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John Hussman has an
interesting post this week on the misguided policies of the Bernanke Fed and
how quantitative easing promotes commodity speculation and hoarding but does
nothing for the real economy. Please consider Bernanke Leaps into
a Liquidity Trap
The belief that an increase in the
money supply will result in an increase in GDP relies on the assumption that
velocity will not decline in proportion to the increase in money.
Unfortunately for the proponents of "quantitative easing," this assumption
fails spectacularly in the data - both in the U.S. and internationally -
particularly at zero interest rates.
How to spot a liquidity trap
The chart below plots the velocity of the U.S. monetary base against interest
rates since 1947.
Few theoretical relationships in economics hold quite this well. Recall that
a Keynesian liquidity trap occurs at the point when interest rates become so
low that cash balances are passively held regardless of their size. The
relationship between interest rates and velocity therefore goes flat at low
interest rates, since increases in the money stock simply produce a
proportional decline in velocity, without requiring any further decline in
yields. Notice the cluster of observations where interest rates are zero?
Those are the most recent data points.
One might argue that while short-term interest rates are essentially zero,
long-term interest rates are not, which might leave some room for a "Hicksian" effect from QE - that is, a boost to
investment and economic activity in response to a further decline in
long-term interest rates. The problem here is that longer-term interest
rates, in an expectations sense, are already essentially at zero. The
remaining yield on longer-term bonds is a risk premium that is commensurate
with U.S. interest rate volatility (Japanese risk premiums are lower, but
they also have nearly zero interest rate variability). So QE at this point
represents little but an effort to drive risk premiums to levels that are
inadequate to compensate investors for risk. This is unlikely to go well.
Moreover, as noted below, the precise level of long-term interest rates is
not the main constraint on borrowing here. The key issues are the rational
desire to reduce debt loads, and the inadequacy of profitable investment
opportunities in an economy flooded with excess capacity.
One of the most fascinating aspects of the current debate about monetary
policy is the belief that changes in the money stock are tightly related
either to GDP growth or inflation at all. Look at the historical data, and
you will find no evidence of it.
You can see why monetary base manipulations have so little effect on GDP by
examining U.S. data since 1947. Expand the quantity of base money, and it
turns out that velocity falls in nearly direct proportion. The cluster of points at the bottom right reflect the most
recent data.
Just to drive the point home, the chart below presents the same historical
relationship in Japanese data over the past two decades. One wonders why
anyone expects quantitative easing in the U.S. to be any less futile than it
was in Japan.
Simply put, monetary policy is far less effective in affecting real (or even
nominal) economic activity than investors seem to believe. The main effect of
a change in the monetary base is to change monetary velocity and short term
interest rates. Once short term interest rates drop to zero, further
expansions in base money simply induce a proportional collapse in velocity.
Look at the price of gold since 1975. When real interest rates have been
negative (even simply measured as the 3-month Treasury bill yield minus
trailing annual CPI inflation), gold prices have appreciated at a 20.7%
annual rate. In contrast, when real interest rates have been positive, gold
has appreciated at just 2.1% annually. The tendency toward commodity hoarding
is particularly strong when economic conditions are very weak and desirable
options for real investment are not available. When real interest rates have
been negative and the Purchasing Managers Index has been below 50, the XAU
gold index has appreciated at an 85.7% annual rate, compared with a rate of
just 0.1% when neither has been true. Despite these tendencies, investors
should be aware that the volatility of gold stocks can often be intolerable,
so finer methods of analysis are also essential.
Quantitative easing promises to have little effect except to provoke
commodity hoarding, a decline in bond yields to levels that reflect nothing
but risk premiums for maturity risk, and an expansion in stock valuations to
levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been
followed by 5-10 year total returns below 5% annually). The Fed is not
helping the economy - it is encouraging a bubble in risky assets, and an
increasingly unstable one at that. The Fed has now placed itself in the
position where small changes in its announced policy could have disastrous
effects on a whole range of financial markets. This is not sound economic
thinking but misguided tinkering with the stability of the economy.
That is a decent sized snip, but I assure you there
is much more in the article to merit a complete read.
Commodity Hoarding
Commodity hoarding and speculation and credit growth is rampant in China, as
noted in Massive Inflation in China, US Inflation Nonexistent
I also happen to have had an email exchange with someone in the apparel
industry regarding cotton over the past few days.
"AI" Writes ...
Mish,
As you know I work in the apparel industry. One item that the media is not
discussing is the massive price increases for clothing that is coming in
2011. Retailers are beginning to feel the pricing pain as we speak. For now
they and their vendors are absorbing through modestly lower margins. By early
spring product shortages will become an issue. As we move into July and
August we WILL see pricing for many items increase by 20% or more because of
cotton shortages and hoarding in China.
I know of one "factory" that made a cash purchase of a substantial
amount of "cotton"/piece goods. To their surprise only 20% was
delivered along with a refund for the balance. The supplier said they plan to
hold the goods longer as prices continue to increase rapidly.
"AI"
Definition of "Factory"
Since "Factory" was in quotes, I had to ask exactly what that
meant. "AI" responds ...
A factory can be an actual
production facility or it could be a sourcing agent who outsources production
to various facilities. The term is often used interchangeably so I felt the
quotes were needed. The same can be said for cotton as it is sometimes used
when people are referring to fabric/piece goods. The
hoarding example I provided was for actual fabric.
Apparel Price Increase Looms?
"AI" thinks a huge price increase looms. I am not so sure. Prices
can only rise if consumers are willing to pay that price. Are they? For how
long?
As for hoarding, there is always the risk of a price collapse. Given the
fragile state of the economy, a sudden collapse in the price of cotton or
commodities cannot be ruled out.
Cotton Weekly
Charts like that seldom turn out well for buyers at these prices.
Liquidity Trap?
I agree with what Hussman is saying about liquidity
traps in general and how this "pushing on a string" cannot work.
However, the entire notion of a "liquidity trap" is a Keynesian
construct that implies "something" must be done.
In reality, the best thing to do is nothing. Eventually prices will fall low
enough where real demand will pick up. The speculators (in this case the
banks), would have been wiped out and the bondholders (mainly the wealthy),
would have taken a hit.
Sadly that is not what we did. We did not even do the second best thing of
funding genuine infrastructure needs. Instead, we bailed out the banks at
taxpayer expense, paved a bunch of roads at huge expense that did not need
paving, and gave money to states that squandered much of it on public unions.
In short, it would be hard pressed to find a policy response worse than what
we did. QE cannot work as the charts from Hussman proves. Yet Bernanke is committed to a
policy of more of the same from the Fed.
Meanwhile, Congress is apt to head the other direction (thankfully) and
tighten up, even though Krugman is screaming his
fool head off. Please see Krugman and the Inevitable "I
Told You So" - Tim Duy "Bad Things Happen
When You Fight the Fed"; Final End of Bretton
Woods 2? for more detail.
The only remaining question is how big various commodity, stock market, and
corporate bond bubbles get in the meantime, before things blow sky high once
again. Risk
is enormous and growing.
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