Monday, June 11, 2012

Monetary and Fiscal Policy Have Hit the Wall

By now, even the casual observer has surely heard the news; numerous signs indicate that the U.S. economy is again slowing.

For example:

• The productivity of U.S. workers and businesses dropped 0.9% in the first three months of the year.

• U.S. factory orders have declined for two consecutive months, dropping 0.6% in April and 2.1% in March, according to the Commerce Department.

• State and local government spending fell a revised 2.5% in the first quarter, more than double the initial estimate of a 1.2% decline.

• Though the U.S. trade deficit narrowed in April, a drop in exports was outpaced by an even larger decline in imports. The decline in both sides of the equation is a signal that global demand is slipping. Of greatest concern, imports fell despite an increase in the volume and price of oil imports.

• While it was initially reported that the US economy grew at a 2.2% annual rate in the first quarter, the Commerce Department has revised that figure down to 1.9%.

Yet, of greatest concern, things may actually be getting even worse.

After adding more than 500,000 jobs in the first two months of this year, the economy has added a mere 289,000 in the past three months, not even enough to keep up with the nation’s growing working-age population, much less lower the unemployment rate.

One of the Federal Reserve's three mandates is to achieve and maintain maximum employment (the others are stable prices and moderate long-term interest rates). Clearly, the Fed is failing to achieve maximum employment. But after all of its rather historic undertakings, the question is, what more can the Fed possibly do?

The central bank has pumped $2.3 trillion into the financial system since 2008, slashed short-term interest rates to near zero, held them there since December 2008, and made the unprecedented promise to keep them that low “at least through late 2014.”

Yet, despite the Fed's best efforts, the economy is sputtering. It seems that monetary policy has finally found its limits. This is the best it can do.

How about fiscal policy?

The federal deficit for fiscal 2008 was a record $459 billion, more than double the previous year’s figure. Then, in the midst of the financial crisis that year, the government tapped a $700 billion Treasury fund to buy toxic mortgage-related securities.

In fiscal 2009, the deficit was $1.4 trillion. That was followed by $1.3 trillion deficits in both 2010 and in 2011. And this fiscal year, the government will run a $1.2 trillion deficit.

All of this spending was intended to keep the economy afloat after the financial collapse and the Great Recession, which began in December 2007.

Despite these massive monetary and fiscal interventions, the economy is slowing, stagnating, and perhaps even shrinking.

As Martin Wolf wrote in the Financial Times, "The fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been."

The U.S. economy and monetary systems are predicated on debt. All money is loaned into existence, making debt inevitable. In essence, money is debt. And without an expansion of debt, the economy cannot grow. Debt (or credit) is the economy's life blood.

However, we seem to have finally found the limits of debt expansion.

Total U.S. household debt reached a whopping $13.8 trillion by 2008. By the end of 2009, total household debt was nine times what it was in 1981 — rising twice as fast as disposable income in the same period. For decades, Americans were spending money they didn't have by taking on ever-increasing amounts of debt.

However, the Great Recession put the brakes on previous levels of debt expansion. Fed data shows that by the end of 2011, household debt was down to $13.2 trillion. Yet, total disposable income was just $10.7 trillion.

Household net worth—the difference between the value of assets and liabilities—was $58.5 trillion at the end of 2011, after having fallen close to 3/4 percent, the first annual decrease since 2008.

Though household net worth has fallen, debt is again rising — albeit more slowly than in the past.

Since the recession ended in June 2009, total U.S. debt has risen at the slowest pace since the Fed began keeping records in the early 1950s. While this can be viewed positively, total debt has nonetheless risen. It's just rising more slowly now.

In the 11 quarters since the recession officially ended, total domestic debt has risen by $702 billion, or 1.4%, compared to the 28% increase in the previous 11 quarters.

However, though debt has declined due to the deleveraging of families, banks, non-financial businesses and state and local governments, debt is still exceptionally high by any measure.

Total debt has fallen from 373% of GDP to 336%. But that is still stunningly high. Though total debt is going in the right direction, a debt level that enormous is, nonetheless, really bad news.

U.S. household debt has fallen to 84% of GDP from a peak of 98%. Non-financial corporate debt has fallen to 77% from a peak of 83%. Financial sector debt has dropped from 123% of GDP to 89%.

However, public debt has risen to 89% from 56%. That's because the government has been stepping to fill the spending gap, thereby averting another depression. But that's a double-edged sword.

As a result of consumer retrenchment (due to unemployment and the housing collapse), government spending is the only thing presently under-girding the economy. The problem is that this is creating continual trillion dollar deficits.

However, if the government reduces spending to balance its budget, that action will have a negative effect on GDP. In past recoveries, the growth of the private sector has overcome that negative effect. But the private sector isn't truly recovering and it cannot recover unless consumers recover. It's all a big, vicious cycle.

The deficit certainly needs to be cut. But cutting the deficit too fast could also throw the country into an even deeper recession. Deficit reduction will also reduce GDP. That means the government will collect less taxes, which makes the deficits worse, which means the government has to make more cuts than planned, which means lower tax receipts, and so on and so on.

The key takeaway from all of this is that after historic levels of deficit spending by the federal government, coupled with equally historic levels of Federal Reserve interventions on the money supply and interest rates, an economy grappling with the specter of recession (or worse) is the best our fiscal and monetary 'masters' can do.

Whatever the eventual outcomes of all these massive interventions — and they will surely turn quite negative at some future point — it is clear that they have at least prevented another full blown depression — at least to this point.

How long we can continue to avoid that outcome is anyone's guess. But one thing is certain; there are limits to trillion dollar deficits, near-zero interest rates and massive increases to the monetary base by creating money out of nothing.

Such interventions are clearly finite. And when they end, the blowback will be harsh and it will be heavy.

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