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Bank loans continue to accelerate


Bank lending to small and medium-sized businesses continues to accelerate. C&I Loans outstanding are up at a 15.2% annualized rate in the past 3 months, and have risen 12.3% over the past year. Since the recent low in Oct. '10, C&I Loans have grown by $174 billion, or about $2.5 billion per week on average; in the past 3 months the pace has picked up to $3.7 billion per week on average.


M2 growth has also been robust, fueled in part by increased bank lending. I think it's rather astonishing, actually, to see in this chart that the M2 measure of our money supply has risen by almost $3 trillion in the past 5 years. The increase since early 2007 works out to $10 billion per week on average. Surely there is no shortage of liquidity in this economy. In fact, M2 has grown over 20% more than nominal GDP since the end of 2006. So far, it would appear that the major driver for M2 expansion has been increased money demand: people simply want to have more "cash" on hand because they are worried about the economy. Savings deposits now represent about 63% of M2, and they have contributed the lion's share of M2 growth in recent years.

One of the biggest changes we should expect to see in the economy and the markets over the next year or two will likely come from the unwinding of all this demand for cash. I seriously doubt whether the Fed will be able to soak up all the money that may be unleashed by a public that is no longer willing to hold a mountain of zero-interest-bearing cash, and wishes instead to exchange that cash for all manner of more interesting things. Stepped-up bank lending and a reversal of cash hoarding could unleash a wave of liquidity into the market and the economy, boosting nominal GDP, boosting corporate cash flows, boosting commodity prices, and yes, likely boosting inflation.

Income taxes are now bailing out Social Security

I'll wager that the vast majority of taxpayers are completely unaware (as I was until today) of the fact that the payroll tax cut "stimulus" that was enacted in December '10 and extended through this year was financed by income tax revenues. This represents an ominous milestone in the history of Social Security, since it marks the first time that the program has ceased to be a government-run annuity program and now operates at least partially as a pure income redistribution scheme. Charles Blahous lays out the facts and the implications in an excellent article, The Dark Side of the Payroll Tax Cut, which I have excerpted here:

In December 2010, President Obama and Congress reached an agreement whereby the Social Security payroll tax would be cut by two percentage points in 2011—from 12.4 percent to 10.4 percent—as a temporary stimulus measure. The president later proposed that the cut be extended and expanded in 2012. Before Congress went home at the end of 2011, it passed a 60-day extension of the two-point tax cut. The payroll tax cut has now been further extended to last throughout 2012 at least.
Most public discussion of the payroll tax cut has pertained to its efficacy (or lack thereof) as economic stimulus. Its greater policy significance, however, lies in another provision tucked into the same law. This provision is now transferring more than $215 billion in general tax revenues (e.g., income taxes) into the Social Security Trust Fund to make up for the reduction in payroll tax revenue.
In other words, the payroll tax cut is not really reducing the amount of tax revenues committed to Social Security. All that it actually does is to shift the Social Security financing burden from covered workers to others—most notably, to those Americans who pay income taxes. This is a transformative change to Social Security, reflecting goals for broader income redistribution now ascendant on the left end of the American political spectrum.
The new policy ends the longstanding requirement that Social Security expenditures be limited to the total amount of its tax collections (plus interest). And, by subsidizing payments with income taxes, it ends the idea that the Social Security benefits are fully “earned” by recipients.
The recent shift to income-tax-financing embodied in President Obama’s payroll tax cut policy cannot be said to represent a bipartisan agreement with this new policy view. Instead, the payroll tax cut was first proposed on the basis that it was necessary for economic stimulus, and later extended with the argument that doing otherwise would impose a painful tax increase on working Americans. The fact that the law also contained a provision to begin significant subsidization of Social Security with income taxes only belatedly gained the notice of the press, and not yet of the general public.
A critical milestone has nevertheless been passed. Beginning in December 2010, and continuing through to the present time, the federal government has embraced the policy of committing income taxes to subsidize benefits beyond those that Social Security itself can finance. Unless this policy is rapidly reversed, readers of this article who pay income taxes should brace themselves for the substantial new taxes they will soon be paying to bail out Social Security.

This is a very important article that deserves your attention. It's a "camel's nose under the tent" story of how and why our federal government's primary function these days is to redistribute income—60% of federal spending now consists of transfer payments—and how income redistribution will continue to expand unless it is forcibly rejected by the voters. Taking money from the more productive members of our society and handing it out to the less productive members can only result in the impoverishment of all, since it creates terribly perverse incentives to work less.

HT: Glenn Reynolds, one of America's MVPs.

P.S. Oh, and by the way, the payroll tax cut is one of the worst ways to use the tax code to stimulate the economy, since it does nothing to reward more work and risk-taking. So this whole "stimulus" program has not only harmed the economy, it's been used as a way to sneak greater income redistribution into our already bloated, redistributionist government. 

Update on the bursting of the housing price bubble


I last posted a version of this chart in early January, citing it as evidence that the housing price bubble had definitely burst. With January data now available, here's an update. According to the National Association of Realtors, and adjusted for inflation, real median home prices of existing single-family homes are now back down to where they were in the mid-1970s. That's a monster correction. Prices could go lower—I'm not saying they won't—but I think investors and potential homebuyers should be looking at this as a sign that the next big thing to happen to the housing market is more likely to be significantly higher prices rather than significantly lower prices.

I received several critical comments about my post yesterday (More progress in the housing market) from readers who assert that data from the NAR is not to be trusted. That could well be true, and is probably good advice, but the same goes for just about any data source that is not based on real-time, liquid market prices (e.g., data on jobs, which can be skewed by faulty seasonal adjustment factors, and are based on surveys and estimates, and which are likely to be revised in the future). Regardless, while the NAR may have a bias to make home sales look stronger than they really are, I doubt that they have an interest in making home prices look weaker than they really are.


In any event, this chart of housing affordability (which shows that a family earning the median income has 195% of the income needed to purchase a median-price resale home using conventional financing) does reinforce my larger point, which is that housing likely has never been more affordable for the average family than it is today, thanks to the combination of sharply lower home prices, record-low mortgage rates, and rising real incomes. (The chart above also comes from the NAR, but affordability is so high that it's doubtful they can be completely fudging the numbers.) This is a time to be excited about buying, not fearful.

Still more improvement in the labor market


It should now be quite obvious to all that there has been some significant improvement in the labor market over the past several months, since first-time claims for unemployment have been consistently lower than expectations. At the current rate of improvement, claims could very soon be about as low as we might expect them to get if the economy were healthy (approximately 300K per week). But of course what is still missing from the picture is a significant increase in new hiring. Businesses have done almost all the cost-cutting that they need to, but they have not yet made a serious effort to grow.

The reluctance to expand and hire more aggressively is very likely due to a number of factors commonly cited, such as increased regulatory burdens, increased healthcare costs, and uncertainty about the future level of tax rates. In other words, businesses are reluctant to hire because the cost of labor has increased substantially, and the cost of labor and overall tax burdens might increase even more in the future. This is what happens when government spending ratchets higher, as it has over the past 3-4 years; a higher level of public-sector spending relative to the economy must eventually require a higher level of taxation, and a state-managed healthcare industry must eventually become more expensive and less efficient (government bureaucrats cannot possibly run the healthcare industry better than free markets can). The slow-growth fundamentals which frustrate us all—and which boil down to government crowding out the private sector—are unlikely to change in the near term, but the outlook for spending and taxation could change significantly (for the better, I hope) as the presidential election debate kicks into high gear this summer.


PE ratios are still substantially below average and profits are at record levels, which means the market is priced to a substantial deterioration in the fundamentals and is probably resigned to some increase in future tax burdens. But with the ongoing improvement in the labor market, equity prices have little choice but to drift higher, as the chart above suggests. As I've been suggesting for years now, this market is being driven not by optimism, but by the realization that the economy has not proven to be as bad as was expected. Three years ago the market thought we would still be in a deflationary depression today, but instead we're in a slow-growth expansion, climbing walls of worry.

Japan gets serious about fighting deflation


This chart shows the Japanese Yen/US Dollar exchange rate since the beginning of last year. What stands out this past month is the sharp depreciation of the yen, which has dropped 5.1% against the dollar in the past three weeks. It's the result of the Bank of Japan undertaking serious intervention steps to weaken the yen, which reached an all-time high of 75.8 against the dollar last October.


Typically, forex intervention is not very effective at changing a currency's value, since most intervention is "sterilized" by monetary authorities. For example, one arm of the government sells its currency for dollars in order to weaken it, thus increasing the supply of its currency, but then another arm sells bonds in order to mop up the extra supply of the currency. With no net change in the supply of its currency, the intervention leads to only a temporary change in the currency's underlying supply/demand fundamentals.

But as the chart above shows, this time the Bank of Japan is working hard to make the increase in the supply of yen permanent, by dramatically increasing its bond purchases and paying for them with bank reserves. In the upper right hand corner of the chart you can see where this latest version of quantitative easing has caused bank reserves to jump by 76% in the year ending Jan. '12. Not only is the BoJ intervening to weaken the currency and pumping up the supply of bank reserves to expand the money supply, but the BoJ has also announced a formal inflation target of 1%. They are working hard to stop the yen from appreciating further—since that leads directly to increased deflationary pressures—and they are actively trying to get inflation to rise at least modestly, from the current zero to 1%. These efforts stand a good chance of working, since they have worked in the past.

The above chart also shows how the BoJ pursued its first round of quantitative easing by greatly expanding the supply of bank reserves from mid 2001 to early 2006. During this time the yen averaged 115 against the dollar, which is about 30% weaker than it is today. In addition, inflation rose from a low of -1.6% in early 2002 to a high of 2.3% in 2008 (a lagged response to easy money in prior years). In other words, that round of quantitative easing produced results. But then the BoJ reversed its quantitative easing, slashing bank reserves by 75% over the course of 2006. This tightening set in motion the yen's record-breaking 60% rise against the dollar, from a low of 124 in mid-2007 to an all-time high of 76 in late October '11.

The chart also shows the origin of the deflation that has plagued the Japanese economy for so long. That's in the middle portion of the chart where I've highlighted the fact that the BoJ allowed zero net expansion of bank reserves from 1990 through 2001. With policy so tight, it is no wonder that the yen rose from a low of 160 in 1990 to 110 by the end of 2000—an appreciation of 45%.

Bottom line: Japanese monetary policy has tilted decisively in favor of at least some mild inflation, and decisively against further deflation. This may improve the outlook for the economy—and I note in that regard that the Nikkei 225 index is up 12% in the past month—if only because it will likely result in a pickup in aggregate demand as money velocity rises. The yen is likely to depreciate further against the dollar, thus providing some support to a dollar that has suffered from significant weakness against most currencies in recent years.

More progress in the housing market



January data released today on existing home sales continues to support my contention that the housing sector is in recovery mode. In the top chart we see that misbegotten government efforts to stimulate housing sales (e.g., rebates) only made sales more volatile—pushing sales up in late 2009 only to depress them in 2010—but not any stronger. Over the past year we have seen some genuine improvement, with sales up about 10% from last February. As the second chart shows, with the pickup in sales activity and a modest decline in homes being put up for sale we have seen the months supply of unsold homes drop to a new post-recession low. The situation today looks better even than it did in the mini housing bust of the early 1980s. The housing market is making real progress, even though it is still in bad shape. It's not the level of home sales that counts, it's the change on the margin, and that is positive.

Charting the recovery

I've put together a fairly random selection of charts that I think provide some valuable insight into the nature of the economic and financial market recovery that began about 32 months ago. Two major themes stand out: 1) although the economy is still quite weak, there is noticeable improvement on the margin in a number of key areas, and 2) markets are still priced to very pessimistic assumptions about the future. Although there are many things to worry about (e.g., huge federal budget deficits, excessive monetary accommodation, sovereign debt defaults), the market is fully aware of the problems and only reluctantly accepting the fact that things are improving on the margin. 


The economic recovery has been very modest—quite weak in fact. I estimate the economy is operating about 13% below its potential, which is why there are 6 million fewer jobs today than there were at the peak of the previous business cycle. The economy is still struggling to grow, most likely because the Fed and the Congress have been trying so hard to "stimulate" it. Yet despite the economy's dismal state, there are numerous indicators that show substantial improvement on the margin. Things could be a lot better, to be sure, but things are nevertheless getting better.


Bank lending to small and medium-sized businesses continues to expand, and at an accelerating pace: C&I Loans are up at a 13.4% annualized pace over the past 3 months, and up 12.1% over the past year. This reflects increased confidence on the part of businesses and banks, and is an excellent sign that underlying financial and economic fundamentals are improving.


The ongoing improvement in the stock market tracks the ongoing improvement in the health of the labor market, in the form of declining claims for unemployment. This rally is based on improving fundamentals, not excessive optimism.



Rising equity prices are being driven in large part by declining fear. The Vix index is still somewhat elevated from an historical perspective (12-15 would be considered "normal"). 10-yr Treasury yields are still very low, and the ratio of the two is a good measure of the degree to which panic and pessimistic views of the future are driving market sentiment. Bottom line, the market is still fearful of the risk of Eurozone defaults, central bank accommodation, and very pessimistic regarding the ability of the U.S. economy to grow, because 10-yr yields are still trading a depression-era levels.



The market is still trading at PE ratios that are below the long-term average, yet corporate profits are at all-time highs, both nominally and in terms of GDP. This is a good sign that the market is still priced to pessimistic assumptions (e.g., profits are expected to decline significantly).


The banking industry is still in miserable shape, but technology and even consumer staples have staged impressive recoveries. Technology is leading the way, and that is good because that's a significant source of improved productivity for workers all over the world, and that, in turn, augurs very well for future economic growth.


Swap spreads in the U.S. are back down to levels that reflect little if any unusual systemic risk in the financial system. Eurozone swap spreads are still quite elevated, however, but do show some recent improvement. The Greek "bailout" announced today does little to improve confidence in Greece's ability to service its debt (a default is still highly likely), but the Eurozone financial system has pulled back from the brink of the abyss thanks to the ECB's efforts to expand liquidity, since this has bought time for the market to digest the huge losses that are priced into Greek debt (trading today at 20 cents on the dollar) and for risk-takers to take on more of the risk of future Eurozone defaults. Given time and and liquidity, free markets can solve almost any problem.


Putting Obama's deficits in perspective


I offer this chart in the hope of clarifying the ongoing controversy over how much federal debt was accumulated during past presidencies. Each bar represents the Federal debt burden at the beginning and end of each presidency, and the bars are added together in cumulative fashion. As should be readily apparent, in his first four years of office Obama will have added considerably more to our federal debt burden that any post-war president. (The Federal debt burden reached an all-time high of more than 100% of GDP at the height of WW II, then declined steadily through the early 1970s.)

Lest I be criticized as too partisan, I note that Clinton achieved the largest reduction in our debt burden of any president since the 1950s.

My assumptions: For Federal debt I use the amount of debt held by the public, not total debt (which includes debt the federal government owes to itself, e.g., to social security). I have compared federal debt outstanding to nominal GDP at the end of each calendar quarter immediately following a president's assumption of office: thus, Bush II starts in Mar. '01 and ends in Mar. '09. I do this in order to give a new president a month or two to get his feet on the ground, and to credit outgoing presidents with the policies they set in motion before they left. Also, this allows me to use data which is only available on a quarterly basis. I reject the notion that an incoming president must necessarily shoulder the policy burdens of the outgoing president, and in this regard I note that there have been several sizable reversals in the chart above (e.g., Clinton inherited a rising debt burden but managed to reverse that in significant fashion, while Bush II did just the opposite). Finally, I consider debt outstanding as a % of GDP to be the best measure of our national debt burden, since it adjusts for growth in the economy and inflation.

In order to project the federal debt burden as of Mar. '13, I assume that the federal deficit in the 15 months prior will be an annualized $1.2 trillion, and that nominal GDP will grow by an annualized 5%. I believe these are conservative assumptions for the purpose of this analysis; the OMB is projecting a higher deficit and there are many analysts projecting slower GDP growth. A bigger deficit and slower GDP growth would obviously result in a much larger increase in the debt burden than shown here.

Finally, I note that Obama's contribution to our debt burden during his first term is likely to be about 25.6% of GDP, while the next biggest post-war contribution came during two terms of Bush II (15.3%). If Obama wins a second term and the economy and fiscal policies evolve along the lines currently projected by OMB, Obama could end up adding more to our debt burden that all past presidents combined, and almost as much as was taken on to fight WW II—a highly dubious distinction, needless to say.


The chart above gives some long-term perspective on debt burdens and interest rates. Note how there is no evidence at all that higher debt burdens lead to higher interest rates, or vice versa (if anything, the correlation appears to be negative). The same can be said for Japan, where the government's debt burden is well in excess of 100% of GDP, yet interest rates are even lower than in the U.S.