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Economic fundamentals from a monetarist perspective

This charts shows the quarterly annualized growth rates for real and nominal U.S. economic growth. Market monetarists, championed by Scott Sumner, have been arguing for some time that one of the main reasons that economic growth has been so sluggish in recent years is that the Fed has failed to deliver 5% nominal growth. When nominal growth slips below 5%, they argue, creditors can't generate the cash flow they had expected, and so defaults rise and this further disrupts economic growth. Unexpectedly slow nominal economic growth (NGDP) is disruptive for nearly everyone because income don't rise as expected. And it makes sense to think that the economy can be disrupted when key variables (e.g., cash flows, incomes, default rates) fall short of expectations.

I think he has a valid point when it comes to what happened in 2008. The worst thing that happened back then was that the financial crisis sparked by the collapse of the sub-prime mortgage market, and the housing market in general, threatened to produce a collapse of the global finance system, as loan defaults surged. The Fed was largely to blame for the intensity of this crisis—which also saw gold and commodity prices plunge—because they were very slow in responding to an overwhelming increase in the demand or dollar liquidity that occurred as the crisis unfolded. When liquidity falls short of the demand for liquidity, you have a liquidity squeeze which is effective a shortage of money. With money in short supply, deflation pressures naturally arose, as reflected in the plunge in 10-yr TIPS break-even inflation expectation to almost zero near the end of 2008, and default rates surged.

But the Fed finally did react, with two rounds of quantitative easing that left the world agape with its boldness and unprecedented size. Dumping tons of bank reserves into the financial markets was the first major step towards ending the Great Recession. Nominal GDP rose sharply from -8.4% in Q4/08 to 4.9% in in Q4/09. Since then, NGDP has grown at a 4.3 annualized rate. That's a little shy of Sumner's preferred 5%, but not by much. So I would submit that although the Fed erred by reacting slowly to the crisis in late 2008, they haven't done such a bad job since, and thus there is little reason to fear that the economy is starved for liquidity today and otherwise vulnerable to another financial collapse or recession.

QE 2 ended in mid-2011, and Operation Twist—an attempt flatten the yield curve by purchasing longer-term Treasuries while simultaneously selling shorter matures, was announced at the end of Q3/11. In the charts above I don't see that the slope of the Treasury curve has experienced any unusual flattening, given the stage of the business cycle we are in. The curve is still quite steep, and that's to be expected since the Fed is still ultra-accommodative and the economy continues to grow. Furthermore, I don't detect any significant weakening of NGDP since the Fed stopped expanding bank reserves about a year ago.

If the lack of more Fed easing or twisting is hurting the economy, I fail to see much evidence that this is the case. The dollar is very near its all-time lows—a fact suggesting that dollars are in relatively abundant supply. That is confirmed by sensitive market-based prices: gold is still 535% above its low of 13 years ago; and commodities are still 130% above their lows of late 2001. Credit spreads are still somewhat high, but I think that is a function of general fears which are keeping PE ratios low (at a time of near-record-high corporate profits. Swap spreads, on the other hand, are firmly in "normal" territory, which suggests that liquidity is abundant and systemic risk is quite low.

Finally, as this chart shows, if Operation Twist, if it has had any impact on the slope of the yield curve from 10 to 30 years, it's not been significant. Indeed, since the end of last September the long end of the yield curve has steepened, which inflation expectations have increase, which in turn suggests just the opposite of the Fed's intended effect.

The main things holding back growth are 1) widespread risk aversion on the part of investors, as evidence in a massive accumulation of banks savings deposits, and 2) the market's very dismal expectations for economic growth, which are reflected in historically low Treasury yields. I don't see how these conditions can be altered significantly through the injection of more reserves or a further extension of very low short-term interest rates. I think it's now up to fiscal policy to make the difference: we need to bolster investor confidence by increasing the after-tax rewards to work and risk-taking (by lowering and flattening tax rates and eliminating loopholes and tax credits for favored industries, and reducing the size and scope of government so that the resources can be freed up for the private sector to work it's productivity enhancing magic.

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