Wednesday, April 17, 2013

"America Has Faced the Unknown Since 1776," so says Warren Buffett

April 17, 2013

“America Has Faced the Unknown Since 1776”

So wrote Warren Buffett in his March 1, 2013 letter to Berkshire Hathaway Inc. stockholders. In the phrase before this quote, Mr. Buffett wrote: “Of course, the immediate future is uncertain …” And after this quote, he wrote: “It’s just that sometimes people focus on the myriad of uncertainties that always exist while at other times they ignore them (usually because the recent past has been uneventful).” I bring this up because ever since early-fall 2012, there has been a Greek chorus of economists appearing in the mainstream media warning us about various uncertainties from the fiscal cliffs of Washington D.C. to the banking whirlpools of Cyprus. These uncertainties were supposed to freeze the purchasing decisions of businesses and households alike, threatening to plunge the U.S. economy back into recession.
Presumably because of this uncertainty, economists were relatively pessimistic about the U.S. economy’s growth prospects for the first quarter of 2013. Back in October 2012, the consensus forecast for real GDP growth in Q1:2013 was 1.7%. Now, it is 2.9% -- not spectacular but a lot better than the previous quarter’s growth of 0.4%. The U.S. data that have been released for Q1:2013 so far suggest that the only sector whose purchasing decisions have been “frozen” is that of the government. Growth in consumer spending appears to have accelerated and the strong growth in business capital spending that occurred at the end of 2012 appears to have continued in the first quarter of 2013.
Like the poor, uncertainty will always be with us. Something else that is now with us, but won’t always be, is the rapid expansion in the Federal Reserve’s balance sheet. Back in the fall of 2012, the Fed announced that it intended to expand its balance sheet by approximately $85 billion per month, which works out to $1.2 trillion per year. What is different about this round of Fed credit creation is that, in contrast to previous rounds, the private banking system also is creating credit. Historically, an acceleration in the sum of Fed and bank credit has been associated with an acceleration in domestic spending. So, the uncertainty investors should be most concerned about is how the Fed manages its balance sheet going forward. Will the Fed terminate the expansion of its balance sheet too early or too late? Right now, it appears to be managing its balance sheet “just right” for investors in risk assets and for economic growth, which is trumping all the other uncertainties, real or imagined, that the talking heads keep warning you about in the mainstream media. I don’t know about you, but I think uncertainty is the last refuge of economist scoundrels who don’t have a clue about what drives the cyclical behavior of the economy and asset markets.
Paul L. Kasriel
Econtrarian, LLC

Wednesday, April 3, 2013

Ben Bernanke, the Rodney Dangerfield of Fed Chairmen

April 3, 2013

Ben Bernanke, the Rodney Dangerfield of Fed Chairmen

First it was 2012 presidential candidate Rick Perry, who wanted to deal with Ben Bernanke’s money-printing “Texas style”. Then 2012 presidential candidate Mitt Romney indicated that Ben Bernanke had better have his personal effects packed up and ready to move out of his Fed office by January 21, 2013. And now it is David Stockman, who is mad as Hell and won’t take it anymore (see Mr. Stockman’s rant in the March 31, 2013 op-ed section of the New York Times, “Sundown in America”), the money printing of the Federal Reserve under the chairmanship of Ben Bernanke being included in “it”. Similar to the late Rodney Dangerfield, Ben Bernanke just can’t get no respect.

I actually agree with much of the political-economic criticism vented by Mr. Stockman in his Times
op-ed.  Yes, government spending has expanded too much in the past four decades. And, to the point of my rant here, the Fed’s printing press was running too fast during most of the past four decades. When Fed Chairman Greenspan was being described as a monetary-policy maestro by Bob Woodward, yours truly was describing him more like the pied piper of Hamelin. And yes, when Ben Bernanke was a mere governor of the Federal Reserve Board under Greenspan’s chairmanship, he never once publicly dissented from Greenspan’s bubblicious policies. But let he who is without sin cast the first stone, Mr. “Supply-Side” Stockman. I believe in redemption. And I believe that the money-printing that Ben Bernanke oversaw after the failure of Lehman Brothers was and continues to be entirely appropriate unless a recession on the order of magnitude of that of 1929-1933 would have been viewed as desirable.

Let me begin my defense of Ben Bernanke’s Fed chairmanship post Lehman. Chart 1 shows the year-over-year percent changes in quarterly observations of the loans, leases and securities on the books of depository institutions – commercial banks, savings institutions and credit unions – from Q1:1960 through Q4:2012. The median year-over-year percent change in depository institution credit from 1960 through 2007, the year before Lehman failed, was 8.4%, as represented by the height of the horizontal red line in Chart 1. (As an aside, Mr. Stockman might want to take into consideration that the Reagan supply-side miracle might not have been so miraculous had it not been for the surge depository institution credit that coincided with it. Was it marginal tax-rate cuts or rapid growth in depository institution credit that worked economic miracles?)

But I digress. Notice that from 1960 through 2012, there have been only two occasions in which the change in depository institution credit was negative. The first occasion was in the early 1990s, at the time of the S&L crisis. You may recall that the economic recovery that started in the spring of 1991 was the first “jobless” recovery in the post-WWII era for the U.S. The second occasion in which depository institution credit contracted commenced in 2009, soon after the Lehman failure. The contraction in depository institution credit was more severe in the second occasion than the first.  As I have discussed in previous commentaries, reasonable people can disagree as to what the optimum rate of growth in depository institution should be and the 1960 – 2007 median growth of 8.4% might not be the optimum, but I would argue that a contraction in depository institution credit is sub-optimum. And that is what we were experiencing for the most of 2009, 2010 and 2011. At 3.4% year-over-year growth in Q4:2012, this remains a tepid increase in depository credit in the context of the past 50-plus years.

Chart 1

Enter the quantitative policies of Fed Chairman Ben Bernanke. Chart 2 shows the year-over-year percent changes of quarterly observations in Federal Reserve credit, here measured by the monetary base. The monetary base represents the cash reserves held by depository institutions and the currency held by the public, both of which are created by the Fed figuratively out of thin air. (This measure of the monetary base does not include the loans advanced to AIG following the collapse of Lehman Brothers.) When Mr. Stockman and others refer to the Federal Reserve’s money-printing operations, they are referring to the behavior of the monetary base. From 1960 through 2007, the median year-over-year change in the monetary base was 6.1%. From 1960 through 2008, the largest year-over-year change in the monetary base was 12.6% in Q4:1999, as the Fed greatly enlarged the amount of currency available to the public and depository institutions to accommodate the increased precautionary demand for such in anticipation of problems that might arise in connection with Y2K. (I still have tins of kippers that, to the amusement of my family, I stockpiled in December 2009.) But that 12.6% year-over-year increase in the monetary base pales in comparison with the 107.9% increase in Q2:2009. From the end of 2008 through the beginning of 2012, the monetary base has, with one quarterly exception, grown far above its 1960-2007 median rate of 6.1%.

Chart 2

Horrors? Perhaps not. Credit evaluation and political issues aside, there is no macroeconomic difference between the Fed providing credit and the depository institution system providing credit. Both create the credit they extend figuratively out of thin air. Thus, when either extends new credit, the recipient of that credit can increase its current spending and no other entity need decrease its current spending. When the Fed purchases Treasury securities in the open market, the cry goes up in some circles that the Fed is monetizing the public debt. Yet, if the depository institution system purchases Treasury securities, monetization alarm bells do not go off even though the macroeconomic impact is the same. When the depository institution system increases its net credit extension by granting more home mortgages, why don’t we hear that private debt is being monetized? In a sense, the depository institution system is an intermediary between the Federal Reserve and ultimate borrowers in the economy. Again, credit evaluation and political issues aside, in theory, the Fed could cut out the middleman, the depository institution system, and directly grant home mortgages, car loans and business loans to the private sector along with creating credit for government entities. What I am getting at here is that the sum of Fed and depository institution credit is what Mr. Stockman should be concerned with, not Fed credit in isolation.

Chart 3 shows the year-over-year percent changes in depository institution credit and the sum of depository institution credit and Federal Reserve credit (the monetary base) from Q1:1960 through Q4:2012. From 1960 through 2008, percent changes in the sum of Fed and depository institution credit and depository institution credit by itself does not differ much. It is starting in 2009 when the divergence in growth rates is magnified. For example, in Q2:2009, depository institution credit contracted by 0.5%, whilst the sum of depository institution credit and Fed credit grew by 7.0%. Recall, it was in Q2:2009 that Fed credit by itself grew year-over-year by 107.9%. Scary in isolation; not so scary when looked at in combination with depository institution credit. Fed credit began to explode in Q4:2008 after Lehman imploded. Yet, from Q4:2008 through Q4:2012, the latest complete data, there has not been one quarter in which year-over-year growth in the sum of Fed and depository institution credit has reached or exceeded the 1960-2007 median growth rate of 8.4% for depository institution credit by itself. In fact, from Q3:2008 through Q4:2012, the compound annual rate of growth in the sum of Fed and depository institution credit has been a mere 3.6%. During this same 17-quarter period, the compound annual rate of growth in depository institution credit by itself was 0.4%. Can you imagine how weak the pace in economic activity would have been post-Lehman had the Fed not sped up its “printing press”?

Chart 3

I suppose Mr. Stockman would have preferred the Fed’s policy in the early 1930s to Ben Bernanke’s. The Fed did speed up its “printing press” after the stock market crash of October 1929, but not nearly enough to offset the contraction in depository institution credit that took place. Chart 4 shows the year-over-year percent change in depository institution credit, Fed credit and the sum of depository institution credit and Fed credit for the semi-annual periods from 1929 through 1941. The shaded areas indicate periods of recession. Notice that during the 1929 – 1933 recession, there was an acceleration in the growth of Federal Reserve credit, but not enough to prevent the sum of Fed and depository institution credit from contracting. In the four years ended the first half of 1933, the sum of Fed and depository institution credit contracted at a compound annual rate of 7.5%. In that same time period, depository institution credit by itself contracted at a compound annual rate of 9.0%. The rebound in depository institution credit starting in the first half of 1934, which corresponded to a vigorous economic recovery, was due to several factors. The Banking Act of 1933 established the Federal Deposit Insurance Corporation. This greatly reduced the threat of runs on banks by depositors, which, in turn, reduced banks’ liquidity demand, enabling them to increase their lending. The Reconstruction Finance Corporation, established in early 1932, helped recapitalize the banking system, again enabling banks to increase their lending. And the Fed increased bank reserves, the “seed money” that the banking system could multiply into a greater amount of bank lending. The sharp spike in the growth of Fed credit/bank reserves that started in the first half of 1934 was related to President Roosevelt’s decision to raise the dollar price of gold – something that Mr. Stockman still is angry about. In 1936, the Fed began its exit strategy from its accommodative policy. From the middle of 1936 to the middle of 1937, the Federal Reserve began to “sterilize” some of the reserves that it had created earlier by doubling the percentage of cash reserves banks were required to hold against their deposits. This caused banks to contract their credit outstanding and the Fed did not offset this bank credit contraction with Fed credit expansion. This helped bring on the 1937 – 1938 recession.

Chart 4

In sum, I would argue that the “money printing” that Fed Chairman Bernanke engaged in after the failure of Lehman Brothers was entirely appropriate if the U.S. were to avoid a recession of the magnitude of that of 1929 – 1933. The Fed was merely creating some credit that only partially offset the contraction in depository institution credit. Despite the rapid growth in the Fed’s balance sheet starting in late 2008, combined Fed and depository institution credit has been growing at a subdued pace when compared with its behavior in the past 50 years. So, for now, let’s show Ben Bernanke some respect for how he has managed monetary policy after the Lehman failure. I have a hunch that there might be legitimate grounds to criticize the Fed chairman, whomever that might be, in the next few years as he or she executes the so-called exit strategy for monetary policy. If the exit strategy is not guided by the growth in the sum of depository institution and Fed credit, which by all indications it will not be, then policy mistakes will be made and Mr. Stockman can write another op-ed for the Times.

Paul L. Kasriel
Senior Economic and Investment Advisor
Legacy Private Trust Company of Neenah, Wisconsin
Econtrarian, LLC