Monday, September 3, 2012

The Economy: “Williams Needs To Be Baker-Acted”

“Williams Needs To Be Baker-Acted”
by Karl Denninger

“Sometimes it's so obvious that we shouldn't need a formal petition; The State should act on its own initiative.  This is one of those times. “Federal Reserve Bank of San Francisco President John Williams called for additional bond purchases by the Fed to spur economic growth that would be open-ended and total at least $600 billion. High unemployment and inflation below the Fed’s 2 percent target “would argue for additional accommodation now,”Williams said today in an interview on Bloomberg Television from Jackson Hole, Wyoming. “I would like to see something that has a measurable effect on job growth. That would be arguing for a pretty large program” that’s “at least as large as QE2,” or the second round of quantitative easing, he said.”

But the previous programs haven't spurred economic growth. One must ask why not, and when you do, you are left with an inescapable conclusion- they haven't worked because they can't, and the reason they can't is determined by the current debt and output profile we have- in other words, why we got in the mess in the first place.
Let's go back to this:

This is the total amount of debt in the system along with the total GDP, and the light-shaded area with the black bar on the top is the debt-to-gdp ratio (right-hand scale.) You will notice that each dollar of GDP was "backed" by about 150% (or a buck-and-a-half) of debt in 1980.  Today, it is "backed" by $3.50 in debt, or well over twice as much. More QE simply adds to this graph on the debt side.

Each dollar of new credit money so-created would of course buy one dollar of GDP.  But, in diluting the existing supply of credit and currency it does not actually add to GDP at all, although it appears to, as it increases the divisor!

Read that last paragraph as many times as it takes until it sinks in- since GDP is denominated in dollars, and dollars are balanced in each and every case by an equal number of them in debt as long as systemic debt is rising faster than GDP then GDP is actually decreasing in constant units- that is, the "gain" is illusory as you are denominating the output in something that is rising in quantity! Therefore, at best this process is a shift of wealth from those who have excess production (that is, those who "saved") to those who did not.  This happens because government fills that new credit with additional deficit spending, which it doles out to people and corporations in various forms of welfare (otherwise called "entitlements.")

But it is the second-order effects of QE that cause the real damage to the economy.  First is that which is associated with all debt- that is, interest.  Since the credit is created but the money to pay the interest is not, such new credit comes with a continuing forward obligation to spend more than was created- that is, it is inherently and mathemtically a negative sum game.  The negative sum comes over time, rather than immediately, and this is the politicians' favorite cudgel- to do now and pay later in the hope that you will not recognize that you're being looted.

The other second-order effect, however, is the most-damaging of all- the destruction of the time premium on money.  Let's say for the sake of argument that you believe that the inflation rate over time will meet the Fed's "mandate", which they "interpret" as 2% inflation per year.  (I will leave aside the fact that the word "stable" in their mandate is not an interpretive word; "stable" is zero, unchanging, but that's an argument for a different column.) Assuming you accept the 2% inflation level as "normal" and further assuming you believe the Fed is credible in preventing inflation from exceeding that target for any material amount of time you have a further problem- in the Treasury Complex you cannot loan the government any amount of money while seeking to make a profit out to ten full years. The reason is obvious- the 10 year Treasury yields only 1.56%, the five year 0.56% and the 13-week T-bill 0.085%; the latter is indistinguishable even in extremely large amounts of money with zero.

Without a positive slope to the curve and a positive real rate of return throughout the curve the ordinary functioning of the lending market is impossible.  Nobody is "lending" to the Federal Government with the expectation of making a profit against economic and thus parity-level monetary growth in the current marketplace.  Further "bond-buying" that depresses yields in the mortgage market further will simply add more of the same distortion to the mortgage system- a distortion that remains all the way down to the 15 year at present (does anyone actually believe that the time premium over fifteen years should be 1%?)

Why is this important, you might ask?  It matters in the real economy because time and risk premia in the lending market is how the marketplace filters out bad ideas and favors good ones.  It is how economic expansion becomes funded by profits rather than by cheap money.  In other words, it is how productivity advancement along with innovation in the marketplace drives GDP in preference to "money" that earns less than the time and inflation value of capital rather than the other way around.

"Cheap credit" does not drive innovation or productivity.  It is given without fear or favor to good ideas and bad, and since bad ideas are destructive to long-run productivity and GDP removing the economic incentives and actions that drive good investment lead to a stagnation and ultimate failure of economic output.

This is the lesson of Japan, where instead of allowing the liquidation of bad bets to take place they instead subsidized and transferred those losses to the taxpayer.  Suppression of interest rates was "successful" but over time the innovation that drove the Japanese economy has departed because good ideas were no longer able to outcompete bad ones.  Japan thus lost its high-tech manufacturing base to China and other nations, its innovation has been sapped and pension costs are absorbing ever-increasing portions of national income.  The nation has been unable to exit its "extraordinary" monetary policy and now is backed into a corner as it self-financed ever higher percentages of government spending.  This back-door tax depressed GDP acceleration and ultimately halted it; nominal GDP for 2011 was 469 billion Yen, a figure first surpassed in 1992! Worse, per-capita GDP was 3.67 million Yen, a figure surpassed in 1991. That's an effective zero economic growth for 20 years.

Japan was "able" to self-fund this delusion due to the extraordinary amount of personal saving that was able to be tapped.  But now that has been exhausted and worse, the rot that took place between 1992 and 2007 is now showing up in the figures- despite the claim that the 07/08 disruption "ended" with Fed and other central bank intervention.

There is no solution to our economic problems that can be found in the attempted propping up of bad credit risks by central banks- or anyone else.  "Cheap money" will indeed destroy the world, but the destruction does not come in an afternoon, a week, a month or a year. Rather it embeds structural dysfunction where good ideas are crowded out by bad, where welfare replaces work, where intellectual rot replaces innovation and where various forms of grift and scam wind up being the only means by which money can still be made.

The road we are on leads to perdition my friends and Ben Bernanke, along with Williams, Evans and Rosengren are the demons leading us through the one-way door.”

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