The huge fiscal and monetary stimulus dispensed in recent years has staved off the onset of chronic deflation. For now.
The deficits created by this spending would be inflationary only if the measures occurred in a period of full employment and created excess demand. That isn’t the case in the U.S., where the large budget shortfalls are a response to private-sector weakness that has depleted tax revenue.
Indeed, even with persistent trillion-dollar deficits and huge monetary-easing programs, the slack we see in the economy reflects the huge size and scope of the offsetting deleveraging in the private sector that I noted in yesterday’s column.
Monetary Stimulus: The Federal Reserve and other central banks have been extremely aggressive. First, the Fed pushed the short-term rates they control to almost zero -- with little effect. Then it turned to quantitative easing, the enormous purchases of government bonds and other securities that have been tried by the Bank of Japan for years without notable success. The Fed, with its dual mandate to promote full employment as well as price stability, is using a very blunt instrument to try to create jobs.
The central bank can raise or lower short-term interest rates, and buy or sell securities. Those actions have little to do with creating more jobs. In contrast, fiscal policy can be surgically precise, aiding the jobless by extending and expanding unemployment benefits.
The Fed is now buying residential mortgage-related securities as a way to push down mortgage rates and spur housing. But the effect of these measures has been largely neutralized by a number of negative forces, including tight lending standards, low credit scores, “underwater” mortgages, uncertain job security or unemployment and the awareness of consumers that for the first time since the 1930s on a nationwide basis, house prices have dropped substantially and could do so again.
Nevertheless, the Fed is relying on five interlocking steps to increase job creation: First, the central bank buys Treasuries or mortgage-related securities. Second, the sellers reinvest the proceeds in assets such as stocks, commodities and real estate, pushing up prices. Third, higher asset prices have a real wealth effect by making investors feel richer. This, in turn, leads people to spend on consumer goods and services, as well as capital equipment. And last, that spending spurs production and demand for labor.
So far, it hasn’t worked as planned. Despite recent improvements, the U.S. unemployment rate, at 7.7 percent, remains very high by historical standards, particularly more than 3 1/2 years after the trough of a recession. And cautious employers have turned to temporary workers who generally are paid less and are easier to dismiss than full-time ones.
Temporary, Limited Effects: Every round of easing by the Fed has been accompanied by a jump in stocks that lasted only until the next crisis in Europe or the U.S. In addition, the gross-domestic-product bang per buck of new debt isn’t what it used to be. From 1947 to 1952, each dollar in additional debt was associated with $4.61 in additional real gross national product. From 2001 through the second quarter of 2012, it was a mere $0.08.
Furthermore, the Fed’s expansion of member bank reserves through QE has had virtually no effect. When the Fed buys securities, the proceeds clear the seller’s bank and end up as additions to that bank’s reserves at the Fed.
In normal times, those reserves are lent out by the bank with successive relending in the fractional reserve system. That meant each dollar in reserves turned into $70 of M2 money. But since August 2008, when the crisis started, the multiplier has only been 1.8. As a result, the unused reserves are piling up in the Fed’s member bank accounts, and the excess reserves, the difference between total and required reserves, are now more than $1.5 trillion.
Note that the Bank of Japan, which pioneered QE years ago, hasn’t had outstanding success, either. Japanese M2 money supply has been growing at about a 3 percent annual rate for the last two decades. Nonetheless, that economy has been subject to deflation more times than not in those years. Yet the Bank of Japan increased its purchases of government and corporate bonds as well as equities to $1.2 trillion by December last year from $168 billion at the start of 2012.
Perhaps out of desperation, central banks’ QE programs are now open-ended, for the first time. The European Central Bank program to buy one- to three-year sovereign debt is unlimited once countries, such as Spain, apply to participate and accept the related austerity conditions. The Bank of Japan plans to start its unlimited-lending program to banks in June 2013. It expects to disburse more than $175 billion in 15 months and is under extreme pressure from the newly installed government of Prime Minister Shinzo Abe to do even more.
The Fed’s latest programs are open-ended, too. Operation Twist involved buying $45 billion per month in long-term Treasuries while selling $45 billion in short-term obligations. The short-term selling has ended and the $45 billion purchases add to the Fed’s $40 billion per month buying of mortgage-backed securities, the second round of easing. This means QE2 creates $85 billion per month in additional reserves for the Fed’s member banks.
In addition, the Fed says it will keep the short-term interest rate it controls close to zero until the unemployment rate drops to 6.5 percent, and long-run inflation remains close to 2 percent. The central bank doesn’t expect these conditions to be met until 2015.
This is transparency at its extreme. Where’s the mystery left in monetary policy, the uncertainty over Fed actions that keeps markets honest and participants on their best behavior? Of course, the Fed can always redefine or wriggle away from its targets, but wouldn’t doing so impair its credibility?
The experimental, almost desperate, reaction by major central banks to the 2008-2009 global financial crisis, subsequent recession and continuing weak recovery resembles the fiscal responses to the Great Depression in the 1930s. In that era, policy makers realized that the collapse in demand relative to supply had spawned major deflation, but they initially tried to close the gap by reducing production.
Nevertheless, supply-reducing efforts, such as the mandated killing of pigs and other livestock, led to negative press attention. So the New Dealers switched to demand-enhancement efforts such government spending on public works and job creation.
Some researchers say, however, that the benefit of those actions was offset by the uncertainty among businesspeople that was created by these novel approaches, along with a lack of clear plans and regulation. For many, the New Deal didn’t end the Great Depression -- rearmament and the high government outlays to fight World War II did.
(A. Gary Shilling is president of A. Gary Shilling & Co. and the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the second in a five-part series. Read Part 1 and Part 3.)
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