By Marshall Auerback, a portfolio strategist and fund manager who writes at New Deal 2.0
Our Treasury Secretary has conceded that it is still a “tough economy” for most Americans, and warned it’s possible the unemployment rate will go up for a couple of months before it comes down. Given the constellation of recent economic data that has come out, Tim Geithner is probably correct.
The US economy is showing signs of slowing, as the fiscal stimulus is dissipating and spending contractions at the state and local government level increasingly undermine the injections from the federal sphere. Worse, it appears that much of the growth has resulted largely from a replenishment of inventories, a process which largely seems to have run its course. Excluding this inventory re-stocking, underlying growth was a very tepid 1.5% annualised. Fiscal drag from state spending contraction could well reduce overall consumption even further in the quarters ahead, an ominous trend for future growth and employment prospects. While we may not experience a “double dip” in purely technical terms, it will certainly feel like a return to recession for most Americans if Geithner’s assessment is anywhere close to being accurate.
At this stage, there is a widespread belief that government fiscal stimulus has run up against its “limits” on the grounds of “fiscal sustainability” and the need to retain “the confidence of the markets”. Consequently, goes this line of reasoning, as private credit conditions improve the private sector must pick up the baton of growth where the public sector leaves off. If this proves insufficient, there is room for an expansion of monetary policy via “quantitative easing“.
Recent speeches by the Fed suggest that they are indeed laying the groundwork for such a return to quantitative easing, or “QE2″ as the markets are now calling it. It’s not the name of a ship-liner: quantitative easing essentially means that the central bank buys up high yielding assets and exchanges them for lower yielding assets. The premise is that the central bank floods the banking system with excess reserves, which will then theoretically encourage the banks to lend more aggressively in order to chase a higher rate of return. Not only is the theory plain wrong, but the Fed’s fixation on credit growth is curiously perverse, given the high prevailing levels of private debt. More borrowing is the last thing the highly stressed and leveraged American household requires today.
As we have argued many times in the past, credit growth follows creditworthiness, which can only be achieved through sustaining job growth and incomes. That means embracing stimulatory fiscal policy, not “credit-enhancing” measures per se, such as quantitative easing, which will not work. QE is based on the erroneous belief that the banks need reserves before they can lend and that this process provides those reserves. But as Professor Scott Fullwiler has pointed out on numerous occasions, that is a major misrepresentation of the way the banking system actually operates:
In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed’s stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.
The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank’s ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.
What is required to drive lending is a creditworthy borrower on the other side of the bank lending officer’s desk, which means an employed borrower, whose income allows him to sustain regular repayments. Absent that, there will be no lending activity. It is pointless to blame the evil bankers for this of state affairs, since they don’t control fiscal policy, which is the remit of the Treasury.
For all the talk from policy makers about not repeating the mistakes of Great Depression, we seem to be perilously close to doing precisely that. This is largely based on a poor understanding of the economic dynamics of that period, even by that noted scholar of the Great Depression, Ben Bernanke.
Most people believe the economy crashed between 1929 and 1932 and then remained depressed until the Second World War, which finally mobilized the economy’s idle resources and brought about a full recovery. That’s complete bunk if you calculate the unemployment data correctly (see here for an explanation) . Even leaving aside the unemployment calculations, it is abundantly clear that, once the Great Depression hit bottom in early 1933, the US economy embarked on four years of expansion that constituted the biggest cyclical boom in U.S. economic history. For four years, real GDP grew at a 12% rate and nominal GDP grew at a 14% rate. There was another shorter and shallower depression in 1937 largely caused by renewed fiscal tightening (and higher Federal Reserve margin requirements). This second depression has led to the misconception that the central bank was pushing on a string throughout all of the 1930s, until the giant fiscal stimulus of the wartime effort finally brought the economy out of depression.
That’s incorrect. The financial dynamics of the huge economic recovery between 1933 and 1937 are extremely striking. Despite their insistence that changes in the stock of money were behind all the cyclical ups and downs in U.S. economic history, even economists Milton Freidman and Anna J. Schwartz in their “Monetary History of the United States” conceded that the money aggregates did not lead the U.S. economy out of the depression in 1932-1933.
More striking, private credit growth seemingly had nothing to do with the takeoff of the economy. Industrial production, off the 1932 low, doubled by 1935. By contrast, bank credit to the private sector fell until the middle of 1935. Because of the collapse in nominal income during the depression, the U.S. private sector was more indebted than ever in the Depression lows. Yet somehow it took off and sustained its takeoff with no growth in private credit whatsoever. The 14% average annual increase in nominal GDP from early 1932 to 1935 resulted in huge private deleveraging, largely as a consequence of aggressive fiscal stimulus.
Tim Geithner should be aware of this, but like his old colleagues at the Fed, his main obsession remains deficit reduction, which is why he is now expending considerable political capital on allowing the Bush tax cuts for the wealthy to expire. Ironically, one of the more amusing aspects of this particular issue is the sight of Republicans such as Mike Pence and Eric Cantor arguing that job creation is more important to Americans than deficit reduction (hence, we should extend the Bush tax cuts for the wealthy, even as their party fought vociferously against extending unemployment insurance benefits for the past several months).
The reasoning of Cantor and Pence is perverse, but on balance — however disingenuous and politically insincere — we support the GOP’s born again support for job creation over deficit reduction. We just wish they would refocus on something that would really help reduce unemployment, such as a Job Guarantee Program. A disproportionate amount of the stimulus program has been enjoyed by those who least need it. We would like to see the Obama Administration at least begin to make the case that fiscal stimulus, whether via tax cuts or direct public investment, is still required to generate more demand and employment. They should not concede anything in this area to the politically insincere GOP, which never met a tax break for the top 2% of the population that they didn’t like.
There might well be very good reasons, on grounds of social equity, to minimize the income gap between the rich and the poor, but Geithner and Obama are not making the case for the elimination of the tax breaks on these grounds. Rather, they continue to do so on the basis that this is the “fiscally responsible” thing to do. This is also consistent with the President’s odd championing of a “bipartisan commission” to study entitlement “reform”, where the focus appears to be on cutting Medicare and Social Security — in effect gutting the Democrats most substantial social legacy of 20th century.
The only concern about government deficit spending should be a whether it generates inflation, in which case it should of course be slowed down. None of those critique the ongoing fixation on fiscal sustainability, or “pork”, or “entitlement reform”, do so on the basis that there are “no limits” on government deficit spending, as has been alleged. What we do argue is that deficit cutting per se, devoid of any economic context, is not a legitimate goal of public policy for a sovereign nation. Deficits are (mostly) endogenously determined by the performance of the economy. They add to private sector income and to net financial wealth. They will come down as a matter of course when the economy begins to recover and as the automatic stabilizers work in reverse (i.e. tax receipts rise and social welfare expenditure comes down). When our policy makers begin to understand this, we can stop with the counsel of despair and actually do something that reduces unemployment today, not years from now — when it will be far too late.