When velocity is low the nation essentially winds up in a “liquidity trap” which is a situation where monetary policy is unable to stimulate the economy either through lowering interest rates or increasing the money supply. This was the condition that Japan found itself enveloped in from 1989 to present. We expect the same problem in this country and hope (really hope) to be wrong. Words: 672

So says Comstock Partners (http://comstockfunds.com) in an article which Lorimer Wilson, editor of www.munKNEE.com, has reformatted below for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article reposting to avoid copyright infringement.)  Comstock Partners go on to say:

Government Debt Replacing Private Debt As the Major Problem
We have been predicting for over 4 years that the government debt (including public, gross, and state and local governments) will increase substantially, while the private debt (all forms) will roll over and decline substantially [and that is what has, is and will continue to happen well into the future].

No Inflation Foreseen in Near Term
Most bears on the stock market are fearful that, [with] the Fed printing so much money, this will result in potential runaway inflation. We, on the other hand, do not think the results of the Fed’s balance sheet increasing through quantitative easing (QE) will result in inflation in the next few years, although it could very well be a serious problem further down the road. We believe the private sector debt will continue to decline (deleverage) regardless of what the Fed and Administration do to attempt to jolt the economy.

The reason that the attempt at money printing to juice the economy will not work, in our opinion, is that the whole private sector is frozen due to the fear of losing more money. Corporations are continuing to build up cash positions and individuals are afraid of taking risk in this environment…

Quantitative Easing Has Failed
The Fed believed that Quantitative Easing (QE) would stimulate the economy but in the current credit crisis QE is not working as well as the Fed and Administration expected. While it has succeeded in jump-starting the monetary base it has failed to increase the money supply or velocity (the ratio of economic transactions to the money supply). Thus, while the banks now have the ability to make new loans, not enough qualified borrowers are interested in borrowing money, and banks are not willing to loan money to anyone that is not a prime borrower.

Velocity of Money is Needed
What we need to stimulate the economy is “velocity” which measures the rate at which money in circulation is used for purchasing goods and services. The velocity of money is computed by dividing the nation’s output of goods and services by the total money supply (circulating currency plus checking account deposits). Velocity of money is also influenced by interest rates. When rates are low, people hold more money in cash, when rates are rising, they put more money in interest paying investments.

A “Liquidity Trap” is Developing
When velocity is low the nation essentially winds up in a “liquidity trap” which is a situation where monetary policy is unable to stimulate the economy either through lowering interest rates or increasing the money supply. This was the condition that Japan found itself enveloped in from 1989 to present. We expect the same problem in this country and hope (really hope) to be wrong.

If we are lucky we will be able to go through the slowdown we expect (or double dip) and repair the household balance sheets enough to grow out of this mess in less time than it is taking Japan.

*http://comstockfunds.com/default.aspx?act=newsletter.aspx&category=SpecialReport&AspxAutoDetectCookieSupport=1

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.

 

The 100% plus expansion in the Fed’s balance sheet (monetary base) has done nothing to rekindle borrowing and lending or revive even the smallest spark of inflation. What is clear is that as long as private market factors in the monetary/credit creation process are shrinking, as they are now, the risk for the economy is deflation, not inflation. Words: 1461

In further edited excerpts from their original report* Van R. Hoisington and Lacy H. Hunt (www.hoisingtonmgt.com) go on to say:

One of the more common beliefs about the operation of the U.S. economy is that a massive increase in the Fed’s balance sheet will automatically lead to a quick and substantial rise in inflation. An inflationary surge of this type must work through the banking system in the form of an increasing cycle of borrowing and lending but as of today, however, excessive debt and falling asset prices have conspired to render the best efforts of the Fed impotent.

Understanding the Complex Monetary Chain
The link between Fed actions and the economy is far more indirect and complex than the simple conclusion that Federal asset growth equals inflation. In economic parlance, for an increase in the Fed’s balance sheet to boost the price level, the following conditions must be met:

1. The money multiplier must be flat or rising;
2. The velocity of money must be flat or rising; and
3. The AS or supply curve must be upward sloping.

The economy and price changes are moving downward because none of these conditions are currently being met; nor, in our judgment, are they likely to be met in the foreseeable future. The practical and straightforward fact is that GDP has declined in the face of a surge in M2 growth. The labor market equivalent of GDP (aggregate hours worked) has declined at a record rate over the last 18 months, the entire span of the recession. That is, the monetary surge was totally offset by other factors; thus, the recession deepened and inflation was nonexistent.

The conventional wisdom is that the massive increase in excess reserves might eventually be used to make loans and reverse the economic contraction now underway, or that the velocity of money might increase. There is a very good explanation for the surge in excess reserves:

1. The Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed… [and, as such,] this “high powered” money is not available for making loans and investments.

2. Velocity (V), or the turnover of money in the economy, is far more likely to fall than to rise. This is because V tends to fall when financial innovation reverses downward. As this process continues excess leverage will eventually diminish and together they will lead V lower. This process has already begun in the household sector.

In addition, the Fed needs an upward sloping supply curve to get the economic ball rolling. Today we estimate that the AS curve is flat. The reason it is in this perfectly elastic shape, rather than upward sloping, is that we have substantial excess labor and other productive resources….Indeed, when excess resources are extreme, the AS curve is likely to be not only horizontal, but shifting outward, meaning that prices will be lower at any level of aggregate demand or GDP. Thus, even if Fed actions could shift the aggregate demand curve outward, which it cannot do under present circumstances, inflation would still be a long way down the road. Thus, theory and current evidence clearly point to deflation as the overwhelming economic risk.

Fiscal Policy a Drag on Growth
Over the next four years, the ratio of U.S. government debt will rise to somewhere between 71% and 80% of GDP, up from 41% at the end of 2008. The 71% figure, which is from the CBO, is probably understated. The CBO figures do not include the debt of Fannie Mae and Freddie Mac (now owned by the U.S. government), and their economic forecasts are probably too optimistic. None of these projections have incorporated the proposed health care bill which would raise the debt ratio considerably. This substantial increase in government spending far exceeds projected rising revenue sources such as the large marginal tax increase that has been suggested by the reversal in 2010 of the 2001 and 2003 tax reductions.

While the federal deficit is expanding, state and local government spending is being reduced and taxes have increased. It is highly unusual that state and local expenditures have actually decreased in current dollars in the past two quarters and, in real terms, spending is lower than a year ago. This is because state and local governments generally do not have the flexibility to incur deficits, yet they face potential deficits of about $121 billion for fiscal 2010. Therefore, the apparent thrust of federal policy is stimulus, while state and local policy is contractionary.

The Term “Federal Stimulus Spending” is An Oxymoron

a) Spending Multipliers
Many assume that the act of sending checks from the federal government sector to the private sector helps the economy through so-called spending multipliers. Multipliers take into consideration the second, third, fourth, etc. round effects from an initial change. Thus, multipliers capture the unintended consequences of policy actions. Although the initial spending objectives may be well intended, the ultimate outcome becomes convoluted.

Robert Barro of Harvard University and Italian econometrician Roberto Perotti of Universita’ Bocconi and the Centre for Capital Economic Policy Research have independently calculated that the government expenditure multiplier has remained at 0. Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth. There may be intermittent periods when government spending will lift the economy, but offsetting episodes will follow. The best available empirical research suggests that the current federal policy of expanding spending will retard, not improve, the performance of business conditions.

b) Tax Multipliers
In addition to spending multipliers, however, there are also tax multipliers. A paper written at the University of California Berkeley by Christina D. and David H. Romer found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3.

Summary
Presently, the federal government is increasing spending that in the end may actually retard economic activity, and is also proposing tax increases that will further restrain private sector growth. In other words, fiscal policy is executing a program that is 180 degrees opposite from what it should be to stimulate the economy. How is it possible to get an inflationary cocktail out of deflationary ingredients?

Business Cycle Implications for Equities
The preferred way to answer the business cycle question of expansion versus contraction is to examine the four variables most integral to the economy’s performance: employment, production, personal income, and sales. For these variables to be consistent over time, the income and sales must be adjusted for inflation and personal income must exclude government transfer payments.

Recessions end when the National Bureau of Economic Research (NBER), the official arbiter of such matters, says they end but sometimes economic conditions suggest that the NBER miscalculated. Economic recovery occurs when these four indicators turn higher at about the same time. If the NBER’s cycle turning dates are aligned with these four indicators they have validity. Regardless of the NBER’s opinion, if the four indicators are not rising, a normal recovery will not occur. This seemingly esoteric point has important implications for the stock market… If a complete recovery of these four variables is still far in the future, then the current gains in the stock market cannot be sustained, just as rallies were not sustained in 2001. Furthermore, with total U.S. debt as a percent of GDP having surged to a new post 1870 record, the economy has become more leveraged even as the recession has progressed and an over- leveraged economy is one prone to deflation and stagnant growth.

The combination of an extremely overleveraged economy, ineffectual monetary policy and misdirected fiscal policy initiatives suggests that the U.S. economy faces a long difficult struggle. While depleted inventories and the buildup of pent-up demand may produce intermittent spurts of growth, these brief episodes are not likely to be sustained. In several years, real GDP may be no higher than its current levels. However, since the population will continue to grow, per capita GDP will decline; thus, the standard of living will diminish as unemployment rises. These conditions will produce a deflationary environment similar to the Japanese condition.

*http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2009/07/13/debt-and-deflation.aspx

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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