By Van Hoisington
Reserve Chairman Ben Bernanke said in a recent television interview
that economic growth was not “self sustaining.” This description also
applies to an economy that is in a classic growth recession. A growth
recession is characterized as an economy where GDP grows but the
unemployment rate also moves higher.
close look at the U.S. economy bears out Chairman Bernanke's
description. The economy has been expanding for 17 months, yet both the
labor force participation rate and the employment to population ratio
stand at new cyclical lows and beneath the cyclical lows of the prior
expansion. This is an unprecedented development (Chart 1). For the past
19 months, the unemployment rate has been above 9%, underscoring the
harshness of labor market conditions. The employment to population
ratio, which is a better measure of labor market conditions than the
unemployment rate, was at the cyclical low of 58.2% in November,
matching the lowest reading since 1984.
addition to the increase in the number of unemployed, the quality of
jobs remaining in the system is also falling. 478,000 full-time jobs
were lost in November, increasing the six month loss in this most
important employment category to 1.6 million (Chart 2). Part-time
employment rose by 878,000 over the last six months, offsetting part of
the loss in full time jobs, but substituting part-time for full-time
employment lowers household income.
U.S. has 15.1 million unemployed persons and another 11 million
underemployed or marginally attached to the labor force. The latter is
measured by the broad or U6 unemployment rate which stood at 17% in
November. Not surprisingly, with this excess labor, the 12 month
increase in average hourly earnings fell to a new cyclical low of 1.6%
in November. A record 43 million persons receiving food stamps confirms
the economic distress.
Monetary Policy Remains Ineffective
by the Federal Reserve, including the start of the second round of
quantitative easing (QE2), have increased bank reserves by approximately
$1 trillion since the latter part of 2008. Virtually all of this gain
is held in excess reserves at the Federal Reserve Banks earning very
close to 10 basis points. In other words, the Fed has provided
substantial new reserves to the banks and they have, in turn, deposited
the funds back with the Fed.
are not money unless banks turn them into loans and deposits. Loans are
made based on bank capital, which continues to erode because of loan
write-offs due to increasing delinquency and default. The bulk of the
problem loans are in the residential and commercial real estate.
Additionally, the private sector does not have the balance sheet
capacity to increase borrowings because their debt ratios are at or near
consider QE policy to be on a successful path because the psychology of
its orchestration has boosted the stock market, thereby creating a
wealth effect. However, QE has also set in motion unintended
consequences. The same factors that have boosted equities have also
lifted commodity prices and mortgage rates, both of which are damaging
to economic activity.
loans can be financed at 1% or less. This encourages speculative buying
of commodities for inventory, thereby causing food and fuel price
increases. For household's of average means, funds for discretionary
purchases are quickly drained. This is especially evident since the pump
price is now at or above $3 a gallon. A 30-year mortgage rate
approaching 5% only serves to accelerate the downward pressure on home
prices - the main source of household wealth. In short, higher stock and
commodity prices are not a net gain in current circumstances.
the past twelve months M2 has risen 3.1% versus the 110 year average
growth of 6.6%. If the velocity of money is unchanged in the next year,
nominal GDP will rise by 3%. If inflation stays at the less than 1%
pace, then real growth will be a paltry 2% in 2011. In the aftermath of
failed financial innovation and private sector deleveraging, velocity of
money has historically declined. Thus, real GDP may rise less than 2%
next year. Either way, the unemployment rate will continue to rise.
Fiscal policy influences GDP through the velocity of money. Thus, the
new tax compromise may serve to stabilize velocity, but if it passes it
will provide limited stimulus to the economy since most of the package
is just an extension of existing tax rates, not a reduction in tax rates
from current levels.
The Tax Compromise - a Minimal Boost
tax compromise reached on December sixth between President Obama and
the Republican leadership is in many respects like QE2. It plays to
psychology but does little to improve fundamental economic conditions.
The psychological benefit is that it ends the uncertainty of what tax
rates will apply to 2011 and 2012. However, the lower tax rate only
applies to these two years and thus, it does not constitute a permanent
extension of the current tax rates. Substantial scientific economic
research indicates that large responses to tax rate changes only occur
when households believe that their permanent income has changed. Also,
the contents of the tax compromise are designed for political impact
rather than economic effect.
security tax rates are cut by 2%, an amount equaling $120 billion. This
is a positive for the economy but the benefit is much smaller than it
appears at first blush. Of this amount, $60 billion replaces the Making
Working Pay outlays of 2009 and 2010. The cut in social security taxes
does not exempt the wage earner from income taxes and this transitory
boost to income may not be fully spent because of concerns of employment
and income in the current environment. Such a cut is really no
different that the rebate stimulus measures already unsuccessfully tried
by Presidents Ford, Bush, and Obama.
extension of unemployment benefits carries an expenditure multiplier of
close to zero, meaning that there is no net boost to the economy.
Historical experience indicates that accelerated depreciation will have a
very limited impact until late in 2011. The accelerated depreciation
will serve to pull 2012 capital outlays into 2011 in order to take
advantage of the benefit. Thus, the net boost from the total package to
GDP growth is not much more than 0.5%. This minimal short term benefit
will be lost over time since the package increases aggregate
indebtedness which is the main structural problem of the U.S. economy.
Significant research indicates
over-indebtedness leads to economic deterioration, heightened systemic risk and, in the case of major contractions, deflation.
State and Local Government Drag
the state legislatures return to work in January, they face combined
deficits in the vicinity of $280 billion. At this stage, most of the
quick fixes and rainy day funds have already been exhausted. Deficits of
this magnitude mean that cuts in spending and higher taxes are likely
outcomes. In November, state and local governments cut 11,000 jobs,
pushing the employment level in this sector back to the 2007 level. This
will be an ongoing theme.
bond yield moves in the same direction as inflation about 70% of the
time annually, and the correlation is even higher for longer periods of
time. While there are numerous episodes when they have not lined up for
shorter-time spans, this relationship is one of most stable in
macroeconomics. The 30 year bond yield is currently well above 4% yet
inflation is less than 1%, resulting in roughly a 3% real yield. The
real yield has averaged about 2% over the last 140 years, suggesting
value at these levels. The US inflation rate will continue to fall as
the economy remains in a growth recession. In time (possibly soon!),
this will produce lower long term Treasury yields.
Van R. Hoisington
Lacy H. Hunt, Ph.D.