007 and 2008, when housing prices were plunging. Based on all of this, I think we could peg 2005 - 2008 as a break in the "perma-stimulus", but it wasn't the end.
As we all know, the financial crisis hit in late '08. At that point, we began the second stage of the "perma-stimulus", as the Federal government and Federal Reserve doubled-down on the policies used in the early to mid 00's.
President Obama and the Democratic Congress passed a monumentally large fiscal stimulus. If you take into account budget policies at the state and local level, as well, the combined US Federal, state, and local deficit was about 16.5% of GDP, or nearly 1/6 of the US economy. This was the 3rd largest deficit surge in American history, only trailing the two World Wars, and exceeding the one in the US Civil War, which peaked at 9.8% of GDP in 1865.
Unfortunately, once we dig deeper beneath the surface, it gets even worse. The World War I stimulus, while large, was short-lived, running about 2 years. It led to a huge burst of inflation, followed by a massive deflationary crash. If we instead examine the cumulative trailing 5-year budget deficits, the 2008 - 2012 stimulus actually surpasses the World War I stimulus in size, reaching 45.3% of GDP over a 5-year period, versus 34.1% for the WWI era.
While the President, Congress, and some state governments were stimulating the economy on the fiscal side, the Federal Reserve, under Chairman Ben Bernanke initiated a massive series of stimuli, which we now know as "QE1", "QE2", "Operation Twist", and "QE3". It's difficult to fully quantify the Fed's actions, but the chart below examines US treasury securities held by the Federal Reserve Bank as a percentage of GDP. From this you can see how the Fed was tightening in 2008, and then began expanding its balance sheet in 2009, 2010, 2011, and again in 2013.
To get a better sense of this, the chart below looks at the US treasury securities purchased by the Federal Reserve as a percentage of GDP in a given year. You can see that treasury purchases amounted to 2.1% of GDP in '09, 3.9% in '11, and 2.8% in '13. 2012 was the one exception to the rule, with a 0.5% of GDP decline in treasuries purchased.
This chart is interesting, but hides a bit of nuance. For instance, in 2011, the combined fiscal deficits were 7.1% of GDP and treasury purchases amounted to 3.9% of GDP, yet the S&P 500 returned 0.0%. If you examine the data more closely, however, you'll see that the almost all of the Fed purchases came in the first two quarters of 2011, as the S&P moved upward. Then, the S&P 500 began a significant decline once the Fed announced the end to QE2. On July 22nd, 2011, the S&P 500 index stood at 1345.02. By August 9th, it had fallen to 1119.46, a 17% decline.
Looking at the data, there appears to be a strong connection between QE and the S&P 500, with the QE periods also being periods of huge stock market gains (2009 - mid 2011, 2013). Conversely, we can also see that the stock market tended to perform poorly when the Fed sold treasuries (e.g. 2008, 2011 after 'end of QE' announcement). While there's likely a connection between the fiscal deficits and the S&P 500, as well, it at least seems less direct and obvious, reaffirming that monetary policy may be more responsible for short-term market movements.
Don't Just Blame the US; Also Blame China
It's easy to focus on the issues in the US, but China (NYSEARCA:FXI) is the other big culprit here. China's stimulus had its roots in the trade liberalization of the 80's and 90's. Greater trade led to huge economic gains and greater wealth for the Chinese people. It also eventually led to a strengthening of China's currency, the renminbi (often referred to as "the Yuan").
China established a US Dollar peg to encourage investment, but around 1996, China decided to stop adjusting the peg to reflect market conditions, since the value of the Yuan began to climb versus the Dollar. This allowed a wide divergence to develop between the pegged value of the Yuan and its intrinsic value versus the US Dollar.
(click to enlarge)The impact of this currency mispricing was an export subsidy in China. Since the Yuan was artificially underpriced, exporters would be able to sell their goods abroad at cheaper prices. This, of course, would come at the expense of Chinese consumers, who lost purchasing power as a result.
In order to maintain this currency distortion, China had to buy a large number of US Dollar-denominated assets, with US treasury bonds being the obvious choice. This had the impact of knocking down US interest rates and may have very well been one of the factors helping drive the housing bubble in the US. Without China's massive buying of treasuries, it's likely that the Federal Reserve would've been forced to raise rates sooner during the Tech Bubble, as well as the latter years of the Housing Bubble.
China's currency peg is merely one stimulus in an economy that has been driven almost completely by government driven stimulus in the past decade. China's $586 billion stimulus act of 2008 is one of the more direct examples of this philosophy in action. This act alone was equal to 12.9% of China's 2008 GDP.
The other major stimulus in China (and arguably the largest) has come via artificially low interest rates. While this is more difficult for me to personally back up with data, it's almost a no-brainer. You can take a glance at China's benchmark interest rates at Trading Economics and see that they've tended to fall in the 5% - 7% range over the past several years, while China's banks only pay depositors around 2% - 3%. Contrast this with double-digit increases in real estate prices and 25%+ interest rates in the shadow banking system and it becomes clear there's a lot of interest rate suppression.
While I've followed China's economy closely, I wouldn't consider myself an expert. For this reason, I'll provide a few links explaining the interest rate controls and China's shadow banking system for better color.
How Interest Rate Controls Create a Shadow Banking System in China, South China Morning Post
Is Shadow Banking China's Subprime Mortgages, The Diplomat
Why I Became a Chinese Shadow Banker, Bloomberg Opinion
The Credit Kulaks, The Economist
The summary here is that the politically connected are able to get access to the artificially cheap loans via China's state-owned banks. Oftentimes, this money is often used either to fund fixed asset investment (e.g. real estate, large machinery for exporting industries) or re-lent out in the shadow banking system at higher interest rates. But the ultimate result is a surging amount of debt in China.
If you want to know more about issues in China, I'd recommend reading Red Capitalism: The Fragile Foundation of China's Extraordinary Rise. Economists Patrick Chovanec and Michael Pettis are also excellent sources of info.
QE and Fixed Assets
Now that I've shown how large the stimulus measures have been over the past 16 years, it's time to examine why these actions are one of the primary drivers of volatility in world markets. Let's first look at quantitative easing and the aggressive monetary stimulus promoted by the US Federal Reserve.
First, we have to understand what part of the economy QE impacts. The goal of QE is to lower interest rates and incentivize more borrowing. Large lenders favor loans backed by tangible collateral with reasonably ascertainable values, such as real estate, machinery, hard assets, or even equities. It's rare for banks to lend out to firms based on intangible assets, such as research and development, which is why you don't see many tech start-ups or baby biotech firms borrowing from banks.
By lowering rates and incentivizing more borrowing, the Fed creates a temporary boost in demand for certain fixed assets, as well as stocks, and possibly corporate debt. This does not necessarily result in more long-term economic growth, however. There is an optimal level of real estate, housing, machinery, etc, in the US economy where supply and demand are in equilibrium. Hence, it's possible (even likely) that QE is simply creating excess demand for certain assets (similar to the housing bubble), with diminishing economic returns.
More demand results in higher prices. In the short-term, this looks good, but unless the price rises are backed by economic fundamentals, it's actually a bad thing. To put it in layman's terms, people are paying more, but getting less.
The other side of the equation is savers, such as retirees, pension funds, insurers, and the Social Security Trust Fund. Lower interest rates mean lower returns for all of these groups. Some will be harmed right away, such as the Social Security Trust Fund, or any investor that is 100% invested in US treasuries. Others will see short-term benefits, as stock and fixed asset prices rise. However, they will still see lower long-term returns.
This drop in investment returns is important, because it will eventually lead to retirees having less money to live on, which will sap consumer spending. Likewise, it could create crises in a few states that already have significant public pension problems, such as Illinois and California. Both of these large states are likely to eventually enact some combination of austerity and benefit cuts in the coming years; indeed, Illinois enacted a major overhaul a few months ago, but I suspect that more cuts await in the future.
It's for this reason that QE may be short-term inflationary, but long-term disinflationary. The program boosts fixed asset lending in the near-term, which creates excess supply and results in a diminishing rate of return. However, unless the short-term boost in prices is accompanied by long-term economic demand growth, it will also result in lower long-term returns. In the short-run, prices rise, returns increase, and inflation pushes higher. In the long-term, prices are more volatile, returns decline, and disinflation eventually hits.
Fiscal Stimulus, Malinvestment, and GDP
It would be foolhardy to try to discredit the concept of fiscal stimulus in less than 500 words. Rather, I merely want to showcase how a huge dependence on fiscal stimulus can lead to extraordinary malinvestment, creating greater volatility, and highly misleading short-term economic growth figures. Let's look at an extreme example to see why.
Let's say that the US government borrows $1 trillion annually to finance a war against Freedonia (which you might be familiar with if you're a Marx Brothers fan). The war last for five years and each year, $100 billion will be used to pay soldiers, $100 billion will go to military R&D, and the other $800 billion will go towards the purchase of equipment such as tanks, ships, and aircraft; as well as fuel and other supplies to pursue the war.
Freedonia poses little real threat to the United States and our issues could have been resolved diplomatically for effectively no cost. Nevertheless, the US goes to war and defeats Freedonia after five years, installing a friendly government.
Economically, the primary benefit the US gains is greater trade with Freedonia, which adds $20 billion in GDP to the US economy after the war is over. We'll also say that the R&D spending results in private sector innovation that boosts GDP by $10 billion per year immediately! Otherwise, the US gains no other economic benefits from the war and all the machinery and equipment from the war serve little function afterwards. For simplicity, we'll also assume that the soldiers have a low-skill set and the net result of their employment in the military neither provides a gain nor loss to the US economy.
From a Return on Investment perspective ("ROI"), this war generates an IRR of -54.18%. This is why I say it's an extreme example. But the point I'm making isn't that government spending is inherently bad, but rather that it can create highly misleading growth and greater volatility.
As another simplifying assumption, we'll also assume that the debt must be repaid. The US will increases taxes by $1 trillion for the five years after the war is over in order to do this. In the real US, it's more likely that we'd generate inflation to pay for the war; however, the ultimate impact is similar.
Next, let's create an alternative scenario where the US diplomatically resolves its issues with Freedonia, and balances its budget. We'll also say that the US grows GDP 3% ever year. We'll make this a highly simplified model, in order to understand the impact on ONLY the Freedonian war. Here is how GDP would progress in the diplomatic scenario (our base case).
And here's the "War vs. Freedonia Scenario". Major differences emerge between the two scenarios in GDP.
If that's too many numbers to follow, here's the simple chart explaining it all. In it, you can see GDP in the two competitng scenarios. Note that the "War vs. Freedonia" scenario looks much better until around Year 7. By Year 10, it's completely clear that the US was better off under the diplomatic scenario.
In other words, the war against Freedonia destroyed a massive amount of economic wealth, but the official stats would lead a casual observer to believe that the "War Scenario" was economically superior until about 8 years in. This is the combined impact of deficit spending and malinvestment.
This is obviously a highly simplified model, but it makes a big point: government spending often leads to scenarios where short-term GDP growth jumps higher, but long-term GDP growth is lower. You can also see that the "War Scenario" is the much more volatile of the two creating a massive five year recession.
I won't argue whether the US or China's stimulus efforts have been "wealth destroying." I merely make the point that it would take a long time for the impact to be felt in GDP. Even when that happens, it's often not clear that failed government stimulus was the reason behind it, due to the complexities of modern economies.
The US and China have both embarked upon a path of massive long-term government-driven stimulus in their respective economies. In the US, this likely helped fuel the tech bubble, the housing bubble, and was largely responsible for the Financial Crisis of 2008. Now, it may be fueling the surge in the stock market over the past few years, as well as another debt-fueled push into fixed assets.
In China, the stimulus has led to a massive real estate boom that has created entire ghost cities. The currency peg (another type of stimulus) has likewise helped create a huge amount of excess capacity in exporting industries, such as manufacturing. The biggest worldwide affect has been China's insatiable demand for building materials, such as copper, iron ore, and steel, which has boosted many commodity-heavy economies across the globe.
For this reason, the US and China both deserve significant blame for a lot of the worldwide volatility. However, many emerging market economies are just as much to blame for their own problems. Brazil, for instance, has benefited heavily from the commodity boom, but has enacted foolish policies that have destroyed a lot of that influx of wealth. Yet, a nation like Chile, which also benefited from the commodity boom, might be less to blame if it falls into recession due to a bust in the copper market. In other words, I think there's a lot of blame to go around, and it varies from nation to nation.
While Krugman and Rodrik argue over whether to blame the US and Europe or the EMs, the bigger issue of modern economics is the wisdom of massive stimulus. The idea that constant streams of government stimulus are good for the economy has become too heavily accepted in economic circles, based on the underlying flaws of certain economic stats, such as GDP. The evidence suggests that monetary and fiscal stimuli often fuel asset bubbles, create greater volatility, and lead to stronger short-term growth, but weaker long-term growth. This is the true crisis of modern economics.
Disclosure: I am short FXI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.