Thursday, November 25, 2010

Bernanke vs. Keynes

Investment drives the economy. It creates jobs, builds factories, develops technology, and stimulates growth. When investment falls, spending slows, unemployment rises, and the economy languishes in persistent stagnation.

Currently, businesses are sitting on nearly $2 trillion because business leaders cannot find profitable outlets for investment. Consumers and households are unable to spend at precrisis levels because much of their personal wealth was wiped out when the housing bubble burst. So, spending is down and borrowing is flat. The lack of demand has widened the output gap and kept unemployment unusually high.

At the same time, retail investors continue to exit the markets. Last week marked "the 29th consecutive week of domestic fund outflows." (zero hedge) Investors have been drawing-down their investments ever since the May "Flash Crash" when the stock market plunged nearly 1,000 points in a matter of minutes. The credibility of the equities markets has been severely damaged by high-frequency traders who use supercomputers to get an edge over "mom and pop" investors. Consider this: "70% of the stocks that are traded are held for just 11 seconds". Many retail investors believe he market is rigged which is why they continue to leave.

Even though investment is weak, the markets have continued to climb higher due to the Fed's zero rates and the speculative activities of high-frequency players. Regrettably, the uptick in equities has had no discernible effect on the real economy which--most people believe-- is still mired in a recession.

The stock market is an important gauge of economic vitality. When stocks soar, the public becomes more optimistic and confidence grows. When confidence grows, consumers are more apt to spend which boosts demand. Here's what British economist John Maynard Keynes had to say on the topic:

"The state of confidence, as they term it, is a matter to which practical men always pay the closest attention. But economists have not analyzed it carefully."

Fed chairman Ben Bernanke's efforts to restore droopy confidence have fallen short because he has taken the approach of a technician rather than a psychologist. Quantitative easing (QE) does not address the fears that people have regarding investment. Rather, it's an attempt to push down long-term interest rates in the hope that it will lead to another credit expansion. But that assumes that the obstacle to investment is interest rates and not something more elusive, like fear or uncertainty. This is the basic flaw in Bernanke's approach, he doesn't see that investment requires confidence in one's long-term expectations and that those expectations dampen when markets are in turmoil and outcomes are affected more by policy than fundamentals. When that happens, uncertainty grows and investors pull back. Here's an excerpt from Robert Skidelsy's "The Remedist" (in the NY Times) which sheds a bit of light on the question of uncertainty:

"Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities."

Central bankers generally ignore the psychological aspects of investing preferring to operate according to their own models. But confidence matters. It's Bernanke's job to restore confidence through regulation, price stability and job-generating monetary policy. But bond yields suggest that the Fed chairman has failed in this regard. In fact, Treasury yields indicate that investors are clinging to cash (and cash equivalents) as ferociously today as the day Lehman Brothers collapsed 2 years ago. Bernanke hasn't restored confidence at all.

Quantitative easing is just more of the same; more fiddling with the financial plumbing instead of striking at the heart of the problem. Bernanke plans to purchase nearly $900 billion in US Treasuries from the banks (Note--$300 billion will come from the proceeds of maturing mortgage-backed securities) to push down long-term interest rates and (hopefully) stimulate additional spending. But more than 90% of the Fed's purchases will be short-dated maturities. (6 month, 2-year, 5-year, 7-year, 10-year) Why? Because Bernanke wants to push investors into riskier assets, like stocks. It's the Fed's version of social engineering, like zapping lab-rats onto the flywheel to earn their kernel of corn. This isn't the role of the central bank. Bernanke should stick to his mandate of "price stability and full employment".

So, how much effect does confidence have on the economy? Here's an excerpt from an article in the Wall Street Journal that deals with the topic:

'Sylvain Leduc, a research analyst at the Federal Reserve Bank of San Francisco, measured confidence by using surveys of economists’ forecasts from 1960 to 2009. An improvement in forecasts suggested respondents were more confident about the economy’s future. He measured economic activity by the jobless and inflation rates.

What Leduc found was that current confidence does indeed have an impact of future activity to a significant extent. For example, when the survey forecasts became more optimistic, the unemployment rate was more than one percentage point lower a year later....

Leduc noted that historically after an increase in confidence, monetary policy becomes more restrictive as short-term interest rates rise.....A wave of pessimism means more of an accommodative stance.

Consequently, the lack of optimism in the U.S. is another argument for why monetary policy will stay accommodative for a very long time." ("Confidence Affects the Business Cycle, Study Finds", Kathleen Madigan, Wall Street Journal)

Confidence shapes one's view of the future, just as one's expectations of the future effects his willingness to invest. But confidence does not exist in a vacuum, it requires particular conditions to thrive, the most important of which is low unemployment. The greatest source of uncertainty and insecurity is joblessness. Give a man a job and his view of the future immediately brightens. Confidence and employment go hand-in-hand. High unemployment means falling confidence, sluggish spending, flagging investment and slow growth.

Neither Bernanke nor President Barack Obama seem to understand the connection between unemployment and confidence. Instead, Obama thinks that the "shellacking" the Dems just got in the midterm elections was the result of a failed public relations strategy. "We just didn't get our message across", they think. But the real issue was jobs, not "messaging". The administration has made no attempt to reduce unemployment since congress passed Obama's $787 billion fiscal stimulus. Voters had no choice but to remove incumbents and give someone else a chance. The GOP won by default, there was no "mandate".

With unemployment still hovering at nearly 10 percent and underemployment at 17 percent, public confidence is at its nadir and the economy is still stuck in a near-depression. Bond yields are low because people are hanging on to risk free assets for "dear life". Savings are being stuffed into mattresses or government insured CDs that earn less than 1 percent per anum. Keynes explored why people hang on to their money when times are uncertain and here's what he found:

"The desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset....

It is this flight into cash that makes interest rate policy an uncertain agent of recovery. If managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself." ("John Maynard Keynes", Robert Skidelsky, New York Times)

Repeat: "It is this flight into cash that makes interest rate policy an uncertain agent of recovery."

Keynes was familiar with quantitative easing (although it was called something else at the time) and supported it as part of a larger monetary/fiscal strategy. But QE won't work by itself. The transmission mechanism (the banks) for implementing policy is broken, which means that stimulus must bypass the normal channels and go directly to the source---consumers, workers and households. There's no need to nibble at the edges of the problem with fancy asset shuffling operations (QE) that achieve nothing. Economists know what to do already. Fiscal remedies have been used for over a half century and they work just fine. The point is to increase government deficits enough to put people back to work. That's what builds confidence, boosts investment, stimulates spending, and puts the economy back on track.

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