Annotated Bernanke Speech - The Elusive Economic Recovery
Ben Bernanke recently gave his speech at the Jackson Hole Economic Summit. The contents were not surprising as we did not expect any announcements of QE 3 until the September FOMC meeting. However, in light of the recent evidence of the weakness spreading through the system, it is important for us to review his outlook on the economy. Ben framed this discussion by posing this question, "In particular, the financial crisis and the subsequent slow recovery have caused some to question whether the United States, notwithstanding its long-term record of vigorous economic growth, might not now be facing a prolonged period of stagnation, regardless of its public policy choices. Might not the very slow pace of economic expansion of the past few years, not only in the United States but also in a number of other advanced economies, morph into something far more long-lasting?"
This is the single biggest question driving everyone from Main Street to Wall Street to our elected officials. When will the economy began to actually recover?
Ben states: "Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if--and I stress if--our country takes the necessary steps to secure that outcome."
Fed policy alone can not cure what ails this economy, and Ben's admission clearly realizes that now. The question is, exactly what is the long-run potential growth supposed to be? In my opinion this is the most important question that needs to be answered when you take into account the fact that the economy has been in a slow deterioration on a year-over-year basis since 1980. The rate of decline is even more evident when you look at economic growth on a rolling 5 year basis. The recent financial crisis and recession are not isolated events, that once resolved, will allow the economy to spring back. They are the result of the mistaken fiscal and monetary policies over the last three decades that have plagued the economy. Therefore, the real issue is how we got here in the first place.
Debt Financed Economy
America was once a country built on the solid foundation of the hard work, satisfaction and pride in the building of stuff. We aren't talking about "namby pamby" stuff - we are talking about real stuff. We used to produce everything from automobiles to steel to blue jeans; right here in America. We ran telephone lines, built roadways and bridges, drilled for oil and constructed buildings. It was the sweat of the brow and the strain on the back that built America into its former shining self. A country made up of opportunity and prosperity with a solid moral foundation and a strong military to back it up.
That was then. Beginning in 1980 two things occurred. First, the economy slipped into a back to back recession after interest rates were pushed higher to break an inflationary spike . In order to restart growth Reagan delved into a round of deficit spending. At the time, this was exactly the right medicine to cure a normal recessionary business cycle. Second, the economy began to shift from a manufacturing base to one of services and financial engineering.
While "Reaganomics" sowed the seeds for economic recovery; the economy fell in love with the wealth creation ability through the use of leverage and easy credit, and the financial system was glad to provide it. Until 1977 it took less than $0.50 of debt to finance $1 dollar of GDP. However, as the economy shifted, jobs that had a high multiplier effect on the economy required more debt to finance further economic growth. Today it requires $4 of debt to finance each $1 of economic growth, which is clearly an unsustainable trend.
Of course, no one saw the impact of a credit induced boom that would ultimately deteriorate our economic prosperity, right?
One school of economic theory did. The Austrian business cycle theory views business cycles “as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.”
In other words, the proponents of Austrian economics believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then, in turn, creates an expansion of the supply of money.
Therefore, the credit-sourced boom ultimately becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities and leading to widespread malinvestments. When the exponential credit creation can no longer be sustained, a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear”. This finally causes resources to be reallocated back towards more efficient uses. Unfortunately, this process of clearing lowers economic growth and levels of consumption.
Bernanke's Elusive Economic Recovery
In Ben's speech he addresses what he "thinks" is the problem that faces America today: "Why has the recovery from the crisis been so slow and erratic? Historically, recessions have typically sowed the seeds of their own recoveries as reduced spending on investment, housing, and consumer durables generates pent-up demand. As the business cycle bottoms out and confidence returns, this pent-up demand, often augmented by the effects of stimulative monetary and fiscal policies, is met through increased production and hiring. Increased production in turn boosts business revenues and household incomes and provides further impetus to business and household spending. Improving income prospects and balance sheets also make households and businesses more creditworthy, and financial institutions become more willing to lend. Normally, these developments create a virtuous circle of rising incomes and profits, more supportive financial and credit conditions, and lower uncertainty, allowing the process of recovery to develop momentum."
This is how normal business cycle recessions work. Unfortunately today, after 30 years of excess credit and leverage, America finds itself in the first "balance sheet" recession only seen during the "Great Depression" and in Japan. Balance sheet recessions require credit contraction to clear the system, as stated above, which is unable to happen as long as the Government continues to intervene in order to forestall the "clearing" process with monetary programs.
As an example Ben stated that; "Over the medium term, housing activity will stabilize and begin to grow again, if for no other reason than that ongoing population growth and household formation will ultimately demand it. Good, proactive housing policies could help speed that process. Financial markets and institutions have already made considerable progress toward normalization, and I anticipate that the financial sector will continue to adapt to ongoing reforms while still performing its vital intermediation functions. Households will continue to strengthen their balance sheets, a process that will be sped up considerably if the recovery accelerates but that will move forward in any case. Businesses will continue to invest in new capital, adopt new technologies, and build on the productivity gains of the past several years."
While Ben is correct in that given enough time, and that is the key assumption, housing will begin to grow again with the normal expansion of the population and household formations. What Ben is not taking into account, however, is the long term impact of a real estate bubble of the size and magnitude experienced in the U.S. Japan was the last economy to experience such a bubble and they have yet to recover from it in the last 30 years.
Since the housing bubble, and coincidentally the economy, was driven by excess leverage, mortgage equity withdrawals, and easy credit, the impact of the deleveraging cycle will take much longer to achieve than the current Administration is taking into account.
The problem that I have with Ben are the "proactive policies" he references to speed up the housing recovery. Reforms such as mortgage equity write-downs, debt forgiveness or modifications, not only impact the original lenders but have unintended consequences that could be damaging in the coming years.
Programs designed to bail out irresponsibility are not much different than the irresponsible lending practices that led us to this problem in the first place. The economy was built upon the strength of contract law and affordability measures. There was a time where you had to have not only good credit but a 20% down payment to purchase a home. This simple down payment requirement kept individuals from over leveraging themselves into a home that they could not afford. When a lender enters into a contract to loan money; that contract became a binding and legal agreement with ramifications if the borrower failed to meet his obligations.
When you began nullifying contacts for the sake of bailing out the homeowner it impedes the process of clearing the system. As evidenced by the "Make Home Affordable Programs", mortgage modifications failed because lending practices that required no down payments, no income verification and artificially suppressed interest rates allowed the homeowner a house they could not afford the house to begin with. Furthermore, by allowing banks to keep loans booked at full market value, due to the accounting rule change in 2009, we have further hindered the process of clearing. Banks are incentivized to hold properties on their books rather than marking them down and selling them off in a foreclosure auction. This has kept real estate prices artificially elevated and in turn has further impeded the natural path of a "price reversion" in the housing market.
However, as Ben alluded to, the process of household deleveraging is one that will continue and will take some time to achieve. There is a very high correlation between unemployment and housing. Unfortunately with the employment to population ratio at levels unseen since 1983, a resolution on the housing overhang is likely to come later than the "medium term" as defined by Ben.
This brings us ultimately to the consumer and the economy. The chart clearly shows the problem. Consumption, which makes up roughly 70% of the economy, has been supported primarily by increasing levels of debt to offset the steady decline in wages. This is an almost perfect correlation between year over year changes in personal consumption expenditures, wages and GDP.
Consumers face a massive delimma. With the credit spigot turned off they are now forced into deleveraging debt at the same time wages continue contract and the cost of living rises. As a consequence, consumers are entangled in a downward spiral which inhibits their ability to consume at levels that would stimulate expansion. Businesses are very sensitive to changes in the level of demand by the consumer. As shown in the recent NFIB survey, "Poor Sales" ranks at the top of the list of concerns while being a "good time to expand" remained at the bottom. As the consumer retrenches business become more defensive and opt for cost cutting measures to protect profit margins. This creates a feed back loop between the consumers, who need jobs to produce, and businesses which need final demand from the consumer. This is not a pattern that creates a conducive environment for productive investment.
There is another problem lurking in the wings that most choose to ignore, and that is the 78 million "baby boomers" rapidly moving into retirement. Ben specifically addresses this important issue, which we covered at length in our blog on the demographics in U.S.; "Of course, the United States faces many growth challenges. Our population is aging, like those of many other advanced economies, and our society will have to adapt over time to an older workforce."
We have several major hurdles that will impede economic growth in the future from underfunded, over obligated, welfare and entitlement programs to less individuals actively saving and investing. In response to their own real estate/financial crisis, Japan implemented many of the same economic policies that are implemented in the U.S. currently. The result of those policies, combined with an aging population, has plagued Japan with a slow growth economy and struggling financial markets.
A recent report by the San Francisco Federal Reserve points to the correlation between the financial markets and these demographic shifts. "Since an individual's financial needs and attitudes toward risk change over the life cycle, the aging of the baby boomers and the broader shift of age distribution in the population should have implications for capital markets (Abel 2001, 2003; Brooks 2002). Indeed, some studies attribute the sustained asset market booms in the 1980s and 1990s to the fact that baby boomers were entering their middle ages, the prime period for accumulating financial assets (Bakshi and Chen 1994)."
However, one of the key arguments against the U.S. being like Japan has been the strength of employment. While the U.S. may not have as severe of an aging gap between generations; a quick comparison between employment to population ratios leaves little question.
Since both countries face similar hurdles of overburdened social welfare programs, a weak economy and struggling financial markets; sustained levels of high unemployment drag on economic growth. This in turn reduces assets that would potentially be invested back into the system.
We can look at Japanese stock market set against the S&P 500, advanced 10 years to align time frames, in order to see the impact of demographic trends on stock prices. The long term trend of the Nikkei continues to be negative as Japan has followed its path of long term economic decline which has impacted employment levels relative to their total population.
The impact of these shifts in housing, employment and the economy began almost 30 years ago in the U.S. and are just now started to be realized with the bursting of the financial/credit bubble in 2008. While Ben questions whether the current economic malaise could result in something "more long lasting" the weight of evidence shows that the consumer is entrenched in a "balance sheet" recession. This process of deleveraging an entire economic system is a process that occurs over a decade or more historically and for Japan it has clearly been "more".
Furthermore that process creates a vicious feedback loop as consumers re-task spending to pay down debt. Reduced expenditures puts businesses in a defensive position which respond by reducing hiring and increasing cost cutting (ie. layoffs) measures to maintain profitability. With higher unemployment comes a competitive available labor pool which lowers wages and salaries. Lower wages decreases the ability for consumers to expend discretionary income which creates lower final demand on businesses. This cycle, once entrenched, is extremely difficult to break. This is the reason why the various stimulus programs have failed to create any lasting economic growth.
Ben Admits Defeat
In what appeared to be fourth down and long for the Fed in terms of economic stimulus programs; Ben punted to the White House. This was either because he has finally realized that Quantitative Easing programs have failed to do anything substantive for the economy; or that the Administration is about to announce their new "economic recovery plan. In either case his statement was clear: "Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank."
"To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time. As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage. The increasing fiscal burden that will be associated with the aging of the population and the ongoing rise in the costs of health care make prompt and decisive action in this area all the more critical.
Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery. Fortunately, the two goals of achieving fiscal sustainability--which is the result of responsible policies set in place for the longer term--and avoiding the creation of fiscal headwinds for the current recovery are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the longer term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives.
Fiscal policymakers can also promote stronger economic performance through the design of tax policies and spending programs. To the fullest extent possible, our nation's tax and spending policies should increase incentives to work and to save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure. We cannot expect our economy to grow its way out of our fiscal imbalances, but a more productive economy will ease the trade offs that we face."
Now, the fate of the world rest squarely in the hands of a President who is at odds with his own party and the conservative right. Fiscal conservatives now want to cut spending at the worst possible time for a weak economy that is currently dependent on government spending. The liberal left want to continue spending but want to "tax the rich" to try and fix the problem which, as history clearly shows, weakens the economy. With both parties so clearly unaware of the true illness that plagues the economy we are almost assured that the wrong medicine will be applied sending the patient into full cardiac arrest.
The "end game" is that we will continue with the "balance sheet" recession for some time come on an all too familiar path blazed by Japan some thirty years ago. I certainly have hopes that things will turn out better. However, "hoping" is not a investment strategy I would want to employ in the long term.