Goosing the stockmarket

Regular readers will know that I am confident that QE3 is on the way sometime after markets get their swoon on. There are a number of reasons why I’ve formed that judgement. First, it’s because, in my view, the US economy is driven by markets, not the other way around. As Alan Greenspan argued in 2009:

The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

… I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. My hypothesis will be tested in the year ahead. If shares fall back to their early spring lows or worse, I would expect the “green shoots” spotted in recent weeks to wither.

In November 2011, Ben Bernanke echoed these sentiments when explaining the rationale for QE2:

With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

So, we seem to have a Federal Reserve that is unchanged in its views: that is, that when equity prices fall so too does economic activity. Hence my conclusion that as equity prices drop coming out of QE2 we can pretty much expect another round of monetary stimulus.

The second reason I’m of that view is the assumption that the US will struggle to renew fiscal stimulus, even though that is the better option in their circumstances.

However, we can’t simply accept this as a done deal. There is clearly a mighty idealogical and political struggle underway in the US and several important recent articles in the world’s media that suggest that fiscal stimulus may be possible ahead of the ‘goosing of the stock market’ approach to monetary policy. For instance, today there is very important piece by Larry Summers in the FT in which outlines the shortcomings of the ‘goose the stockmarket’ approach:

Inflation dynamics defined the traditional postwar US business cycle. Recoveries continued and sometimes even accelerated until they were murdered by the Federal Reserve with inflation control as the motive. After inflation slowed, rapid recovery propelled by dramatic reductions in interest rates and a backlog of deferred investment, was almost inevitable.

Our current situation is very different. With more prudent monetary policies, expansions are no longer cut short by rising inflation and the Fed hitting the brakes. All three expansions since Paul Volcker as Fed chairman brought inflation back under control in the 1980s have run long. They end after a period of overconfidence drives the prices of capital assets too high and the apparent increases in wealth give rise to excessive borrowing, lending and spending.

Our current situation is very different. With more prudent monetary policies, expansions are no longer cut short by rising inflation and the Fed hitting the brakes. All three expansions since Paul Volcker as Fed chairman brought inflation back under control in the 1980s have run long. They end after a period of overconfidence drives the prices of capital assets too high and the apparent increases in wealth give rise to excessive borrowing, lending and spending.

Larry Summers was one of the key architects of the post-modern US economy and its dependence upon financial market-driven growth. It was he, with Robert Rubin and Alan Greenspan, that helped dismantle much of the financial regulation that had been in place in the US since the Great Depression reforms of FDR’s New Deal. Whilst Summers is certainly not recanting those ideals, he is explicitly calling time on the asset-driven growth model that resulted. By recognising that the US has a demand shortage, he is also, intrisically, acknowledgeing the decline of the American middle class. He almost says as much:

Beyond the lack of jobs and incomes, an economy producing below its potential for a prolonged interval sacrifices its future. To an extent once unimaginable, new college graduates are moving back in with their parents. Strapped school districts across the country are cutting out advanced courses in maths and science. Reduced income and tax collections are the most critical cause of unacceptable budget deficits now and in the future.

Summers concludes that:

The fiscal debate must accept that the greatest threat to our creditworthiness is a sustained period of slow growth. Discussions about medium-term austerity need to be coupled with a focus on near-term growth. Without the payroll tax cuts and unemployment insurance negotiated last autumn we might now be looking at the possibility of a double dip. Substantial withdrawal of fiscal stimulus at the end of 2011 would be premature.

…At the same time we should recognise that it is a false economy to defer infrastructure maintenance and replacement, and take advantage of a moment when 10-year interest rates are below 3 per cent and construction unemployment approaches 20 per cent to expand infrastructure investment.

Obviously Summers’ comments should be seen in the context of the current political wrangle in the US over the debt-ceiling and the Budget deficit. But coming from Larry Summers, the former champion of fiscal restraint, derivatives and financial market-led growth they seem more profound than that. Fact is, Summers sounds an awful lot like Paul Krugman, who wrote last week that:

Back when the original 2009 Obama stimulus was enacted, some of us warned that it was both too small and too short-lived. In particular, the effects of the stimulus would start fading out in 2010 — and given the fact that financial crises are usually followed by prolonged slumps, it was unlikely that the economy would have a vigorous self-sustaining recovery under way by then.

By the beginning of 2010, it was already obvious that these concerns had been justified. Yet somehow an overwhelming consensus emerged among policy makers and pundits that nothing more should be done to create jobs, that, on the contrary, there should be a turn toward fiscal austerity.

…So, here we are, in the middle of 2011. How are things going?

…As the stimulus has faded out, so have hopes of strong economic recovery. Yes, there has been some job creation — but at a pace barely keeping up with population growth. The percentage of American adults with jobs, which plunged between 2007 and 2009, has barely budged since then. And the latest numbers suggest that even this modest, inadequate job growth is sputtering out.

So, is the worm turning back towards fiscal stimulus? Finally, let’s refer to Ben Bernanke’s most recent speech:

The prospect of increasing fiscal drag on the recovery highlights one of the many difficult tradeoffs faced by fiscal policymakers: If the nation is to have a healthy economic future, policymakers urgently need to put the federal government’s finances on a sustainable trajectory. But, on the other hand, a sharp fiscal consolidation focused on the very near term could be self-defeating if it were to undercut the still-fragile recovery. The solution to this dilemma, I believe, lies in recognizing that our nation’s fiscal problems are inherently long-term in nature. Consequently, the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk. At the same time, establishing a credible plan for reducing future deficits now would not only enhance economic performance in the long run, but could also yield near-term benefits by leading to lower long-term interest rates and increased consumer and business confidence.

Hmmm…not a lot of daylight there for expanding the Budget, although a short term plan to boost demand, if coupled with a long term plan for consolidation, might fit Bernanke’s needs.

David Llewellyn-Smith
Latest posts by David Llewellyn-Smith (see all)

Comments

  1. Summers: “…At the same time we should recognise that it is a false economy to defer infrastructure maintenance and replacement, and take advantage of a moment when 10-year interest rates are below 3 per cent and construction unemployment approaches 20 per cent to expand infrastructure investment.”

    Absolutely agree. The question of why some of the billions of fiscal stimulus has not been directed to infrastructure replacement and development in the US has long perplexed me. A traditional road to economic re-invigoration, employment growth and tangible real assets of generational benefit. Post GFC, the US took one road to recovery, the Chinese, another. The fixed asset infrastructure road is surely the way to go. Banks probably still need some support but the average US citizen needs more.

    I could see this entirely regenerating the American spirit not to mention its economy. This is eciting and should be the form QE3 takes.

    • I could see this entirely regenerating the American spirit not to mention its economy.

      Maybe Obama could use this as a catch phrase for re-election. How about “Yes we can!”

      …er, hang on. 🙂

    • Infrastructure investment is all well and good if its needed.

      We tried a bit of that in Australia (pink batts, solar rebates, BER, NBN etc) but there’s been a lot of waste, and lot of stuff got built that no-one really wants or needs. Heck, my town got $16M on new sports fields and a few bike tracks to nowhere, when we really could have done with a bypass. Black signs were everywhere, and locals are still scratching their heads.

      Can you imagine how much waste there’s been in China? Just imagine.

      OTOH, the US could really do with a lot of its crumbling infrastructure rebuilt. Instead they bailed out banks, who were back to paying bonuses within six months.

      So its not as black & white as infrastructure spending good, cash handouts bad. It depends what the problem is you’re trying to fix. In the depths of the GFC when demand collapsed and confidence was crushed Ken Henry’s “Go early, go hard, go households” was definitely the righth thing to do, and very effective. The infrastructure spending (BER etc) that came later was poorly managed.

      In China, a country that already has surfeit of infrastructure, they built more, and more, and MORE! Perhaps the Chinese should have spent more on cash handouts, welfare safety nets, universal health care etc which might have got domestic consumption happening … because lack of investment in infrastructure has never been the problem in China, lack of domestic demand is.

  2. Bernanke: “Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

    …and how is that working out for him?

    (we really need the family feud buzzer to accompany comments like Bernanke’s)

    H&H: “So, we seem to have a Federal Reserve that is unchanged in its views…

    Well not really. That quote is 8 months old and explains their thinking leading into QE2. He now has 8 months of data that shows that his expectations were wrong: GDP down, consumer confidence down, employment flat lining, labor share of income down, consumer spending slowing, business investment slowing, housing more affordable …um well yeah nice one, tick, there is a housing double dip so it is certainly more affordable.

    • QE1 didn’t stop QE2. Bernanke hasn’t repudiated any of his views and has made a lot of excuses about commodity prices not being his fault or problem…

      • QE1 didn’t stop QE2.

        and how did those metrics go during QE1 vs QE2?

        and buying MBS in a plummeting housing market is the same as buying treasuries because … ?

  3. Invest in infrastructure, that is exactly what the goverment in Australia should have done too, rather than hand out cash & first home buyers grants. I think that while the big boys at the banks still run the goverment in both countries we will not see a recovery. The bankers are to consumed with greed to have it any other way.

    • Banks too do well in times of economic prosperity…in the long run economic revival is in their interest. Think in the US – housing market dead, business growth dead, consumer spending dead – all activities at the basic level financed by and profited on by banks.

      Massive infrastructure spend would require new equipment, machinery, vehicles, tyres, nuts, bolts, spares, steel, concrete, high tech control systems, engineers, project managers, laborers skilled and unskilled, contract controllers, architects…oh god, the list is endless. All earning, regaining confidence in the economy, resuming spending, retail improves, confidence continues to grow, new business lending, new consumer lending – you get the picture. The housing market might even stabilise! Why the US government could mandate a percentage spend to be sought from within the US. Manufacturing revives. Detroit rebuilds. Am I getting carried away?

      Surely in the banks long term interest.

      • Yes in their long term interest, but not in their short term bonus, which will always take precedence

  4. No mention here of banks not lending, and the impact on the money supply, and inflation which Ben desperately wants; QE didn’t provide that for him directly. In general the banks don’t see too many credit worthy individuals or companies to lend to.

    WRT to infrastructure I agree, but I know of projects in the US where only half of the funds can be raised given the risk on view of banks and investment houses have (both national and international).

    QE3 might happen, but I’m questioning that now. There has been over a trillion in QE’ing, but other than a short term stock market rise …what else? Not to mention the P/E average rising from 12 to 23 ish. Who’s going to buy US stocks. Don’t get me wrong there are good value companies, but in general… Some good companies I know of had P/E’s of 60 ish. It’s not just about the P/E as that is only one item in looking at a value stock, but it’s not a good sign.

    Looking a bit beyond where the FED is now, who is going to buy the MBS and other asset purchases that the FED might want to sell to unwind the balance sheet? Does anyone know?

    • “In general the banks don’t see too many credit worthy individuals or companies to lend to.”

      With Australian stimulus lite (halls, batts and solar) banks appeared to have lent on the awarding of government contracts – what’s to stop similar happening in the US.

      QE1&2 probably had a different purpose – shoring up banks and balance sheet rebuild – now it’s time to directly stimulate the domestic economy – QE3 in the form infrastructure spend (on a huge scale) is the go.

      Not impossible, surely.

      • Yeah agree on the different purpose, but if I can find Ben statement wrt to inflation I’ll post it.

        Also agree anything is possible, but having lived in the US for quite a while they vote against most infrastructure builds (at least in CA where I lived). Just check the stats on their Nuclear Reactors and almost everything infrastructure.

        Seems logical, but will they???

      • QE refers to the purchase of financial assets by the Fed – mostly longer dated securities issued by the Treasury – in order to keep interest rates low. This is a monetary measure.

        Spending on infrastructure is not a monetary measure and is not something the Fed is permitted to do. This is a fiscal measure and can only be done if the Congress and the President agree to appropriate the money and then spend it.

        The US needs both monetary and fiscal stimulus. But the political fashion of the day is to call for “fiscal consolidation” – less fiscal stimulus – and to oppose QE3.

        The facts are that QE1 and 2 helped. Fiscal stimulus helped. They did not go far enough, but they helped stabilize the economy at a time when state governments were cutting their spending and households have been reeling from job losses and the collapse of the property market.

        The US government appears likely to start a premature tightening of fiscal policy. This will intensify the contractionary pressure in the economy and reflects the abysmal dysfunction of their political system.

        The US needs to stimulate employment. But the withdrawal of monetary and fiscal support will make unemployment worse. This is a total scourge in a society that does not have a working social welfare net. Widespread and prolonged unemployment is returning to the US. It is a terrible thing. At least the Fed seems to be conscious of this and is trying to use its limited powers to do something about it. So far, they have had no thanks for it.

        • I sympathise with the Fed and agree that they’re in a bind. However, they played their role in creating that bind through decades of bailing out financial markets and enabling the great debt mountain to build.

          Fact is, if they go for another round of asset purchases, they’ll blow up the world economy IMHO.

        • QE refers to the purchase of financial assets by the Fed – mostly longer dated securities issued by the Treasury – in order to keep interest rates low.

          That description is for QE2. QE1 was the purchase of MBS following a collapsing housing market (and resulting insolvency of banks who held MBS).

          The facts are that QE1 and 2 helped. Fiscal stimulus helped.

          What facts do you have that show QE2 helped?

          And while interest rates are generally low along the curve they have fluctuated. In other words while they may have intended to influence rates downward this didn’t happen because they targeted quantity rather than price. i.e. they committed to purchasing a fixed quantity over a period rather than setting a target rate along the curve and defending that rate by buying and selling where necessary.

  5. In my more tinfoil moments its occurred to me that the squid has engineered this whole QE-followed-by-correction-followed-by-more-QE scenario simply to trade the market.

    The squid hates a flat market. As long as the market is doing something, the squid wins.

    Remember that quarter when Goldman had no losing trades? Or is that every quarter now…

  6. Larry Summers seems to be suffering from amnesia!!
    .
    FFS, He was the head of the economic team that designed the “too small to succeed” stimulus. In fact, he was primarily responsible for giving away 1/3rd of the stimulus in the form of tax cuts.

  7. H&H, what exactly is “goosing” the stock market? And what is its purpose (in an economic sense, I assume you are not talking about the impact on investors)?

  8. In the first case, I think he literally means stuffing it (like a turkey) full of liquidity to boost prices, thus getting a wealth effect (which works by expanding the bottom line at the NY and Chicago Maserati/Lamborghini dealerships)…….

    Economically, it makes no sense to me, but I’ll leave that to the macro analysts!

  9. Bridges to nowhere: try Japanese infrastructure buildout.Poured more concrete than entire OECD(ex China)at the time.

    So bridges to everywhere is the solution?

    Understand the Bernanke: a Bernanke paper delivered in January 2000: “Japanese Monetary Policy:A Case of Self-Induced Paralysis.” In his conclusions for Japan to relieve the heavy burden of deflation, Mr.Bernanke advised taking all types of NON-STANDARD measures. He advised the Japanese MOF and BOJ to undertake policy with ROOSEVELTIAN RESOLVE and said:
    “In the end, the most effective actions he took were the same that Japan needs to take. Namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment, In short, to do whatever was necessary to get the country moving again.

    Beware what you wish for.

    However, gentlemen, it was a total failure then.
    NEW DEAL OR RAW DEAL-MORGENTHAU

    New Deal
    In 1934, when William H. Woodin resigned because of poor health, Roosevelt appointed Morgenthau Secretary of the Treasury (an act that enraged conservatives). Morgenthau was an orthodox economist who opposed Keynesian economics and disapproved of some elements of Roosevelt’s New Deal. In New Deal or Raw Deal?, Burton Folsom quotes Morgenthau, testifying before the House Ways and Means Committee in May 1939: “We are spending more money than we have ever spent before and it does not work. I want to see this country prosperous. I want to see people get jobs. We have never made good on our promises. I say after eight years of this administration we have just as much unemployment as when we started and an enormous debt to boot.”
    http://en.wikipedia.org/wiki/Henry_Morgenthau,_Jr.

    • Do it right!

      Actually Sean, it seems that the US did recover and indeed flourish post Morgenthau, at least for a period, wouldn’t you say. Of course the war no doubt provided some catalyst – but that is definitely not something to be wished for.

      The employment generation potential of QE3 in this form is the key for me – fundamentally important in so many ways,

      I find it hard to image how Austrian measures would fix this fine mess. You would know far more on that – what are your ideas?

      Cheers

  10. So to follow through, the Bernanke has but one strategy: Crash on through.

    How: rehabilitation of the banking system and devaluation of the currency to promote monetary easing.

    WTF: There has been NO rehabilitation of said “banking system.”

    Currency devaluation here we come.

    For those that want some information on the “Rubin, Summers, Geithner” nexus try “Gibson’s Paradox”.

  11. This is what passes for economic policy in the US hinterland…complete stupidity:

    http://www.bloomberg.com/news/2011-06-14/arizona-lawmakers-let-jobless-aid-lapse.html

    “Arizona lawmakers declined to act on a call by Governor Jan Brewer to extend federal jobless benefits, allowing support for 15,000 people and almost $3.5 million per week in federal aid to expire.

    Republican lawmakers, who control the Legislature, argued that unemployment checks deter job-seeking. They also expressed concerns about the federal deficit and the amount of U.S. Treasuries held by China. Instead, they pushed for “job- creation” tax breaks for corporations.

    “This is just a Band-Aid on a very infected sore, the bad economy of the United States,” Senator Sylvia Allen, a Republican from Snowflake, said yesterday during a special session called by Brewer. In the Senate’s opening prayer, which she led, Allen asked God to help unemployed workers find jobs.”