A Magic Multiplier?

In what is becoming an infamous example, David Leinweber went searching for random correlations to the S&P 500. Peter Coy described Leinweber's findings in a Business Week article titled "He who mines data may strike fool's gold" (6/16/97). The article discussed data mining, Michael Drosnin's book The Bible Code, and the fact that patterns will occur in data by pure chance, particularly if you consider many factors.

Many cases of data mining are immune to statistical verification or rebuttal. In describing the pitfalls of data mining, Leinweber "sifted through a United Nations CD-ROM and discovered that historically, the single best predictor of the Standard & Poor's 500-stock index was butter production in Bangladesh." The lesson to learn according to Coy is a "formula that happens to fit the data of the past won't necessarily have any predictive value."

Understanding the rationale of why butter production in Bangladesh might influence the performance of the SPY is quite beyond me.  Yet, I believe in the predictive value of economic cycles. An economic cycle is a reflection of the collective human response to a situation at a point of time; it is rational, it is recurring and so it works.

When the late stage of an economic cycle is underway, the one sector which must return to health is financial services.  Without access to capital, the next economic upswing cannot start.  This late contraction stage of the cycle can be very, very long (hard landing) or short (soft landing).  Active intervention through monetary and fiscal policy has resulted in shallow cycles compared with the boom and bust pattern of the decades gone past.  And this is why I believe that the monetarist and Keynesian responses proposed by Paulson and Bernanke are commendable; you may wish to read A Proposed Admirable Response to the Crisis. And, in my view the creative use of the Keynesian multiplier effect is absolutely wonderful.

Over the decades, Keynesian responses to stimulate the economy could include going to war, government investment in infrastructure, simply digging holes and then re-filling them; it could be anything to provide employment and keep investment flowing in order to restore the economy to health.

In the present situation, the government will step in and invest $700 billion.  These investments serve several purposes, the most important of which is the provision of liquidity, instilling a sense of confidence in the financial markets and addressing the risk of insolvency.

Now, let's face it, $700 billion is a drop in the ocean when you consider an economy with a GDP of $13.7 trillion during 2007.  Going to war, investing in infrastructure or digging holes worth $700 billion might help.  But what the administration intends is far better. It is timely, productive and and creative; the solution could reignite private investment aided by the Keynesian Multiplier.

Keynes argued that the solution to depression was providing an inducement to invest.  This could include both lower interest rates and government investment.  How this might work in very simple terms is as follows:

United States invests $700 billion in financial services.  If there is a reserve requirement of 10%; the banks could theoretically lend $7,000 billion.

Now this is a great over-simplification; several banks and financial institutions need to shore up their capital.  To be well capitalized under the regulations, the tier 1 (core capital - mainly equity) capital ratio needs to be at least 6%.  In addition the tier 1 plus tier 2 (reserves, revaluation reserves, general provisions, hybrids and subordinated debt) capital ratios need to be 10%.  Additionally, the leverage ratio must be at least 5%.  Finally, the bank should not be subject to a written directive, order, or written agreement to maintain specified capital levels.  Simply put, a well capitalized bank must have the following capital and leverage ratios.

Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6%

Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10%

Leverage ratio = Tier 1 capital / Average total consolidated assets >=5%

But that the investment which would result from a $700 billion injection would be a multiple of the amount initially invested is a foregone conclusion.  As a worst case assumption, let's assume $200 billion stays to shore up capital ratios, while $500 billion is the initial investment available with a 10% reserve requirement.  This is indicative of a $5,000 billion injection to the economy.

The story does not end here.  Now this $5,000 billion invested would generate income of an equal amount.  A marginal propensity to consume (amount of an incremental $ of income which would be consumed; the balance being saved) of 80% would mean additional savings of 20% ($1,000 billion). This $1,000 billion in income would have 80% consumed with a further 20% saved ($200 billion); and so on.  The end result is that $5,000 initially invested would generate $6,250 (5000/(100% Less 20%) worth of economic activity assuming a marginal propensity to consume of 20%.

A traditional Keynesian response, starting with say government spending of $700 billion on infrastructure, would (assuming a marginal propensity to consume of 20%) result in economic activity of $875 billion.  No doubt as this wealth flows back into the economy the bank multiplier effect would arise to further stimulate economic growth; in fact the economic stimulus would probably be higher at $6,750 billion (assuming $200 billion is needed to shore up capital ratios and a reserve requirement of 10%). 

Such a strategy has one big disadvantage - it will cause a long stay in the late stage contraction phase of the economic cycle because until the financial services sector recovers its health, the next cyclical upswing cannot commence.  It is for this reason that I prefer the Paulson/Bernanke plan - tackling the financial services sector at the outset has the best chance of avoiding a super hard landing for the economy.

Once the financial services sector stabilizes, we can look forward to investment in productivity; this phase is typically led by technology.  As employment rises as do incomes, consumer confidence improves; this phase is led by consumer discretionary.  As the economy improves, in anticipation of strong demand from industrials, the basic materials sector prospers.  As the economy goes from strength to strength, the next sector to prosper is industrials.  As the engines of industry roar, the demand for energy rises; and yes, it is energy that outperforms.  By now, the exuberance of the cycle has caused inflation; commodity prices are up, interest rates are rising to tame inflation and slow growth. 

Now caution prevails; the rotation into the security of healthcare commences; when you get sick you need medical assistance, it is a safehaven and the yield is nice; at the same time growth potential exists.  As time passes, the caution spreads, the flight to safety continues as the economy contracts; now investors turn to the security of investing in necessities and essentials; the consumer staples sector prospers.  The economy contracts further; unemployment is climbing, valuations in staples have risen reducing yield, valuations are streched considering the sectors low growth potential.  Value becomes fashionable, dividends are important considering rising unemployment; investors shift to utilities.  Now risks to growth are elevated, inflation is past its peak, stimulative rate cuts are anticipated in the late contraction stage.  In anticipation of better spreads and credit expansion, financials outperform. 

We have gone a full cycle; but each cycle remains unique - the lead sectors are beneficiaries of a strong secular trend.

Comments

[Steven Hansen:]

maybe i missed something here but i thought the $700 billion was going to remove the toxic crap off of balance sheets. the next effect of trading $700 billion for crap is zero. you make the bank somewhat healthy, strap the consumer with the debt because the bank cannot offload it, and do absolutely nothing to stimulate the economy.

a healthy banking system is essential to the economy? there is no economy without the consumer.

although i am not against this $700 bailout (yes it is a bailout), it has no stimulus for the consumer, and no legislation to prevent it happening again. until this bill has a consumer stimulus component and legislation for regulation - i am not motivated to supporting this.

in addition, the unbelievable performance of the market on friday in the face of dire economic news and bailout turmoil is evidence the government can control things short term until a proper and complete bailout package can be created.

2008 Sep 27 08:44 PM

[The Realist:]

Wow, people still follow Keynes? He has a lot of good quotes but economically he has been refuted over and over.

You probably believe that the stimulus package worked!

The reason your multiplier does not work is that the banks have already lent this money out, now the $700bil will be used as capitalization for those loans. Furthermore, there is absolutely no proof that they will lend money out.

The Fed has already purchased these instruments from the banks, just not permanently. All those loans the Fed is making to these banks with this garbage as collateral should have the same effect...but it is not.

I do love Keynes' quote that in the long run we are all dead. Although I think most people in this country wished that in the short run all the bankers had died well before this happened.

The way to fix this is to make those responsible pay, and pay dearly so that there is a deterrence from this happening in the future. Sometimes the old Soviet way would work best. I am sure this would not happen ever again if we lined up all the Investment Bank CEOs, CFOs, added in the home builders and mortgage companies guys and put them down like rabid dogs.

2008 Sep 27 09:17 PM

[MaverickBian:]

Based on M1, the multiplier is less than 2, and on M2 money supply, the multiplier is around 8.

You have to consider the money drain out of the banking system, such as cash held under your mattress.

At current stage, banks' reluctance to lend to each other also significantly affect the multiplier you mentioned above.

Also, those banks with below required reserve ratios or with a very low D/E ratio need to consolidate their capital or reserve first, which will discount this multiplier a lot.

2008 Sep 27 10:41 PM

[MaverickBian:]

My biggest question is:

This bailout plan may help banks to clean up their balance sheets and banks will start lending again, yet how come Paulson & Co stops the countinuous downturn of the US housing market?

2008 Sep 27 10:47 PM

[Danny Newton:]

You lost me at the point where holes were being dug and filled back in with no apparent purpose. I have a relative who thinks that unemployment could be eliminated by simply turning off the Social Security computers and letting the unemployed write the checks out by hand. I thought he was just a goof ball but now I know he is a Keynesian. I nor my wife have no genetic relation to this relative. But, my dad has lately gotten the idea of elimination Social Security all together by just waiting until the ratio of people on Social Security to paying into Social Security equals 1/2 and just have each of the people still paying in write a check to the one who is still living and eligible.

2008 Sep 28 01:42 AM

[Danny Newton:]

I would really love it if my city, county and state government had a little less money to borrow. Is there any way to keep the good part of this "crisis?"

2008 Sep 28 01:44 AM

[OldLimey:]

"United States invests $700 billion in financial services. If there is a reserve requirement of 10%; the banks could theoretically lend $7,000 billion."

First, as The Hand points out above, you seem to be assuming that all the garbage already shovelled through the Fed's various hangar doors (sorry, 'windows') stays there and that the $700 billion or whatever it turns out to be is new money. (One alternative, covered elsewhere on today's SA, is that the real purpose of the money is to bail out the Fed; that discussion is a bit above my pay grade.)

Second, you also seem to be assuming that the $700B will soak up all the toxic stuff on every bank's balance sheet and that we'll then be 'off to the races' again. Hard to see that's the case. I would have thought that there will be a lot more right-downs still to come which will deflate your multiplier; if not - say, because the accounting rules are tampered with even further - then banks' willingness to take on counterparty risk will keep pressure on the credit markets.

2008 Sep 28 10:36 AM

[pkscottx:]

Houston we have a problem!

We have a financial system that is run by "economists" like this one who believe the absurd notion that you can build a prosperous economy out of a mountain of debt.

This is a classic Ponzi scheme that works really fine untill you stop shoveling debt into it.

Unfortunately this mountain of debt is built on the back of the American consumer and we are TAPPED OUT!

This truely awfull "bailout" is an end game ploy to force the US taxpayer to take on more debt and confiscate it using the force of law through taxation.

The banks get the money right now. The tapped out taxpayer gets a deeper hole and an intergenerational transfer of wealth.

It won't work.

Do you see the FLAW? This is a Ponzi scheme, it doesn't matter how much money your pour into it, unless your resources are infinate, it will inevitably fail.

Theoretically can you pour infinate "money" into it, but in the real world that didn't work out so good for Zimbabwe.

2008 Sep 28 07:37 PM

[DavyJ:]

You make it seem so simple. Just like the tax cuts and stimulus package seven years ago would bring us to prosperity and actually increase government revenue.

Now $4 TRILLION in deficits later, lets throw in another $700 billion. Somewhere this new math fails me.

2008 Sep 28 09:10 PM

[Xyrus:]

The best way to get out of a hole is to dig a deeper hole. Then, from where you're standing, you're not in a hole.

The banks screwed everyone over, and now we are bailing them out with our money. Absolutely brilliant.

The banks need to fail. The pain needs to be felt. Nothing will change otherwise.

~X~

2008 Sep 28 09:40 PM