October 18, 2014
A Tale of Two Economies – It Was the Better of Times, It Was the Worst of Times
As quantitative easing comes to an end (apparently) by the Fed and is taken up by the European Central Bank (ECB), let’s compare the behavior of nominal domestic demand in each central bank’s economy and venture a reason for any differences.
Plotted in Chart 1 are index values of the nominal Gross Domestic Purchases in the U.S. and the eurozone, respectively. Each index is set at a value of 100 for Q4:2008. Since Q4:2008, Gross Domestic Purchases in the U.S. increased a net 18% through Q2:2014 (that is what the index value of 118 indicates). For the eurozone, Gross Domestic Purchases increased a net of only 3% in this same time period. In terms of compound annual growth rates over this period, the U.S. experienced growth of 3.0% and the eurozone, just 0.5%.
Now, let’s examine the behavior of credit created by the central banks and depository institutions in each of these economies. This is credit that is created figuratively out of thin air. When central banks purchase securities in the open market, such as they do when they engage in quantitative easing (QE), they create credit out of thin air. When the depository institution system expands its loan and securities portfolios, it creates credit out of thin air. Credit created out of thin air enables the borrower to increase his/her current nominal spending while not requiring any other entity to reduce its current spending. Plotted in Chart 2 are index values of the sum of central bank and depository institution credit outstanding for the U.S. and the eurozone, respectively. Each index is set at a value of 100 for Q4:2008. Since Q4:2008, U.S. thin-air credit increased a net 28% through Q2:2014, which works out to be a 4.6% compound annual rate. In this same period, eurozone thin-air credit has contracted a net 2%, or at a compound annual rate of minus 0.4%.
The Fed has engaged in QE in three separate phases in recent years, the first of which commenced in Q1:2009. From the end of Q4:2008 through the end of Q2:2014, U.S. thin-air credit increased a net $3.692 trillion, 82% of which was contributed by the Fed. During this same time period, the compound annual rate of growth in depository institution thin-air credit was only 1% rounded. Recall, that the sum of Fed and depository institution thin-air credit grew at a compound annual rate of 4.6% during this 22-quarter period vs. a long-run median annual growth rate of 7.4%. During this period, the ECB has refrained from engaging in QE and eurozone thin-air credit has contracted on net. Had the Fed not engaged in QE, U.S. total thin-air credit growth would have been quite weak, similar to what the eurozone has experienced.
A clue as to why depository institution thin-air credit creation has been weak in both the U.S. and the eurozone can be found in former Fed Chairman Bernanke’s recent revelation that he was unable to refinance his home mortgage. The explanation for weak depository institution thin-air credit creation is not so much related to lack of demand for it, but rather depository institutions’ inability to supply demanded credit. Following the bursting of the residential real estate bubbles in the U.S. and the eurozone, depository institutions experienced a severe “evaporation” of capital. Because of capital constraints, depository institutions were not able to expand their holdings of loans and securities. In the U.S., depository institutions relatively quickly began repairing their capital deficiencies. At the same time, however, regulators increased capital requirements and imposed more stringent liquidity and other regulatory requirements on depository institutions. Thus, while someone with a relatively high, but variable income, similar to Ben Bernanke’s current financial situation, would have had no difficulty in qualifying for a mortgage in 2001, he now has greater difficulty.
If Ben Bernanke had looked at some of the Fed survey data when he was Fed chairman, he would not have been surprised that he might have difficulty refinancing his mortgage once he became a “free agent”. Plotted in Chart 3 are the responses to the Fed’s quarterly Senior Loan Officer Survey of bank lending terms related to residential prime mortgage applications. As the housing bubble began deflating in late 2007, the percentage of banks tightening their prime mortgage terms began rising, skyrocketing in 2008. Although the percentage of banks tightening their mortgage lending terms tailed off significantly by 2010, the percentage actually beginning to ease their lending terms has only begun to meaningfully rise in 2014.
The Fed conducts another quarterly survey that relates to banks’ willingness to lend, the Survey of Terms of Business Lending. Plotted in Chart 4 are the survey results showing the average rate charged by banks in the survey on all commercial and industrial (business) loans minus the Fed’s target federal funds rate. From Q3:1986 through Q4:2007, the median loan spread was 1.99 percentage points. The median spread from Q1:2008 through Q3:2014 rose to 3.05 percentage points, with the spread in Q3:2014 being 2.61 percentage points. These higher spreads following the financial crisis indicate banks’ inability to supply demanded credit because of capital constraints and/or increased regulatory scrutiny.
In case you hadn’t noticed, I have been attempting to make the case that the Fed’s engagement in QE and the ECB’s lack of QE account for the difference in the performance of the U.S. economy vs. the eurozone economy since 2008. But for all you Keynesians out there, what about federal fiscal policy, in particular federal spending? Some Keynesians (Krugman?) make the argument that the fiscal austerity in the eurozone is what has held back aggregate eurozone economic activity. Contrary to what some op-ed writers in The Wall Street Journal (Wesbury?) might have you believe, there has been fiscal austerity in the eurozone. In the five years ended 2013, the latest complete data I have, eurozone central government nominal spending grew at a compound annual rate of just 1.5%. And again, despite what some other op-ed writers in The Wall Street Journal (editorial board?) might have you believe, there also has been fiscal austerity in the U.S. To wit, in the six fiscal years ended 2014, total federal government nominal spending grew at a compound annual rate of 2.7% compared to a median annual change of 5.5% from FY 1981 through FY 2008. Total U.S. federal government expenditures in FY 2014 were actually $13.5 billion below those of FY 2009! Admittedly, federal government expenditures did soar in FY 2009 vs. FY 2008 because of TARP, the American Recovery and Reinvestment Act of 2009 (Obama’s fiscal stimulus) and “automatic stabilizers” such as unemployment insurance and food stamps.
The point is that in both the U.S. and the eurozone, there has been fiscal austerity in recent years. Yet, U.S. aggregate domestic demand has been considerably stronger than that of the eurozone. The tale of the two economies is that in one, the U.S., the Fed pursued a QE policy, resulting in the better of times. In the other, the eurozone, the ECB eschewed a QE policy, resulting in the worst of times.
Paul L. Kasriel
Senior Economic and Investment Adviser
Legacy Private Trust Co. of Neenah, Wisconsin