The velocity
of money—outside the Fed's control
The last problem the Fed faces in their LSAP program is their inability to control the velocity
of money. The AD curve is planned expenditures for nominal GDP. Nominal GDP is equal to the velocity
of money (V) multiplied by the stock
of money (M), thus GDP = M x V. This is Irving Fisher's equation
of exchange, one
of the important pillars
of macroeconomics. V peaked in 1997, as private and public debt were quickly approaching the nonproductive zone. Since then it has plunged. The level
of velocity in the second quarter is at its lowest level in six decades. By allowing high debt levels to accumulate from the 1990s until 2007, the Fed laid the foundation for rendering monetary policy ineffectual. Thus, Fisher was correct when he argued in 1933 that declining velocity would be a symptom
of extreme indebtedness just as much as weak aggregate demand. Fisher was able to make this connection because he understood Eugen von Böhm-Bawerk's brilliant insight that debt is future consumption denied. Also, we have the benefit
of Hyman Minsky's observation that debt must be able to generate an income stream to repay principal and interest, thereby explaining that there is such a thing as good (productive) debt as opposed to bad (non-productive) debt. Therefore, the decline in money velocity when there are very high levels
of debt to GDP should not be surprising. Moreover, as debt increases, so does the risk that it will be unable to generate the income stream required to pay principal and interest.
Perhaps well intended, but ill advised The Fed's relentless buying
of massive amounts
of securities has produced no positive economic developments, but has had significant negative, unintended consequences. For example, banks have a limited amount
of capital with which to take risks with their portfolio. With this capital, they have two broad options: First, they can confine their portfolio to their historical lower-risk role
of commercial banking operations—the making
of loans and standard investments. With interest rates at extremely low levels, however, the profit potential from such endeavors is minimal.
Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face
of limited bank capital, less money is available for traditional lending. This deprives the economy
of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking. Perversely, confirming the point made by Dr. Hall, a rise in stock prices generated by excess reserves may sap, rather than supply, funds needed for economic growth.
Incriminating evidence: the money multiplier
It is difficult to determine for sure whether funds are being sapped, but one visible piece
of evidence confirms that this is the case: the unprecedented downward trend in the money multiplier. The money multiplier is the link between the monetary base (high-powered money) and the money supply (M2); it is calculated by dividing the base into M2. Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion
of the monetary base, the money multiplier stood at 9.3, meaning that $1
of base supported $9.30
of M2.
If reserves created by LSAP were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition. The September 2013 level
of 3.1 is the lowest in the entire 100-year history
of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low
of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence
of actually reducing economic growth. Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high- and low-income households. When policy makers try untested theories, risks are almost impossible to anticipate.
The near-term outlook Economic growth should be very poor in the final months
of 2013. Growth is unlikely to exceed 1%—that is even less than the already anemic 1.6% rate
of growth in the past four quarters. Marked improvement in 2014 is also questionable. Nominal interest rates have increased this year, and real yields have risen even more sharply because the inflation rate has dropped significantly. Due to the recognition and implementation lags, only half
of the 2013 tax increase
of $275 billion will have been registered by the end
of the year, with the remaining impact to come in 2014 and 2015.
Additionally, parts
of this year's tax increase could carry a negative multiplier
of two to three. Currently, many
of the taxes and other cost burdens
of the Affordable Care Act are in the process
of being shifted from corporations and profitable small businesses to households, thus serving as a de facto tax increase. In such conditions, the broadest measures
of inflation, which are barely exceeding 1%, should weaken further. Since LSAP does not constitute macro-stimulus, its continuation is equally meaningless. Therefore, the decision
of the Fed not to taper makes no difference for the outlook for economic growth. Lacy Hunt
Old news for a new day on those who preserved capital as we sorted out who and not why.
http://www.caseyresearch.com/articles/f ... e-mounting