Economic Atonement |
This Friday is Yom Kippur, the
day when Jews around the world ask forgiveness for their transgressions
from the year past. Rabbis remind the penitent to dwell on their sins of
omission, in which they did nothing when a more thoughtful and
proactive action was needed, and sins of commission, in which they
actively participated in an unjust action. And while not all economists
are Jewish, Gene Epstein the economics editor at Barron's, offered his thoughts on how this applies to the group.
While Gene is certainly on to something, I think he could have gone
much further in his finger pointing. Increasingly, economists are
calling the tune to which businesses and consumers dance. Since their
words and opinions matter, they may consider seeking forgiveness for
what they have said, and what they have not.
Sins of Omission
Despite clear evidence that elevated prices in stocks, bonds and
real estate remain a direct consequence of zero percent interest rates
and quantitative easing, the crowd has asserted again and again that the
prices are justified by the surging U.S. economy. There is very scant
evidence upon which to base such an opinion.
Most economists have held very tightly to the view that was widely
shared at the end of 2013; that 2014 will be the year that the U.S.
economy finally shakes off the malaise of the Great Recession. And even
though the script has failed to live up to these expectations, the
economists haven't seemed to notice.
During the First Quarter of this year, the economy contracted at an
astounding annual pace of 2.1%. But economists and politicians were
very insistent that the severe miss was solely a result of the difficult
winter. Although severe winters can be a drag on an economy (my
research shows that the 10 roughest winters over the last 50 years
knocked about two points off the normal first quarter GDP), the snow
could not fully explain a five point miss from what had been forecast by
the consensus at the end of 2013. But that's exactly what they did.
This omission was compounded by their reaction to the 2nd quarter
rebound, which showed the economy expanding by 4.6%. But while the
crowd was ready to dismiss the very weak first quarter GDP as being a
weather-related anomaly, they were not willing to acknowledge the role
played by the same anomaly in artificially boosting second quarter GDP.
My research, based on figures from the Bureau of Economic Analysis, has
shown that strong second quarter rebounds almost always follow sub-par
weather-related first quarters. This makes intuitive sense as well.
Activity that is delayed in winter gets unlocked in spring. But
economists look at the second quarter as if it represents the entire
year. But already plenty of evidence has emerged that should sow doubts
on the remainder of the year.
Even with the strong second quarter, economists are choosing to
gloss over the fact that growth in the entire first half came in at just
1.25%, far below the projections that most have for the calendar year.
To get to 2.5% GDP growth, which would be typical of a weak year, not
the first year of a long-awaited recovery breakout, GDP would have to
come in at 3.75% for the entire second half. To hit 3% for the year,
second half growth would need to be 4.75%.
But this will have to occur without the tail winds of Fed QE
support and at a time of heightened geopolitical concerns, and a housing
and stock markets that look increasingly weak and vulnerable to
correction. As a result, economists should take off their rose-colored
glasses and ratchet down their full year estimates to conform more
closely to reality. But that is not happening.
Sins of Commission
Rather than seeing, hearing, and speaking no evil, some leading
figures are much more culpable in spreading bad information. While this
list could prove lengthy, here are the top two offenders.
Fed Chairwoman Janet Yellen - In her September
press conference, Yellen made the stunning assertion that the Fed's
balance sheet, which in recent years has swelled to a gargantuan $4.5
trillion, will likely be reduced in size to "normal levels" by the end
of this decade. While most accept this statement at face value, Yellen
must know the absolute inability of the Fed to deliver on this promise.
To bring its balance sheet back to pre-crises levels of around $1
trillion, the Fed must sell about $3.5 trillion of debt over the next
five years, or a pace of about $700 billion per year. This is a negative
equivalent of about $58 billion per month in QE. Additionally, Yellen
has claimed that this can be done without actively "selling" assets, and
without tipping the economy back into recession. This claim is so
fantastical that it must be considered active deception, a grave sin
indeed.
First, if QE was necessary to inflate asset prices and create a
wealth effect to drive consumer spending and power the recovery, how can
the process be reversed without unwinding its effects and producing an
even larger recession than the last? If the recovery is already stalling
with interest rates still at zero, how can it gather more upward
momentum if the Fed raises rates back to normal levels?
Secondly, if the Fed does not actively sell bonds into the market,
it must hope to draw down the balance sheet by simply allowing older
bonds to mature. This ignores the fact that the maturation process is
far too slow to accomplish the task by the end of the decade, and it
assumes that the Fed will not have to buy any new Treasury or
Mortgage-backed bonds over that time. But in order to provide financing
for ongoing Federal budget deficits, or to stimulate the economy if
there were another economic downturn, the Fed would have no choice but
to start buying again with both hands. Since the current "recovery" is
already 15 months longer than the average post-war recovery, it would be
illogical to assume that we can make it through the next five years
without another recession.
Of course, by affirming its intention not to actively sell any of
its holdings, Yellen is attempting to defray any concerns the markets
might have over the impact such sales would have on bond prices. Lost on
everyone, including Yellen herself, is that the impact on the markets
is the same regardless of how the Fed's balance sheet shrinks. Even if
the Fed allows bonds to mature, the Treasury would then be forced to
sell an equivalent amount of bonds into the market to repay the Fed. The
fact that a distinction without a difference reassures anyone shows
just how delusional market participants remain.
World bank President Jim Yong Kim - In an
interview at September's Clinton Global Initiative, the World Bank
president urged the European Central Bank to follow the same
"successful" experiments in quantitative easing that had been pioneered
by the Federal Reserve. As proof of the policy's success, Kim pointed to
the stronger GDP growth that is expected in the US in
2015 and 2016. In other words, he is attempting to prove his point not
by what has happened thus far, but by what the consensus expects to
happen in a year or two. This is no way to argue a point. Dr. Kim is a
smart guy and I suspect he knows this, hence another sin of commission.
It would be difficult to make the case that six years of
Quantitative Easing has created a healthy US economy. In addition to the
subpar first half of 2014 GDP growth, the labor market, consumer
sentiment, and wage growth all show signs of stagnation. So Dr. Kim has
no choice but to hang his hat on a bright future that he, and most
mainstream economists, expect to be right around the corner. But
dressing up a future possibility as a current certainty is a major foul
in the business of economic forecasting. Dr. Kim, and others who have
made similar claims, should fast an extra day.
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