Hoisington and Lacy Hunt have figured out what few others have, that
excessive debt and falling asset prices have conspired to render the best
efforts of the Fed impotent.
Please consider the Hoisington Second Quarter 2009 Outlook.
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. [However] An inflationary surge of
this type must work either through the banking system or through non-bank
institutions that act like banks which are often called “shadow
banks”. The process toward inflation in both cases is a necessary increasing
cycle of borrowing and lending. As of today, that private market mechanism
has been acting as a brake on the normal functioning of the monetary engine.
For example, total commercial bank loans have declined over the past 1, 3, 6,
and 9 month intervals. Also, recent readings on bank credit plus commercial
paper have registered record rates of decline. The FDIC has closed a record
52 banks thus far this year, and numerous other banks are on life support.
The “shadow banks” are in even worse shape. Over 300 mortgage entities
have failed, and Fannie Mae and Freddie Mac are in federal receivership.
Foreclosures and delinquencies on mortgages are continuing to rise,
indicating that the banks and their non-bank competitors face additional
pressures to re-trench, not expand. Thus far in
this unusual business cycle, excessive debt and falling asset prices have
conspired to render the best efforts of the Fed impotent.
that, we can safely add Hoisington to the small group of people who
understand that Belief In Wizards
Is Misguided. Continuing with a discussion from
The Complex Monetary Chain
link between Fed actions and the economy is far more indirect and complex
than the simple conclusion that Federal asset growth equals inflation. The
price level and, in fact, real GDP are determined by the intersection of the
aggregate demand (AD) and aggregate supply (AS) curves. Or, 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.
that lower velocity does not cause anything to happen. Lower velocity
is a result of increasing demand for money (i.e. a reluctance by consumers to
borrow, and banks to lend).
Reluctance to lend can easily be seen in a chart of bank reserves.
Excess Reserves of Depository Institutions
With reserves rising the following chart should not be so surprising.
M1 Money Multiplier
The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.
Please see Money Multipliers,
Velocity, and Excess Reserves for more on
Money Multiplier Theory
Conventional wisdom regarding money supply suggests there is massive pent up
inflation in the works as a result of the buildup of those reserves. The
rationale is that 10 times those excess reserves (via fractional reserve
lending) will soon be working its way into the economy causing huge price
spikes, a collapse in the US dollar, and possibly even hyperinflation.
However, conventional wisdom regarding the money multiplier is wrong.
Australian economist Steve Keen notes that in a debt based society, expansion
of credit comes first and reserves come later.
Indeed, this is easy to conceptualize: Banks lent more than they should have,
and those loans are going bad at a phenomenal rate. In response, the Fed has
engaged in a huge swap-o-rama party with various banks (swapping treasuries
for collateral of dubious value) in addition to turning on the printing
This was done so that banks would remain "well capitalized". The
reality is those excess reserves are a mirage. Banks need those
reserves for credit losses coming down the pike, as unemployment rises,
foreclosures mount, and credit card defaults soar.
Banks are not well capitalized, they are insolvent, unwilling and unable to
Global Debt Bubble, Causes and Solutions
If you have not yet done so, please read Global Debt Bubble,
Causes and Solutions with a reference to a very
interesting video by Keen.
Inquiring minds may also consider my theory on credit and debt as presented
in Fiat World
Steve Keen's thinking helped me finalize that model.
Debt Deflation and Bonds
Returning once again to Hoisington:
U.S. debt as a percent of GDP surged to 375% in the first quarter, a new post
1870 record, and well above the 360% average for 2008. Therefore, the economy
became more leveraged even as the recession progressed.
An over-leveraged economy is one prone to deflation and stagnant growth. This
is evident in the path the Japanese took after their stock and real estate
bubbles began to implode in 1989. At that time Japanese debt as a percent of
GDP was 269% (Chart 5).
Japanese Debt - Total, Public, Private
This 1998 when it peaked at 345%, below the current level in the U.S. While
the Japanese increased leverage for nine years after the bubble highs,
neither highly inflated stock and real estate prices nor economic performance
could be sustained as
debt repayment became more burdensome.
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
Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield
level may be similar to that of the Japanese.
and Hold Still Bad Advice
Hoisington's observations are something I have mentioned on numerous
In regards to treasuries, I agree with Hoisington that long-dated treasuries
are attractive at this level. However, I do entertain the idea, and have done
so ever since the December, that the bottom in yields may be in. For more
discussion, please see U.S. Treasuries
Yields - Where To From Here?
In regards to equities, please consider the following snip from Buy and Hold Still
stocks are a better buy now than in 2007 or 2008. But that does not mean
stocks are cheap. Indeed, by any realistic measure of earnings, stocks are
decidedly not cheap. Then again, 6-month treasury yields are yielding a
Can equities easily beat that? Yes they might, but that does not mean
Fundamentally, the S&P 500 can easily fall to 500 or below, a massive
crash from this point. Alternatively, stocks might languish for years.
Two Lost Decades
The Japanese Stock Market is about 25% of what it was close to 20 years ago!
Yes, I know, the US is not Japan, that deflation can't happen here, etc, etc.
Of course deflation did happen here, so the question now is how long it
lasts. Even if it does not last long, there are no guarantees the stock
market stages a significant recovery.
A friend, "BC" sent the following comments in regards to chart 5
(shown above) from the Hoisington article.
chart 5 illustrating the conditions persisting during Japan's slow-motion,
deflationary, debt-deleveraging depression from the mid-to-late '90s when the
Japanese Boomer demographic drag and persistent price deflation took hold. I
strongly suspect that we will experience a similar pattern between private
and public debt/GDP.
We could see bank lending/GDP return to the 30% long-term average area from
today's peak of 50-51% (and bank real estate loans/GDP of 27% vs. the
long-term average 10-11%).
If so, we are likely to see little or no bank lending growth, which in a
debt-money economy means little or no GDP growth and further
mass-consolidation of capacity and debt defaults or gradual pay down.
Instead of "recovery" or "expansion", we should think in
terms of a Schumpeterian Depression phase of the Long Wave trough,
characterized as a debt-deflationary, deleveraging, demographics-induced
Long-term 3.3% real GDP growth has decelerated to ~1.5%, and I expect average
growth from the '00 peak to the mid- to late '10s to decelerate further to 1%
The bottom line is that private debt-based growth is simply not possible,
whereas any "growth" we do experience will be as a result of
incremental government borrowing and spending, most of which will be in the
form of war spending, bailouts, and social service transfers at very low GDP
Inquiring minds might be interested in concepts like Creative Destruction.
economic concept of creative destruction was first introduced by the
Austrian School economist Joseph Schumpeter.
Theory and Examples
Companies that once revolutionized and dominated new industries – for
example, Xerox in copiers or Polaroid in instant photography – have
seen their profits fall and their dominance vanish as rivals launched
improved designs or cut manufacturing costs. Wal-Mart is a recent example of
a company that has achieved a strong position in many markets, through its
use of new inventory-management, marketing, and personnel-management
techniques, using its resulting lower prices to compete with older or smaller
companies in the offering of retail consumer products.
Just as older behemoths perceived to be juggernauts by their contemporaries
(e.g., Montgomery Ward, FedMart, Woolworths) were eventually undone by
nimbler and more innovative competitors, Wal-Mart faces the same threat. Just
as the cassette tape replaced the 8-track, only to be replaced in turn by the
compact disc, itself being undercut by MP3 players, the seemingly dominant
Wal-Mart may well find itself an antiquated company of the past. This is the
process of creative destruction.
Other examples are the way in which online free newspaper sites such as The
Huffington Post and the National Review Online are leading to creative
destruction of the traditional paper newspaper. The Christian Science Monitor
announced in January 2009 that it would no longer continue to publish a daily
paper edition, but would be available online daily and provide a weekly print
The Seattle Post-Intelligencer became online-only in March 2009. Traditional
French alumni networks, which typically charge their students to network
online or through paper directories, are in danger of creative destruction
from free social networking sites such as Linkedin and Viadeo.
In fact, successful innovation is normally a source of temporary market
power, eroding the profits and position of old firms, yet ultimately
succumbing to the pressure of new inventions commercialized by competing
entrants. Creative destruction is a powerful economic concept because it can
explain many of the dynamics of industrial change: the transition from a
competitive to a monopolistic market, and back again.
Creative destruction can hurt. Layoffs of workers with obsolete working
skills can be one price of new innovations valued by consumers. Though a
continually innovating economy generates new opportunities for workers to
participate in more creative and productive enterprises (provided they can
acquire the necessary skills), creative destruction can cause severe hardship
in the short term, and in the long term for those who cannot acquire the
skills and work experience.
There is much
more in the article for those interested in history or book references.
This blog, Calculated Risk, Minyanville's News and Views, Big Picture, Naked
Capitalism, Zero Hedge, Market Ticker, Life After The Oil Crash, The Oil
Drum, Financial Sense, Patrick, Piggington, and numerous other widely read
sites are all part of the Creative Destruction process.
High quality content is now available for free. In many instances it's far
better than what you can pay for.
Factors Sealing The Deflationary Fate
The five month, 50% rebound in the S&P 500 was certainly spectacular.
However, the more important question is where to from here?
Take a look at Japan's "Two Lost Decades" for clues.
Creative destruction in conjunction with global wage arbitrage, changing demographics,
downsizing boomers fearing retirement, changing social attitudes towards debt
in every economic age group, and massive debt leverage is an extremely
powerful set of forces.
Bear in mind, that set of forces will not play out over days, weeks, or months.
A Schumpeterian Depression will take years, perhaps even decades to play out.
Thus, deflation is an ongoing process, not a point in time event that can be
staved off by massive interventions and Orwellian
Proclamations "We Saved The World".
Bernanke and the Fed do not understand these concepts, nor does anyone else
chanting that pending hyperinflation or massive inflation is coming right
around the corner, nor do those who think new stock market is off to new
highs. In other words, almost everyone is oblivious to the true state of
Mish's Global Economic Trend