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Bank lending continues to accelerate


Bank lending to small and medium-sized business has been increasing at double-digit rates for the past year, as shown in this chart of Commercial & Industrial Loans. The net increase in lending since late 2010 now amounts to an impressive $237 billion. C&I Loans are up at a 16% annualized pace over the past six months, and up 13.8% relative to a year ago.

This series continues to be a sign of improving economic and financial fundamentals. On the margin, banks are increasingly willing to lend and businesses are increasingly willing to borrow. With $1.49 trillion of bank reserves still sitting idle as "Excess Reserves" on deposit at the Fed, banks have no constraint on new lending other than their own prudence.  Businesses may still feel like lending is constrained, but on the margin things are definitely getting better, and this reflects increased confidence on the part of both banks and businesses. And increased confidence, in turn, is an important ingredient for new investment and eventually new hiring and more economic growth.


Increased bank lending has also been a source of the ongoing expansion of the broad money supply. M2 is up about $1 trillion since C&I Loan growth started growing in late 2011, with almost all of that increase coming in the form of new savings deposits, whose growth still shows no signs of abating. 


It's tough to find any sign here that money is in short supply or that the Fed needs to do more to promote the expansion of the money supply. The reason there is not more money circulating in the economy is that people still just want hold an awful lot of it in the form of savings deposits, even when those deposits pay almost no interest. The economy is still dominated by risk aversion, in other words, but on the margin things are getting slowly better.

Tax thought of the day

I take it that it is best for all to leave each man free to acquire property as fast as he can. Some will get wealthy. I don't believe in a law to prevent a man from getting rich; it would do more harm than good. So while we do not propose any war upon capital, we do wish to allow the humblest man an equal chance to get rich with everybody else. [Applause.] When one starts poor, as most do in the race of life, free society is such that he knows he can better his condition; he knows that there is no fixed condition of labor, for his whole life. I am not ashamed to confess that twenty five years ago I was a hired laborer, mauling rails, at work on a flat-boat---just what might happen to any poor man's son! I want every man to have the chance---...---in which he can better his condition ---when he may look forward and hope to be a hired laborer this year and the next, work for himself afterward, and finally to hire men to work for him! That is the true system.

Portion of a speech by Abe Lincoln, New Haven CT, March 6, 1860 (HT: Russell Redenbaugh)

I doubt that many politicians, right or left, would disagree with Lincoln (however, I have my doubts about Obama, since he is an unabashed advocate of income redistribution). Nevertheless, as is the case with monetary policy that seeks to control exchange rates—wherein the more effort expended to keep a currency from falling, the greater the likelihood that it will fall—so it is with incomes policies. The more effort expended to equalize incomes through the use, for example, of standard deductions, earned income tax credits, and progressive taxation rates, the more difficult it becomes for the poor to climb the ladder of success. Most people are in favor of helping the poor become rich, but too often the best of intentions produce unwanted results.

Under highly progressive tax regimes, the marginal tax rate faced by the poorest becomes extremely high as their income increases, thus discouraging greater work effort. At very low levels of income, deductions and tax credits can make effective tax rates negative, but at higher levels of income, those deductions and tax credits disappear, making effective marginal rates much higher than statutory rates. Thus, some of the very poorest can make more money by not working, or by working very little, than by working a lot harder. The moderately poor can see almost all of their increased work effort gobbled up by the tax system. This is the unintended consequence of a progressive tax rate structure: that it makes climbing the wealth ladder extremely difficult, thus locking in poverty those it would seek to help—and in the process, making them more and more dependent on government largess. See an excellent of this here, as it applies to subsidies for healthcare costs under Obamacare.

Industrial production still looks healthy

U.S. May industrial production was a bit weaker than expected, but the improving trend is likely still intact: production is up at an annualized 4.6% pace over the past six months, and up 4.7% in the past year. German industrial production through April shows clear signs of weakness, but note in the first chart below how much stronger Germany's recovery to date has been relative to the U.S. Germany is suffering from the PIIGS crisis in recent months, to be sure, but the Germans have still managed to stage a very impressive recovery in recent years.



U.S. manufacturing production (which strips out the contribution of utilities) was also a bit on the weak side in May, but it nevertheless has risen at an impressive 6.2% pace over the past six months. I doubt the recent weakness is evidence of a new downturn; it is more likely a sign that the manufacturing sector is simply taking a breather. Everyone has turned more cautious in recent months, but that is not necessarily a reason to think that the economy is entering a new downturn. 

Over the years, I've learned that there is wisdom and logic behind the argument that if a business fails to grow, then it will eventually die; but the same is not true for economies. Just because the U.S. economy is suffering from a huge output gap and real growth is below its long-term 3% trend, is not a reason to fear another recession. I prefer the glass-is-half-full approach: despite all the headwinds it faces (e.g., the Eurozone crisis, the approaching "fiscal cliff," the unprecedented collapse of the housing market, the surge in the size and burden of federal government, the potential inflation risk posed by the Fed's unprecedented expansion of its balance sheet), the U.S. economy is still managing to grow, and that is a testament to its inherent dynamism and the hard-working culture that still reigns in most sectors of the economy. 


Despite an increased risk of more defaults, there is light at the end of the Eurozone tunnel

Rising yields on Spanish and Italian bonds point to an increased likelihood of painful defaults, but declining swap spreads point to an eventual Eurozone recovery. Central banks are not stimulating, they are reacting, as they should, to intense demand for liquidity; that allows financial markets to continue functioning, and that in turn is a necessary condition for an eventual economic recovery.




These charts confirm the headlines: the Eurozone is still plagued with serious problems. 2-yr sovereign yields, a good barometer of near-term default risk, are quite elevated for the weaker PIIGS (Portugal, Ireland, Spain, and Italy). Ireland and Portugal have gone to the back burner since late last year, while Spain and Italy are now front and center; they are the biggest PIIGS debtors, with $3 trillion between the two of them.

Greece is a basket case, having already defaulted; the only question there is whether the Greeks this weekend will vote to leave the European Union and the Euro or not. Greece's decision by itself won't matter much to the world economy or to the financial markets, but if Greece decides to exit the euro—a decision that sounds easy on the surface, but spells great pain and suffering for most of the Greek population—then markets will worry that that will be the beginning of the end for the euro. I think a Greek exit from the euro, should it happen, might prove to be a wake-up call for the rest of Europe, since the consequences are impoverishment of the private sector via a wealth transfer to the public sector. The only one who stands to gain from a devaluation is the public sector. Everyone else will see their net worth decline significantly, their living standards eroded, and the return of inflation.



With a Greek vote—and its potentially dire consequences—imminent, with markets fearful that Eurozone defaults may reach many hundreds of billions of euros, with bank runs making headlines, and with recessions afflicting most of the PIIGS economies, it is very surprising—and encouraging—to see that Eurozone 2-yr swap spreads have fallen to their lowest level since last August. At 27 bps, U.S. 2-yr swap spreads are about as close to "normal" as one could hope. This can only be evidence that central banks are fulfilling their "lender of last resort" function. Europeans are desperately seeking safe havens (e.g., 2-yr Treasury yields of 0.3%, 10-yr Treasury yields of 1.6%, gold at $1625/oz., 5-yr TIPS real yields of -1.2%), and European bank stocks have lost fully 83% of their market cap since 2007, thanks to their huge exposure to PIIGS debt. If the ECB and the Fed weren't willing to inject massive amounts of liquidity to compensate for the almost insatiable demand for liquidity, the Eurozone by now would have been in the throes of a depression and deflation and most banks would have been wiped out.

So when I see the Bloomberg headline "Stocks Rise on Central Bank Stimulus Bets," I think the spin is completely wrong. By injecting liquidity through quantitative easing and near-zero short-term interest rates, central banks are not stimulating anything, they are reacting—as they should—to extreme levels of fear that threaten to drain liquidity and freeze financial markets. To the extent that equity prices are rising even as Eurozone conditions are dire and the U.S. economy is growing at a measly 2% rate, it is not because central banks are going to fix everything by dumping more money into the system, it is because central bank actions are preventing what could otherwise be a financial crisis from becoming an economic crisis. In other words, the S&P 500 is up because the U.S. economy is not collapsing, not because the economy is getting ready to take off. As I've argued for a very long time, markets have been priced to extremely pessimistic assumptions, which means that as long as we avoid a catastrophe, then prices have room to rise.

The decline in Eurozone swap spreads this year is thus a down payment on the eventual end of the Eurozone crisis, just as the decline in U.S. swap spreads in late 2008/early 2009 preceded the end of the U.S. recession by some 6 months.

By forestalling a liquidity shortage and financial market meltdown, central banks are establishing the necessary conditions for an eventual recovery. You can't have a recovery if financial markets collapse, but functioning financial markets can go a long way to helping an economy recover.

It's worth repeating what I said almost a year ago: the losses that result from PIIGS debt defaults have already occurred in an economic sense. Money was essentially flushed down the toilet the moment that Greece borrowed money to support the lifestyle of a bloated and unproductive public sector. Greece never used the money it borrowed for any productive purpose, and so it was eventually unable to repay its debt. It's as simple as that. Spain seems likely to default as well, but that's not as important as the fact that the losses from an eventual default occurred long ago when the money was first borrowed and then wasted on unproductive activities. What we are seeing now is the battle over who is going to have to take responsibility for these losses. The losses have already occurred; the other shoe that is yet to drop is whose balance sheet is going to have to take the hit. More PIIGS defaults are not going to create new economic weakness in the Eurozone, they are simply going to result in a transfer of wealth from those bearing the burden of the loss to the sovereigns being relieved of some or all of their debt burden.

The shareholders of Eurozone banks have already taken an enormous hit, probably absorbing the lion's share of the eventual losses. All Europeans are likely to share in the losses as well, to the extent that central bank liquidity injections result in a weaker Euro and higher inflation in the years to come. The Germans may get pressured to absorb some additional losses if keeping the euro and the Eurozone intact are important to them. Whatever the case, the losses are real and they are water under the bridge. By supplying enough liquidity to keep financial markets liquid, central banks are laying the groundwork for a resolution to the Eurozone crisis and forestalling what would otherwise be a depression/deflation of terrible proportions.

Federal budget update

Federal spending and revenues continue to follow a semi-virtuous path: revenues are inching higher, thanks to a modestly-growing economy, more people working, and slightly higher incomes; and spending growth remains very low, thanks to fewer people receiving unemployment benefits, and a Congress that has been gridlocked for most of the past three years.


As the chart above shows, revenues have risen from $2 trillion in 2009 to $2.4 trillion over the past 12 months, while spending has increased by only $0.1 trillion from 2009 to the past 12 months. As my good friends Art Laffer and Steve Moore note in their op-ed in today's WSJ, this supports Obama's claim to have overseen an extended period of very slow growth in federal spending. But it is ironic that Obama should take pride in the slow growth of spending under his administration when he continues to be among the most vociferous proponents of increasing government spending. They argue, and I would agree, that if Obama were to pursue policies that reduce spending further, without raising taxes, the economy would be much stronger going forward.




The first of the above three charts shows spending as a percent of GDP. One of the best things to happen as a result of relatively flat spending over the past few years is that the size of government has shrunk by two percentage points of GDP. This is a step in the right direction, since as Moore and Laffer remind us, and as Milton Friedman argued long ago, "government spending is taxation ... government can't tax an economy into prosperity. Friedman made it clear time and again that restraining government spending stimulates the economy by liberating private resources." Excessive spending can be financed by selling debt, but ultimately it must be paid for by higher taxes. So it's not so much the size of the deficit that is important, but the magnitude of spending, especially as a percent of GDP. The good news is that we have been moving in the right direction in recent years, and as a result, the deficit has receded from a scary 10.4% of GDP to 7.7% currently (by my estimate). Spending is still very high relative to GDP, however, higher than at any time since WW II, and that continues to be a burden that is slowing economic growth. 

Blogging has been light

... since our trip to The Hamptons and now New York City kept me tied up much more than I expected. 

Until I can find some time to do something substantial, I recommend an excellent and thoroughly provocative essay by Victor Davis Hanson, "The Liberal Super Nova." Liberals likely will be offended, but at the very least I would argue that he has shed light on a very important shift in the political winds in this country. 

From Greece to Italy to California to Wisconsin to Obama’s Washington, the verdict is in: the democratic statist model of trying to provide cradle-to-grave benefits, administered by an elite technocratic class, using demonization to bully the opposition and redistribute income, not only does not work, but cannot ever work.