Can’t put it any clearer than this. From the WSJ:
Fed Policy Is a Drag on Recovery
The stock market is soaring. Yet real median income has fallen 5%, unheard of for a recovery.
Former Federal Reserve Chairman Paul Volcker said in a speech to the Economic Club of New York on Wednesday that the Fed should not be asked to “accommodate misguided fiscal policies” and “will inevitably fall short.” He outlined a preferred monetary policy based on orthodox central banking aimed at a stable currency in order to maximize employment. “Credibility is an enormous asset,” he said. “Once earned, it must not be frittered away.” Those words are true and timely.
As this month’s stock and bond market gyrations showed, traders are obsessively focused on every nuance of the Fed’s monetary plans. Billions of dollars are at stake for Wall Street, which profits mightily from the Fed’s bond buying and cheap credit.
The problem is the broader economy’s poor performance in growth and jobs. The Fed, which was once a key proponent of market-based economic policies, has forced U.S. interest rates to near zero for four-and-a-half years with no plans to stop. It has bought nearly $3 trillion in bonds, with the express goal of channeling credit to the government, government-owned enterprises and large corporations in the hope that this will boost employment.
The Fed’s bond-market interventions probably helped during the 2008 crisis when markets had frozen, but after that the economy would have done much better without them. Recoveries are normally fast and broad once markets are allowed to clear and begin operating. Quarterly growth topped 9% in 1983 after a deep recession and 7% in 1996 leading into President Clinton’s re-election. Interest rates were high, yet median incomes were rising sharply.
Growth in the current recovery only rose above 4% once, in the fourth quarter of 2011, and averaged just 2% per year in its first four years versus 5% in the same period of the 1980s recovery, 3.2% in the 1990s recovery and 2.9% in the 2000s recovery. The underperformance over the past four years translates into more than three million jobs that should have been created but weren’t, an economic disaster that lowered real median incomes by 5%.
The disastrous state of affairs was rationalized as a “new normal” following the Great Recession, but the reality is that poor policy choices hurt growth. Tax-and-spend policies sapped investment, and the Fed’s low rates and bond purchases damaged markets, hurt savers and channeled credit to the government at the expense of job creators. It’s a zero-sum process that should be stopped because of the bad effect on growth and jobs.
Incredibly, as Fed Chairman Ben Bernanke alluded to in his May 22 congressional testimony, the Fed is now angling to create a semi-permanent control dial with which the Fed can increase its $85 billion in monthly bond purchases when growth slows and reduce them if growth ever speeds up. This creates maximum uncertainty for the private sector, giving an advantage to traders, the government and the rich but hurting growth and long-term investors.
Washington thrives on the impression that the economy and markets are dependent on the Federal Reserve and deficit spending. This is the wrong lesson. More likely, past government excesses—trillions added to the national debt and the Fed’s liabilities—lowered the growth rate. The economy and markets would adjust and be better off without them.
One line of Fed criticism has emphasized money printing and an inflation risk. This is off target and, with inflation low, gives the Fed an opening to keep going. When the Fed buys bonds, it pays for them with liabilities to banks called excess reserves. There’s no creation of new money in the private sector. The M2 money supply, the measure of bank deposits often used by monetarists to anticipate inflation, is unaffected. Private-sector credit grew only 0.8% from the end of 2008 through the end of 2012, whereas credit to the government grew 58%.
Rather than money printing that turns into cash, the excess reserves are, in effect, an IOU from the Fed. Interest is paid on them and they aren’t spent or used by banks to increase lending. This distinguishes current policy from the inflationary 1960s and 1970s, when the Fed created reserves that banks used as backing for multiple loans and rapid growth in private-sector credit.
The stronger criticism is that the Fed’s policy is contractionary, harming growth. The Fed’s intention is that the low bond rates it provides the government will spill over to big corporations and banks, who in turn will help the little guy. This trickle-down monetary policy has contributed to very fast growth in corporate profits, part of the explanation for the record stock market, but also to weak GDP growth and declining middle-class incomes. The extra credit the Fed channeled to government and big corporations meant less credit elsewhere in the economy, a contractionary influence since most new jobs come from small businesses.
Still, three important developments may lift the economy despite the Fed, forcing it to taper its bond purchases and allow the recovery to accelerate. First, the Jan. 2 tax bill removed the risk of tax rate increases—on income, dividends, estates and the alternative minimum tax—that depressed growth in 2010-12. Second, most businesses are encouraged by the sequester and the idea of the government tackling spending, however clumsily. Third, private credit has started to grow, helped by thousands of new nonbank lenders. Total credit grew at a 5.6% annual rate in the fourth quarter of 2012 after contracting for much of 2009-12.
But whether the economy turns up or not, it should be clear that the Fed’s unprecedented and far-reaching monetary policy has been a drag, not a stimulus.
Posted at Amazon:
I wanted to give this book at least 2 stars in respect for Mr. Smith’s journalistic skills and his previous fine work with The Russians. However, this exposition is so flawed and wrong in its diagnosis of the problems and prescriptions that I can barely give it one star. It also saddens me to see 109 five-star reviews – after reading a few I’m left wondering how readers can be so easily led by just-so stories by our media elites. Or is this analysis so ideological that readers just choose to believe what they want to believe and disregard any counter-factual evidence? That is truly a lost, if not stolen, American dream.
First, Smith gives a good journalistic rundown of select history, as we would expect. His selected comparison is the post-war period referred to as the Great Compression. But he fails to see that this virtuous moment in our history was more a product of historical events than public policy. The US was the sole developed nation with an intact industrial base, while all of Europe, Russia and Asia lay in ruins. So, employable skilled labor was in short supply and American workers commanded a greater share of the returns relative to capital. The world was forced to buy our goods, even if we had to extend them the credit. This would not last and came undone in the late 60s. The 1970s was a period of stagnation when wages and corporate profits were similarly depressed by energy spikes and misguided economic policies.
Smith finds his villain in Justice Lewis Powell, who motivated a cabal of rapacious corporate raiders and turn-around artists like Chainsaw Al Dunlap and Neutron Jack Welch to take over American business. Please. The battle for corporate control was a response to ineffectual management that fed fat cat perks in the corporate boardroom while depriving other stakeholders of value. Stagnating stock prices reflected this and provided the opportunity for people like Dunlap and Welch to create value. Yes, and sometimes this depressed value was due to the mismanagement of labor inputs, so the remedy was to increase profits by reducing costs. This is how competitive business becomes efficient. If it hadn’t been Al and Jack, it would have been someone else. The business of America is wealth creation, not job creation. If we want to deal with the problems of winner-take-all globalization, we’d better understand that first.
Thus, Mr. Smith’s basic premise is not only flawed, it’s wrong. What caused the shift in power between capital and labor was the 30-year credit bubble (accommodated by a fiat dollar) that drove down interest on debt (with its tax subsidy), permitting the over-leveraging of capital ownership shares. Combined with the liberalization of developing nations in East, Southeast and South Asia, the world supply of labor exploded, driving down wage incomes across the board. Globalization powered by technology, transportation and communications, has delivered a new world that is so different from the post-war America Mr. Smith craves as to make the comparison ludicrous. We’re not going back to Kansas, Dorothy, no matter what the Wizards promise us.
Mr. Smith’s remedies are equally ill conceived, as we might expect from false premises. He’d like us to imitate Germany’s corporatist industrial policies, and in this he seems to share the same delusions as our current Democratic administration. Corporatism is a form of economic feudalism where control over economics and politics gravitates up to the national level with grand compromises made among peak labor unions, business roundtables, and government bureaucrats. Guess who wins and who loses? Elites win big while average Joe is told to be satisfied with a promised job, retirement, healthcare and three squares a day. This works currently in Germany because of several factors specific to Germany: a homogenous culture and labor force, an export-dependent economy, and a population of 80 million – none of which apply to the U.S. The long-term results of this policy are also less sanguine: the fertility rate of Germany is 1.36, well below the replacement rate of 2.1. There are more deaths than births and immigration does not make up the difference. In other words, like its European neighbors, the nation of Germany is dying a slow death. Hardly a model we would wish to follow. One must ask why, if life is so good, Europeans refuse to invest in the future by having children? Obviously, the developing nations that are liberating their societies see a much brighter future.
One more point that piqued my attention was Smith’s focus on public-private partnerships to recreate a past that he only imagines. This idea is a real buzzword for people who want to believe in the myth of a third way between socialism and capitalism. But does anybody really understand what the terms of these partnerships yield? Private interests use their connections in government to receive taxpayer subsidies to make investments in which they capture the excess returns. The risks of loss are borne by taxpayers, but these taxpayers never receive any direct return from success. This is a pure form of “heads we win, tails you lose” cronyism perpetrated by the elites in business and government. If taxpayers underwrite the risks, why don’t they have residual claimancy on any success? At heart, private-public partnerships are immoral because they violate the golden rule of moral capitalism: she who takes the risk, receives the gain or suffers the loss. (If you wonder about the morality of this rule, consult the Bible or the philosophy of law that defends the innocent from the transgressions of the powerful.)
This gets to the issue of true prescriptions to correct the failures of crony (not free market) capitalism that pervades our world. A world that advances freedom, and that includes the freedom to trade, must promote and defend the basic rights of ownership that undergird not only capitalism, but human nature itself. A worker is little more than an input cost, but ownership represents the residual claimancy on productive effort after all input costs have been paid. The success of capitalist society is measured by the creation of excess wealth associated with productive activities, in other words, profits. The problem is that 20th century industrial policy has associated the distribution of economic success through employment alone. In other words, most citizens only participate in the system as a labor cost. Thinking outside this “job creation” box calls for a wider distribution of the risks and returns to the ownership of the resources used in economic production, not least of which is financial capital. How does Mr. Smith really think all those CEOs got so rich? They all had stock options! Was there theft? Yes, from other stakeholders, principally shareholders. Unions should become the agents representing diversified ownership in American business for workers, and by association for all Americans. That’s a job that would get them on the right side of history.
The way Mr. Smith (and others of his persuasion) would lead us would be the ruin of the greatest experiment in freedom the world has ever known. That’s sounds more like a nightmare than a dream. Please folks, wake up. Do it for the children.
Could it be that, for all our fighting over taxes and spending, it’s our reliance on fiat money that is at the root of our long travail?
Gee, d’ya think?
From the WSJ:
As the Federal Reserve approaches its 100th anniversary in December, the focus of monetary reform centers on a bill called the Centennial Monetary Commission Act. Introduced this month in the House of Representatives by Chairman of the Joint Economic CommitteeKevin Brady, the bill would “establish a commission to examine the United States monetary policy, evaluate alternative monetary regimes, and recommend a course for monetary policy going forward.”
Mr. Brady’s bill is not the kind of direct attack on the Fed that has been launched by, say, Rep. Ron Paul, who has called for eliminating the central bank altogether. But the bill—noting that a National Monetary Commission, established after the panic of 1907, led to the Fed’s creation on Dec. 23, 1913—would set up a new commission at the start of the Fed’s second century.
The Centennial Monetary Commission would start with a formal review of the Fed’s performance across the decades, including how its policies have affected the economy in terms of “output, employment, prices and financial stability over time.” The commission would also evaluate a range of regimes, including, in the bill’s language, price-level targeting, inflation-rate targeting, nominal gross-domestic-product targeting, the use of monetary policy rules, and the gold standard.
Mr. Brady proposes a 14-member, bipartisan commission, led by the chairman and ranking minority member of the Joint Economic Committee. The commission would be tasked with making recommendations. The group’s composition would make it more balanced than President Reagan’s 1981 Gold Commission—an important body, but one stacked with partisans of fiat money, i.e., a currency backed by nothing other than government decree. That commission is remembered primarily for its dissent, written by Rep. Paul and another commission member, Lewis Lehrman, a businessman and scholar, calling for a restoration of gold-based money.
It was the collapse of the dollar in the 1970s that led to the establishment of the Gold Commission. The dollar’s value had plunged by 1980 to less than an 800th of an ounce of gold from a 35th of an ounce at the start of the previous decade.
The monetary crisis of the era abated in the 1980s under the combination of Chairman Paul Volcker’s tight money and President Reagan’s supply-side fiscal measures. Over time, value flowed back into the dollar, which had soared to a 265th of an ounce of gold on the day George W. Bush was sworn in as president in January 2001.
Yet by the time President Obama took the oath of office in January 2009, the wars in Afghanistan and Iraq and profligate spending by Congress had driven the value of the dollar down to less than a third of its worth when Mr. Bush was sworn in. Its value has been halved again under Mr. Obama, to less than a 1,600th of an ounce of gold.
Watching this from his perch at the Joint Economic Committee, Mr. Brady last year introduced the Sound Dollar Act. It would end the Federal Reserve’s dual, and often contradictory, mandate that requires it not only to stabilize prices but also to boost employment. The Fed would instead have a single mandate: long-term price stability. [Note: at least that’s something they could actually accomplish if they wanted.]
The Sound Dollar Act would not end the Federal Reserve but would make it more transparent and give presidents of the regional Federal Reserve banks permanent seats on the Open Market Committee. The act also would not set up a gold standard, but it would require the Fed to monitor the price of gold.
Mr. Brady has reintroduced his Sound Dollar Act this year. The Centennial Monetary Commission Act is a parallel and more strategic measure, proposed at a time when there are those who wonder whether Congress has been focusing on the wrong question.
Could it be that, for all our fighting over taxes and spending, it’s our reliance on fiat money that is at the root of our long travail? Rep. Paul forced this question into the Republican campaign during the 2012 primaries, and the establishment of a monetary commission became part of the GOP platform. Mitt Romney, however, failed to stand forcefully on the plank.
Mr. Brady, in any event, seems determined to approach the question on a bipartisan basis and to avoid letting it hang in the ether. His bill would start the commission working in June and give it a year to produce its report.
No doubt it would face a difficult hurdle in the Senate, and there are those who chafe at the idea of another commission, since commissions are so often a way of burying an idea. But a commission created in the Congress, tied to the centennial of the Federal Reserve, and structured in a bipartisan way, is a promising way forward.
This is particularly true when politicians seem to have forgotten that the power to coin money and regulate its value is enumerated in the Constitution itself and granted not to a central bank or the president but to Congress.
One thing is certain: The impetus to reform will not come from the Federal Reserve, which has fought an audit passed by the House last year with overwhelming bipartisan support. Congress clearly needs to step up and lead the way, and Mr. Brady is giving it the chance.
There’s a lot of popular controversy in the media about democracy and fair voting systems, most of it focused on the Electoral College and the mistaken idea that democracy means a majoritarian voting system (one person = one vote, where the popular majority determines the winner).
This is an interesting 30 minute video lecture offered by the educational lecture series called The Great Courses. It explains fairly clearly how no voting system is perfect and why the voting system must weigh trade-offs in interpreting what determines the true will of the people. Good explanation of Arrow’s Impossibility Theorem. Worth a watch…
This article suggests there may be an important side effect to Obamacare’s policies on small to medium size businesses: that is the breaking up of business entities into smaller incorporated units, presumably with broader equity ownership structures. This will have the unintended effect of spreading the risks and rewards of business ownership away from the large public corporate ownership structure. This runs counter to Obama’s preferred corporatist politics that favors large business and organized labor over entrepreneurship and small business enterprise (which are both bearing the brunt of income and capital tax increases).
Economic risk-taking, innovation, job and wealth creation are largely the product of successful small business start-ups, to say nothing of the freedom of being one’s own boss and the direct beneficiary of one’s own success. Equity in capitalism is the best way to ‘spread the wealth,’ but certainly not one with this administration’s intentions.
From the WSJ:
To Outsmart ObamaCare, Go Protean
Don’t fire staff to avoid the 50-employee trigger. Make them corporations.
How big can a company get with just 50 employees? We’re about to find out.
Thousands of small businesses across the U.S. are desperately looking for a way to escape their own fiscal cliff. That’s because ObamaCare is forcing them to cover their employees’ health care or pay a fine—either of which will cut into profits and stymie future investment and growth.
We’ve already seen many of America’s biggest companies respond to the new law by laying off employees, putting them on part-time, or raising prices. But those are short-term solutions. Ultimately, these corporations will have to innovate and restructure to thrive in the era of ObamaCare. If small businesses follow their lead, they may even gain an advantage over their big competitors.
In his 2009 book “The Future Arrived Yesterday,” veteran Silicon Valley journalist Michael S. Malone described a new organizational model called a “Protean Corporation.” Like a protozoan single-cell organism, the protean corporation has the ability to “shape shift,” rapidly adapting to internal and external forces in the market and the company. At the heart of a true protean corporation is a tiny number of core employees surrounded by a large cloud of resources, generally contracted or outsourced talent that does most of the work.
While the concept has been used successfully in large corporations like Intel, Microsoft and IBM, it is bound to appeal to smaller companies now. Such businesses have several ways to get their workforce under the 50-employee limit at which certain ObamaCare rules kick in. These include reducing workers’ hours to move full-time employees to part-time; laying off workers; and either selling the company or closing down.
“Going protean” offers a better strategy for many businesses. Owners of protean companies create a core of strategic employees who manage the big-picture elements of the enterprise—the culture, business model, product mix, vision, strategy, etc. This core then outsources the business tasks to other corporations.
Non-core tasks could include things like accounting, marketing, product development, manufacturing, IT, PR, legal, finance, etc. There is almost nothing that cannot be outsourced—including even the CEO function (which can already happen, e.g., when a company is in turnaround.)
To most business owners, “outsourcing” means shipping jobs overseas. But in the protean sense, it means having tasks performed in the context of a contractual relationship as opposed to an employment relationship. It’s not about replacing employees with contractors, but about replacing employees with corporations.
These new contracts will be a mix of large corporations, small businesses, micro-corporations and even nano-corporations (an individual doing business as a corporation). But to be a protean solution, it must involve a corporation-to-corporation relationship. Any substitute—e.g., a sole proprietorship—is only a time bomb because eventually the government will pressure you to turn any so-called 1099 contractors into employees.
In the context of ObamaCare, a small business could go protean by offering current employees contracts for doing their current work as a corporate entity instead of as an employee. Entrepreneurial employees will jump at the chance to form a corporation and run their own business. Non-entrepreneurial employees can choose to move on and find other work—or work hard to join the core company.
Going protean won’t work without a massive mental shift. A company no longer manages employees, but tasks and contracts instead—a quantum leap in management styles and process.
The biggest change is replacing human-resources. Instead of writing position descriptions and managing employees, the protean corporation writes contracts and scope-of-work documents and manages those.
There is another subtle but powerful shift. Instead of relationships being vertical—e.g., boss-employee—the relationships are peer, corp-to-corp. Having your work done by people who own corporations will be completely different than working with people with an employee mindset.
Perhaps the biggest change protean corporations will experience is in the nature of their relationships with people. When a person is an employee, he or she is, by definition, in partnership with the government—the Equal Employment Opportunity Commission, the Occupational Safety and Health Administration, etc.—and is subject to all the government’s regulations. But when a protean corporation enters into a relationship with that same person, now a corporation, it is a purely contractual relationship with a fellow enterprise. As long as there is no fraud or breach of contract, and the agreement is legal, the government really has nothing to say.
In the years ahead, as government continues to impose itself into the marketplace and reduce the freedom of the commercial sector through statist programs like ObamaCare, businesses will have to look for creative solutions to survive. Going protean is only one way, and others will emerge.
Yet as small enterprises approach 50 employees (or retreat back below that number), look for a significant number of them to concentrate on growing in revenues without ever again growing in employees. The result can be a wave of entrepreneurship, new company creation, business growth and economic freedom. Not a bad result when you consider that it will be spurred by the government’s bid to keep America’s businesses under its thumb.
I had to reprint this article as I was completely taken by surprise that the NY Times could actually be objective enough to publish such an expose.
The Legacy of Timothy Geithner
As the problems escalated, Mr. Geithner came to stand for providing large amounts of unconditional support for very big banks – including Citigroup, where Robert Rubin, his mentor, had overseen the dubious hiring of a chief executive and more general mismanagement of risk.
By SIMON JOHNSON
“Too big to fail is too big to continue. The megabanks have too much power in Washington and too much weight within the financial system.” Who said this and when?
The answer is Peggy Noonan, the prominent conservative commentator, writing recently in The Wall Street Journal.
As Timothy F. Geithner prepares to leave the Treasury Department, most assessments focus on how his policies affected the economy. But his lasting legacy may be more political, contributing to the creation of an issue that can now be seized either by the right or the left. What should be done about the too-big-to-fail category of financial institutions?
Mr. Geithner came to Treasury in the middle of a severe financial crisis, a set of problems that he helped to create and then worked hard to prevent from worsening. As president of the Federal Reserve Bank of New York, starting in 2003, he watched over – and failed to defuse – the buildup of systemic risk. In fact, the New York Fed was relatively on the side of allowing large, seemingly sophisticated financial institutions to fund themselves with more debt relative to their thin levels of equity.
This was a major conceptual mistake for which there still has not been a full accounting. In fact, blank denial continues to be the reaction from the relevant officials.
Mr. Geithner was also in the hot seat as more explicit government support for large financial institutions began in earnest in early 2008. The New York Fed brokered the sale of failing Bear Stearns to relatively healthy JPMorgan Chase, with the Fed providing substantial downside insurance to JPMorgan, against potential losses from assets they were acquiring.
Mr. Geithner also acquiesced to Jamie Dimon, the chief executive of JPMorgan Chase, allowing him to remain on the board of the New York Fed even as his bank was suddenly the recipient of very large additional subsidies (the insurance for his acquisition of Bear Stearns). This was the beginning of a deeper public realization that there had come to be too little distance between some parts of the Federal Reserve and the big banks.
For some senior officials within the Federal Reserve System, the appearance of this potential conflict of interest was a cause for grave concern. Unfortunately, their concerns were ignored by the New York Fed and by leadership at the Board of Governors in Washington. The result has been damage to the Fed’s reputation and an unnecessary slip toward undermining its political independence.
From March 2008, when Bear Stearns almost failed, through September 2008, very little was done to reduce the level of risk in the financial system. Again, Mr. Geithner must bear some responsibility.
In fall 2008, Mr. Geithner worked closely with Henry Paulson – Treasury secretary at the time – in an attempt to prevent the problems at Lehman Brothers from spreading. They were unsuccessful, in fairly spectacular fashion. The failure to anticipate the difficulties at American International Group must stand out as one of the biggest lapses ever of financial intelligence – again, a responsibility in part of the New York Fed (although surely other government officials share some blame).
As the problems escalated, Mr. Geithner came to stand for providing large amounts of unconditional support for very big banks – including Citigroup, where Robert Rubin, his mentor, had overseen the dubious hiring of a chief executive and more general mismanagement of risk. (While a director of Citigroup, Mr. Rubin denied responsibility for what went wrong.)
Rather than moving to change management, directors or anything about the big banks’ practices, Mr. Geithner favored more financial assistance – both from the budget (through various versions of the Troubled Asset Relief Program), from the Federal Reserve (through various kinds of cheap loans) and from all other available means, including insurance for private debt issues provided by the Federal Deposit Insurance Corporation.
In official discussions, Mr. Geithner consistently stood for more support with weaker (or no) conditions. (See “Bull by the Horns,” by Sheila Bair, former chairwoman of the F.D.I.C., for the most credible account of what happened.)
Mr. Geithner’s appointment as Treasury secretary in January 2009 allowed him to continue to scale up these efforts.
In retrospect, what helped stem the panic was the joint statement of Feb. 23, 2009, issued by the Treasury, the F.D.I.C., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Reserve, that included this statement of principle:
The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses. The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth. Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.
Mr. Geithner is often given credit for pushing bank stress tests in spring 2009 as a way to back up this statement, so officials could assess the extent to which particular financial institutions needed more loss-absorbing equity. But such stress tests are standard practice in any financial crisis.
Much less standard is unconditional government support for troubled banks. Usually such banks are “cleaned up” as a condition of official assistance, either by being forced to make management changes or being forced to deal with their bad assets. (This was the approach favored by Ms. Bair when she was at the F.D.I.C.; her book lays out realistic alternatives that were on the table at critical moments. The idea that there was no alternative to Mr. Geithner’s approach simply does not hold water.)
Any fiscally solvent government can stand behind its banks, but providing such guarantees is a recipe for repeated trouble. When Mr. Geithner was at Treasury in the 1990s and Mr. Rubin was Treasury secretary, the advice conveyed to troubled Asian countries – both directly and through American influence at the International Monetary Fund – was quite different: clean up the banks and rein in the powerful people who overborrowed and brought the corporate sector to the brink of financial meltdown.
In Mr. Geithner’s view of the world, the 2010 Dodd-Frank financial reform legislation fixed the problem of too-big-to-fail banks. Outside of Treasury, it’s hard to find informed observers who share this position. Both Daniel Tarullo (the lead Fed governor for financial regulation) and William Dudley (the current president of the New York Fed) said in recent speeches that the problems of distorted incentives associated with too big to fail were unfortunately alive and well.
Ironically, despite the fact that the Obama administration failed to rein in the megabanks and allowed them to become larger and arguably more powerful, this has not helped the Republicans in electoral terms.
As Ms. Noonan puts it bluntly: “People think the G.O.P. is for the bankers. The G.O.P. should upend this assumption.”
This is a significant opportunity for anyone with clear thinking on the right – someone looking for a Teddy Roosevelt trustbusting or Nixon-goes-to-China moment. Again, Ms. Noonan gets it right: “In this case good policy is good politics. If you are a conservative you’re supposed to be for just treatment of the individual over the demands of concentrated elites.”
Recall that some grass roots conservatives are already there: House Republicans initially voted down TARP, the former presidential candidate Jon Huntsman’s plan to end too big to fail received widespread applause from many Republicans and a number of influential commentators, including George Will and Ms. Noonan, have advocated ending too big to fail.
This would play well in the Republican presidential primaries – and even better in the general election. Watch PBS “Frontline” on Jan. 22 for an articulate presentation of why serious potential financial crimes were not prosecuted during the first Obama administration, and think about how to turn these facts into political messages.
A smart candidate could even mobilize plenty of financial-sector support in favor of breaking up or otherwise restricting the too-big-to-fail financial entities. The megabanks have very few genuine friends.
The lasting legacy of Timothy Geithner is to create the perfect electoral issue for Republicans. Will they seize it?
We’ve been tracking Fed policy here now for about two years and making these same arguments. Fellow blogger, News to Use, has done the data work that demonstrates how monetary policy for the past decade has done little else but inflate asset prices while depressing real growth. See the data charts below.
The odd paradox is that the Obama administration has continued these same policies that caused the financial crisis of 2008. The Fed has bailed out the bankers with easy money and excessive debt, juicing commodity prices like energy and food, while depressing savings income for retired folks on fixed incomes. At the same time, the CPI has been flat because wages have not risen and because energy and food prices are not included in the CPI. So, Social Security and wage COLAs do not increase even though the prices of necessary goods like energy and food keep going up. This puts a major financial squeeze on those who can least afford it.
When these policies collapse in on themselves again, the poor and middle class will bear the brunt of the pain with more unemployment, lower wages, and higher prices for necessary goods. Folks on fixed incomes will be decimated.
Is this how we deal with inequality? By making it worse? Ironic, no?
Maybe the debaters last night should have had a large banner over their heads for their audience reading: “This is Your Life.” Pay attention, folks.
Reposted from Seeking Alpha:
What If The Fed Has It All Wrong?
Bankers… are merely experimenting with totally unproven ways and means, hoping to gain enough time until more responsible politicians emerge.
By Denis Ouellet
This is the fourth major intervention from the Fed since 2009, each one apparently inflating asset prices without having a definitive impact on the economy other than, most importantly, preventing a lethal debt deflation spiral.
(click image to enlarge)
The chart above is used extensively to illustrate the close relationship between QEs and equity prices. Hence, the investors’ Pavlovian reaction to last week’s FOMC announcement of an open ended and unlimited money printing program. Virtually every asset class rose, giving credence to Ben Bernanke’s attempt to create a stimulating wealth effect.
What if the Fed has it all wrong?
Correlation does not imply causation. Could there be another reason for the spectacular rise in equity prices since 2009? Let’s try earnings, just in case that intuitive, time-tested relationship might still be working:
If there were a direct link between QEs and corporate profits, it should be apparent in S&P 500 companies’ revenues. Yet, Index sales have only grown 16.5% during the last 3.5 years — nothing close to the 60% jump in Fed assets. Given that the Fed is now totally focused on growing employment, I doubt that it would take credit for the spectacular jump in profit margins since 2009, since most of it emanated from cost cutting (mostly labor) and rising productivity.
Additionally, some recent facts point to weaker earnings ahead:
- Quarterly sales and earnings have peaked in the last 9-12 months.
- Corporate profit margins are at an all-time high.
It is therefore, dangerous to assume that margins will expand any further. From now on, corporations need to increase sales to grow their earnings. Unfortunately, demand is waning.
American wages — currently at a 50-year low as a percentage of GDP — are rising very slowly, so slowly that it is hampering consumer spending and the overall economy. At the time of previous QEs, also designed to create a wealth effect, wages were rising at a much faster clip than today. Furthermore, real wages were rising during 2009 and 2010, partly offsetting slow employment growth.
Today, employment growth remains below 1.5% YOY, a rate insufficient to reduce unemployment. Nominal wages are growing 1.2%, while inflation is 1.7% and threatens to accelerate, in large part due to the impact that the Fed’s actions are having on commodity prices, particularly oil prices.
The U.S. economy got lucky in 2011 when gasoline prices dropped 18% to $3.20/gallon just in time for the back-to-school season and Christmas. Its luck extended into 2012, when the U.S. experienced an extraordinarily warm winter. Unless something extraordinary happens soon (SPR releases?), the exact opposite will happen. Gasoline prices have jumped 16% since July, adding to the squeeze just as we enter the most important shopping period of the year (chart below from gasbuddy.com):
The following chart plots the Fed’s printing with commodity prices. Unlike the relationship with equity prices, it is difficult to find anything else than excess financial liquidity to explain the spectacular rise in commodity prices. Considering how world economies have been doing lately, why is it that commodity prices have not declined significantly?
The Fed’s balance sheet is set to grow another $800 billion by the end of 2013 — the same amount it has increased since 2009 — a period during which commodity prices jumped 20%.
The Fed wants to grow employment faster, but jobs don’t grow out of thin air. Corporations create jobs when they have the means, they see a need, and there is visibility to commit. Needless to say, the last two conditions are far from being met these days. The Fed can’t offset negative U.S. politics, the European mess, or the Chinese slowdown.
Bringing mortgage rates further down might help the slowly recovering housing sector and restart construction employment, but low wages and rising inflation remain a problem, which might perversely be aggravated by the very actions the Fed is taking.
Wages are not about to accelerate but inflation and taxation are problematic. If the American consumer can’t spend, who will provide the needed spark?
Higher P/E Ratios to the Rescue?
Earnings have stalled, corporations are cutting guidance, and analysts are busy revising their estimates downward. Q312 estimates have been cut 8% since March, and are now below Q2 earnings, which themselves came in much lower than originally expected. Q3 earnings are now projected to be lower YOY.
If so, trailing 12 months EPS peaked last quarter and will decline in Q3. The earnings tailwind has disappeared.
There have been eight periods since 1935 when equities have risen in the face of declining earnings (see Banking (Betting) On Bankers?). In all cases, inflation declined, along with earnings.
The dependable Rule of 20 says that “Fair trailing P/E = 20 minus inflation”. Lower inflation begets lower P/Es. Fair P/E is thus 18.3 at the current 1.7% inflation level, 23% above the current 14.8x P/E, pointing to 1800 as fair value on the S&P 500 Index based on trailing EPS of $98.69. If this undervaluation is narrowed by the liquidity pumped out by the Fed, could it create enough wealth effect to push U.S. consumers into a spending spree, despite negative real labor income growth?
The problem with Bernanke’s wealth effect thesis lies with the new reality in America. Lately, income and assets have been so significantly redistributed that only a tiny few actually feel a wealth effect from rising equity prices. Here are some sad facts:
- Last year, the top 20% of households took in 51.1% of all income in 2011, up from 50.2% in 2010 and the highest share since at least 1967, according to the Census Bureau. After the top, each quintile of income earners saw their share of income decrease, with the biggest drop among middle income earners. The middle fifth of households took in 14.3% of all income last year. (WSJ)
- In 2007, the top 20% of income earners had 53% of their financial holdings in stocks (directly and indirectly), down from 59% in 2001. Middle income earners had 38% of their financial assets in stocks in 2007, down spectacularly from 47% in 2001.
- Stock holdings have obviously declined since 2007:
- U.S. home values remain 30% below their 2006 peak level, and are unchanged from their 2003 levels.
- Total residential mortgage debt has only declined 7.5% since 2008. Some 1.5 million homes are in foreclosure, but 10.8 million homes remain in negative equity.
The “wealthy few” may feel wealthier if stocks advance, but they could nevertheless have much less after-tax income to spend when politicians finally address the looming fiscal cliff nestled within the rapidly growing mountain of debt.
Keep in mind that it is these wealthy people who run American corporations, keeping them lean and mean and flush with cash. They remember how profits literally disappeared in 18 months in 2007-08. They remember how financial markets totally froze in 2008. They see the humongous budget deficits and the debt piling on, and the not-so-distant day of reckoning. They realize that all the QEs can’t offset inept and irresponsible politicians on either side of the Atlantic. Yet, they are the ones targeted by the so-called wealth effect!
Call that pushing on a golden string.
Meanwhile, the less affluent — the other 80%, some 250 million people — are little concerned by an eventual wealth effect but highly, directly and immediately impacted by the side effects of all these QEs, namely rising commodity prices and near zero interest rates. Consider that:
- 15% of the U.S. population lives in poverty.
- 44% of those 46.2 million poor Americans are in “deep poverty,” which is half the poverty line defined as $22,811 for a family of four.
- More than 45 million Americans are in the food stamps program — 15% of the population compared with the 7.9% participation from 1970-2000. Food-stamp enrollment has been rising at a rate of 400,000 per month over the past four years. Only last August, more people went on the food-stamp program (173,000) than those who managed to find a new job (96,000).
- More than 11 million Americans are collecting federal disability checks.
- 11.2% of the labor force is out of work if we include the 7 million people no longer seeking employment. This number (over 17 million workers) is unchanged since 2009.
- Full-time employment remains 1.4 million below its 2009 level. Needless to say, part-timers earn and spend considerably less.
- Most of the 43.5 million American retirees must cope with nominal interest rates near zero through 2015 when inflation is around 2.0%.
Call that pushing on a chafed string.
Betting on Bankers?
Now that U.S. and Europe central banks have delivered the financial heroine needed to compensate for inept and irresponsible politicians, should we jump back into equities?
Will professional investors drive equities higher?
The risk here is that, much like business people, investors stay cautious, given the numerous and highly complex difficulties the U.S. and the world are facing. They will also consider that, at the time of previous QE program launches, equity markets were similarly undervalued, but many economic trends were then more positive:
- Earnings were in a strong uptrend on rising margins
- Oil prices were much lower
- U.S. real wages were rising (not in 2011)
- The 2011-12 winter was one of the mildest on record in the U.S.
- Europe was not in recession
- China was still growing strongly
Interestingly, equities undervaluation, as measured by the Rule of 20, narrowed from 40% to 0 during QE1, from 23% to 7% during QE2, and from 19% to 14% during Operation Twist (see the black line in chart below). The recent rally has narrowed the undervaluation from 27% to 19%. It would be very surprising if we got near fair value anytime soon. If 10% undervaluation (average of QE2 and OT) is the best we can hope for, the resulting 16.5 P/E (90% of 20 minus 1.7% inflation) brings the S&P 500 to 1625, just about 10% above current levels.
(click image to enlarge)
That assumes that inflation stays constant at 1.7% YOY. However, gasoline prices are +7% YOY in September after rising 1.8% in August.. If they remain unchanged until year-end, gas prices will be +18% YOY in December. Not only would that considerably disrupt Christmas sales, it would also help raise inflation (gasoline is 5.5% of the CPI, energy is 9.7%). If inflation rises to 2.0%, a 10% undervaluation would get the S&P 500 Index to 1565, a mere 6% above current levels.
If the Fed has it all wrong, simply pushing on golden or chafed strings, and the only effect of QE3 is to boost inflation, only God(ot) knows what will happen.
While the Fed waits for the wealth effect to take effect, the European Central Bank is also waiting for its own Godot following Draghi’s magic with the ECB rules and regulations. Super Mario’s “whatever it takes” promise is powerful, but not without pitfalls:
- When, if ever, will the Eurozone achieve the necessary banking and fiscal unions?
- Will Spain and Italy surrender before it is too late?
- Will ever more austerity finally work?
- When will the debt spiral stop?
- How much longer will the Germans put up with the situation, accepting that the ECB ruins its balance sheet taking unlimited risk on behalf of the German taxpayers, risking their fiscal sovereignty to save the “reckless Southerners”?
- How much longer will the hordes of unemployed young Europeans put up with the situation?
Bankers have indeed delivered. In truth, however, they are merely experimenting with totally unproven ways and means, hoping to gain enough time until more responsible politicians emerge. Given the significant risk still facing us until Godot arrives, investors should await more evidence that either earnings resume their uptrend or some kind of miracle(s) happen.
Equity holdings should be trimmed to conservative levels. Sustainable income should be favored. Cash earns essentially nothing, but is safe for now. Gold remains attractive for many, many obvious reasons.
A wealth of right ideas. Interview with George Schultz from the WSJ:
Memo to Romney — Expand the Pie
George Shultz, the former secretary of state and Treasury says America’s current problems are large, and its power in the world is diminished. But the policies for revival are obvious with the right leadership.
George Shultz has one of the most preposterously impressive résumés in recent American history. World War II Marine (1942-45); distinguished academic economist; business executive; secretary of labor (1969-70); director of the Office of Management and Budget (1970-72); secretary of the Treasury (1972-74); chairman of Ronald Reagan’s economic transition team; and the secretary of state (1982-89) who wound down the Cold War.
He’s also been an active adviser to GOP leaders including George W. Bush in the years since. And, as I just learned, he’s not a bad singer either.
When I called out of the blue on Wednesday morning, the 91-year-old éminence grise was in his office at Stanford University’s Hoover Institution and willing to meet for an interview that afternoon.
The executive summary? On the economy: “We have some big problems in this country.” He’s very concerned about debt, and about monetary, tax and regulatory policy. On foreign policy: “We’re weaker, much weaker” abroad than we were two decades ago.
But despite it all, Mr. Shultz is confident that if we get the policies right again, America can regain its footing: “When Ronald Reagan took office, inflation was in the teens, the prime rate was in the 20s, and the economy was going nowhere. We still had the remnants of wage and price controls, particularly in oil and gas. And Jimmy Carter said we were in ‘malaise.’ It was a bad time. I’m convinced the economy can be turned around because I watched Ronald Reagan do it.”
“It took long-term thinking,” Mr. Shultz emphasizes. “I’ll give you an example. [Reagan] knew and we all advised him you can’t have a decent economy with the kind of inflation we’ve got. . . . The political people would come in and say ‘You’ve got to be careful, Mr. President. There’s gonna be a recession [if the Federal Reserve tightens the money supply]. You’re gonna lose seats in the midterm election.’
“And he basically said, ‘If not us who? If not now when?’ And he held a political umbrella over [Fed Chairman] Paul Volcker, and Paul did what needed to be done. And by late ’82 early ’83, inflation was under control, the tax changes that he made were kicking in, and the economy took off. But it took a politician with an ability to take a short-term hit in order to get the long-run results that we needed.”
Is inflation a primary threat today? Not an immediate one, says Mr. Shultz, “but it’s a building problem because of all this liquidity that’s being stored up. . . . They [the Fed] think their contribution to doing something about [our economic troubles] is very easy money. Well, by this time money is very easy. It doesn’t have to get any easier. . . . It takes other things to get the economy going—not more money.”
Mr. Shultz dwells at length on the national debt, and on the Fed’s role in enabling it: “It’s startling that in the last year, three-quarters of the debt that’s been issued has been bought by the Fed and the balance has been bought by other countries, so U.S. citizens and institutions are not on net buying U.S. debt. . . . The Fed doesn’t have an unlimited capacity because when it buys the debt what it’s doing is monetizing the debt. Sooner or later that has got to get out into the economy. Can’t be held forever. And when it does in that kind of volume—as Milton Friedman taught us, inflation is a monetary phenomenon—it’s gonna be hard to control.”
As Mr. Shultz sees it, there is plenty of empirical evidence about which policies promote growth and which don’t.
“I think the things that need to be done are sort of in the air, and you almost feel as if everybody knows what they are,” he says. “It’s quite apparent that we need to have another round of the 1986 tax act. That is, clean out the preferences and lower the rates. . . . It’s also not a mystery that our corporate tax rate is way too high and there are preferences there that could be cleaned out.”
For Mr. Shultz, the tax issue is not just about rates—though he believes lower rates often produce more revenue than higher ones, and “it’s the revenues you’re looking for”—but about predictability.
He asks me what sports I like. “Let’s talk about football. . . . You want to know the rules and have an impartial referee, but you also want to make sure somebody isn’t going to come along and change the rules in the middle of the game. . . . Now it’s as though we have all these people who have money on the sidelines and we say ‘Come on and play the game,’ and they say ‘Well what are the rules?’ and we say ‘We’ll tell you later.’ And what about the referee? Well, we’re still struggling for who that’s gonna be. . . . That’s not an environment designed to get people to play.”
Mr. Shultz cites the handling of the auto bankruptcies as an important deviation from rules-based economic policy. The question was “are we gonna have a political bankruptcy or a rule-of-law bankruptcy? Political bankruptcy was chosen. So the result is that the unions got paid off and the regular creditors didn’t.”
He also cites Washington’s “habit of passing bills that are thousands of pages long and you know most legislators haven’t even read what they’re voting for.”
That would be ObamaCare, of course. “I fear that the approach to controlling costs in the health-care business is moving more and more to a wage-and-price-control approach. And one thing you know from experience is when you control the price of something, you end up getting less of it. So if you control the price of health-care providers, you will have fewer of them and that’s gonna wind up as a crisis. The most vivid expression of that . . . was Jimmy Carter’s gas lines.”
Experience. Examples. Evidence. Shultz themes.
As we turn to foreign policy, the national debt again looms large: “Now remember something. Alexander Hamilton, our first secretary of the Treasury, and a very good one, redeemed all of the Revolutionary War debt at par value, and he said the ‘full faith and credit’ of the United States must be inviolate, among other reasons because it will be necessary in a crisis to be able to borrow. And we saw ourselves through the Civil War because we were able to borrow. We saw ourselves able to defeat the Nazis and the Japanese because we were able to borrow. We’ve got ourselves now to the point where if we suddenly had to finance another very big event of some kind, it would be hard to do it. We are exhausting our borrowing capacity.”
Mr. Shultz is not an alarmist about the rising power of China. He believes Chinese leaders understand their interest in having good relations with the United States. He is withering in his critique of those who would blame cheap Chinese labor or a cheap Chinese currency for U.S. economic problems:
“We are consuming more than we produce and we’ve done that a while and we’re complaining about the fact that we have an imbalance of trade with China. But if you consume more than you produce, you have to import. It’s just arithmetic. And if you spend more than you earn, you have to borrow. It’s just arithmetic.”
Mr. Shultz is more concerned about the Middle East, an area where he concedes even the Reagan administration struggled, “just like everybody.” So what would he do about the threat of an Iranian bomb? Is he concerned we haven’t seized the current opportunity to weaken Iran’s ally in Damascus?
“[Syrian President Bashar al-Assad] and the Iranians have been a strategic adversary. Gadhafi was sort of a tactical adversary. . . . I think I would have said to the Turks, ‘I see you are providing safe havens on your border and probably you could use some help. We’re there with you.'”
He also thinks we can have a deterrent effect without major military strikes. He recalls an episode from the 1980s when the U.S. Navy became aware of Iranian efforts to mine the Persian Gulf: “We boarded the ship. Took off some mines for evidence. Took off the sailors, sank the ship. Took the sailors to Dubai, I believe, and said to the Iranians ‘Come and get your sailors and cut it out.'”
What about Mitt Romney? Is he running on the right themes? Will he have a mandate if he wins?
“He made one speech that I thought was outstanding, addressing a long-term problem. And that was the speech about K-12 education, and he pointed out the degree to which the United States is falling back. . . . We know that economic growth in the long run is correlated to education achievement.”
Could he recommend one book for Mr. Romney to read this summer? “This book that John Taylor”—the Stanford economist and Mr. Shultz’s colleague at Hoover—”has just published, ‘First Principles: Five Keys to Restoring America’s Prosperity.’ You don’t have to spend weeks reading it.”
Mr. Shultz also mentions the memo his economic transition team wrote for President-elect Ronald Reagan in 1980, recently excerpted in The Wall Street Journal (“Advice for a New President,” May 26): “If you just took that and put that into effect again, then we’d be in business.”
I try hard to pull Mr. Shultz back toward despair. Aren’t we an older, more poorly educated society than the one that climbed out of similar debt after World War II?
“Well, we gotta get after these things! Somehow people are locking into the idea of chronological age. There’s another way of calculating age. That is what is the probability of your dying within the year. If you use that way of calculating, people who are 75 today on that basis are 65 as of some earlier time. . . . We need to gear our retirement system in such a way that people keep working longer.”
He suggests ending Social Security taxes for people who have paid in for 40 years. The way to meet our demographic challenge is to keep people in the labor force longer, Mr. Shultz says, and not fall for European notions that there is some fixed amount of work to be divided up. “The trick is to keep expanding the pie.”
We end on some wistful and optimistic notes. “There’s no lack of creativity in the United States.” Silicon Valley, he says, “is a giant Stanford spinoff.” He waxes lyrical for a moment about Steve Jobs. “My wife tells a story,” he says about a party with Jobs’s wife. “[My wife] says well ‘Where’s Steve?'” “Steve is thinking. He’s decided to take six months off and think” is the response. “He was a creative genius,” adds Mr. Shultz with admiration.
Shultz conservatism is not dour, budget-balancing conservatism. Nor was Reagan’s. It is a belief in the human spirit.
And, of course, in economic policies based on evidence. As the interview closes, I am treated to a song—not a note out of place—that was sung by the secretary on Milton Friedman’s 90th birthday:
“A fact without a theory is like a ship without a sail. Is like a boat without a rudder. Is like a kite without a tail. A fact without a theory is as sad as sad can be. But if there’s one thing worse in this universe, it’s a theory . . . without a fact.”