Repeating the New Deal, Inhibited Growth and Job Creation, Limitations of Monetary Policy and Financial Turbulence
Carlos M. Pelaez
This post considers in (I) slower economic growth and job creation, repeating the New Deal in (II), inhibited growth and job creation in (III), limitations of monetary policy in (IV), financial turbulence in (V), interest rates in (VI) and brief conclusions in (VII). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/
I Slower Economic Growth and Job Creation. An accurate description of job stress in the US economy is provided by Fed Chairman Bernanke: “private-sector employment has grown only sluggishly, the small decline in the unemployment rate is attributable more to reduced labor force participation than to job creation, and initial claims for unemployment insurance remain high. Firms are reluctant to add permanent employees, citing slow growth of sales and elevated economic and regulatory uncertainty. In lieu of adding permanent workers some firms have increased labor input by increasing workweeks, offering full-time work to part-time workers, and making extensive use of temporary workers” (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm ). The “elevated economic and regulatory uncertainty” is paralyzing spending, investment and hiring decisions. Short-term economic indicators continue to disappoint. Initial seasonally adjusted (SA) jobless claims were 473,000 in the week ending Aug 21, declining by 31,000 relative to the prior week’s upwardly revised 504,000. Non-seasonally adjusted (NSA) initial claims fell by 23,613 to 380,935 in the week ending on Aug 21 from 404,548 in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Initial jobless claims stabilized at high levels in 2010 after declining through most of 2009. The index of existing-home sales of the National Association of Realtors fell 27.2 percent to an annual SA rate of 3.83 million units in Jul from the revised 5.14 million in Jun and 25.5 percent lower than 5.14 million in Jul 2009. Existing-home sales are the lowest since the index was started in 1999 and single-family sales are the lowest since May 1995 (http://www.realtor.org/press_room/news_releases/2010/08/ehs_fall ). In Jul 2010, sales of new homes in the US were at the SA annual rate of 276 thousand, 12.4 percent below the revised Jun rate of 315 thousand and 32.4 percent below the Jul 2009 rate of 408 thousand (http://www.census.gov/const/newressales_201007.pdf ). New house sales in Jan-July 2005 NSA were 801 thousand (http://www.census.gov/const/newressales_200507.pdf ) compared with 207 thousand NSA in Jan-Jul 2010 for a decline of 74.2 percent. New orders of manufactured durable goods rose by 0.3 percent in Jul after dropping 0.1 percent in Jun and 0.7 percent in May. Orders excluding transportation fell 3.8 percent and rose by 0.3 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ).
Growth in the expansion phase of the credit/dollar crisis and global recession is subpar relative to recoveries from past economic contractions. The proper comparison is with the similar contraction in 1981-1982 following another recession in 1979-1980, as shown in Table 1. In the first year of recovery in 1983, GDP grew at the SA annual equivalent rate of 5.1 percent in 1Q83 and then at rates of 9.3 percent, 8.1 percent and 8.5 percent in the three following quarters. After four quarters of growth beginning in 3Q09, GDP was revised to growth of 1.6 percent in 2Q10 with still weak demand (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). The subpar rate of growth of the US economy in the current expansion phase perpetuates extremely high levels of unemployment and underemployment. The major cause of subpar growth is the combination of massive fiscal and monetary stimulus with radical changes in business models by legislative restructurings, regulatory shocks, mandates and expectations of taxation and higher interest rates because of a jump in government spending to 24.7 percent of GDP, which is a historical high after World War II.
Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA
| Quarter | 1981 | 1982 | 1983 | 2008 | 2009 | 2010 |
| I | 8.6 | -6.4 | 5.1 | -0.7 | -4.9 | 3.7 |
| II | -3.2 | 2.2 | 9.3 | 0.6 | -0.7 | 1.6 |
| III | 4.9 | -1.5 | 8.1 | -4.0 | 1.6 | |
| IV | -4.9 | 0.3 | 8.5 | -6.8 | 5.0 |
II Repeating the New Deal. An interpretation of the New Deal is that fiscal stimulus must be massive in recovering growth and employment and that it should not be withdrawn prematurely to avoid a sharp second contraction as it occurred in 1937 (Christina Romer http://www.whitehouse.gov/assets/documents/Testimony_of_Christina_D.pdf ). Proposals for another higher dose of stimulus explain the current weakness by insufficient fiscal expansion and warn that failure to spend more can cause another contraction as in 1937. According to a different interpretation, private hours worked declined by 25 percent by 1939 compared with the level in 1929, suggesting that the economy fell to a lower path of expansion than in 1929 (works by Harold Cole and Lee Ohanian cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7). Major real variables of output and employment were below trend by 1939: -26.8 percent for GNP, -25.4 percent for consumption, -51 percent for investment and -25.6 percent for hours worked. Surprisingly, total factor productivity increased by 3.1 percent and real wages by 21.8 percent (Ibid). The policies of the Roosevelt administration encouraged increasing unionization to maintain high wages with lower hours worked and high prices by lax enforcement of antitrust law to encourage cartels or collusive agreements among producers. The encouragement by the government of labor bargaining by unions and higher prices by collusion depressed output and employment throughout the 1930s until Roosevelt abandoned the policies during World War II after which the economy recovered full employment (Ibid). The fortunate ones who worked during the New Deal received higher real wages at the expense of many who never worked again. In a way, the administration behaved like the father of the unionized workers and the uncle of the collusive rich, neglecting the majority in the middle. Inflation-adjusted GDP increased by 10.8 percent in 1934, 8.9 percent in 1935, 13.0 percent in 1936 but only 5.1percent in 1937, contracting by -3.4 percent in 1938 (US Bureau of Economic Analysis cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 151, Globalization and the State, Vol. II, 206). The competing explanation is that the economy did not decline from 1937 to 1938 because of lower government spending in 1937 but rather because of the expansion of unions promoted by the New Deal and increases in tax rates (Thomas Cooley and Lee Ohanian http://professional.wsj.com/article/SB10001424052748703461504575443402028756986.html?mod=wsjproe_hps_MIDDLEFifthNews ). Government spending adjusted for inflation fell only 0.7 percent in 1936 and 1937 and could not explain the decline of GDP by 3.4 percent in 1938. In 1936, the administration imposed a tax on retained profits not distributed to shareholders according to a sliding scale of 7 percent for retaining 1 percent of total net income up to 27 percent for retaining 70 percent of total net income, increasing costs of investment that were mostly financed in that period with retained earnings (Ibid). The tax rate on dividends jumped from 10.1 percent in 1929 to 15.9 percent in 1932 and doubled by 1936. A recent study finds that “tax rates on dividends rose dramatically during the 1930s and imply significant declines in investment and equity values and nontrivial declines in GDP and hours of work” (Ellen McGrattan http://www.minneapolisfed.org/research/wp/wp670.pdf ), explaining a significant part of the decline of 26 percent in business fixed investment in 1937-1938. The National Labor Relations Act of 1935 caused an increase in union membership from 12 percent in 1934 to 25 percent in 1938. The alternative lesson from the 1930s is that capital income taxes and higher unionization caused increases in business costs that perpetuated job losses of the recession with current risks of repeating the 1930s (Cooley and Ohanian, op. cit.).
III Inhibited Growth and Job Creation. A case for draconian regulation of financial institutions and highest capital requirements, or regulatory view, is made by Sheila Bair, Chair of the Federal Deposit and Insurance Corporation (FDIC), by means of three arguments (http://www.ft.com/cms/s/0/a1dfbd02-aee8-11df-8e45-00144feabdc0.html ): (1) debt by leverage may be less expensive than equity capital but in comparison with a “properly” regulated world, debt holders would require a risk premium for eventual bank defaults; (2) the social costs of inadequate regulation and bank capital are measured by the waste of resources in housing, unemployment of humans and idle productive capacity instead of economic wellbeing that would have been promoted by allocating them to progress-creating energy, infrastructure and industry; and (3) financial reform must align the incentives for sound allocation and internalizing in banks the costs of leverage and risk-taking. The leitmotiv of this view is that bankers acting on their self-interest engage in excessive risk taking to obtain ever increasing profits that reward them with prodigal remuneration at the expense of their shareholders and society.
The argument of the regulatory view misses the critical role of policy in creating the credit/dollar crisis and global recession. The misallocation of resources and loss of employment was primarily caused by monetary policy jointly with housing policy considered in turn (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). First, the Fed lowered interest rates to 1 percent between Jun 2003 and Jun 2004 with the objective of preventing deflation while simultaneously Treasury suspended the issue of 30-year Treasuries with the objective of increasing purchases of 30-year mortgage-backed securities to lower yields and stimulate housing. Policy is not very different currently except in much higher dimensions with the fed funds rate at 0 to 0.25 percent and a Fed portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). Monetary policy created problems instead of reckless management of financial institutions as alleged by the regulatory view. The zero interest rates and the effort to reduce long-term interest rates created the impression that financial assets would never decline in value, encouraging high leverage, low liquidity, excessive risk and careless credit decisions. The wording of the Federal Open Market Committee (FMOC) “forward guidance” created the illusion of near-zero interest rates forever such that the Fed would prevent losses in financial exposures similar to a put option, or floor, on asset values written by the Fed. In fact, as it happens currently, Fed policy intended to encourage risk and spending to pump the economy by creating the illusion that brakes would not be applied indefinitely. Second, the near-zero interest rates and suspension of the issue of 30-year Treasuries merely magnified the effects of a yearly subsidy of housing measured in 2006 at $221 billion, policy of affordable housing, capital by Fannie and Freddie of $900 per $200,000 mortgage (Edward J. Pinto, The Future of Housing Finance, WSJ, Aug 17, 09 http://professional.wsj.com/article/SB10001424052748704407804575425231311880538.html) and acquisition or guarantee by Fannie and Freddie of $1.6 trillion of nonprime mortgages. Fannie and Freddie were under lax oversight by tax-creating political institutions compared with oversight by boards and internal controls of for-profit financial institutions. The audit, oversight and regulation of Fannie and Freddie was dominated by politics, creating the “too politically important to fail,” resulting in expensive bailouts paid with taxpayer funds. The regulatory view alleges that governance of financial institutions failed because of taking advantage in bailouts by the “too big to fail” doctrine. The fact is that investment banks failed and large commercial banks were restructured or sold, smaller banks were liquidated, TARP was imposed on banks that did not need capital, large private financial institutions repaid bailout capital with high interest, management of all levels in financial institutions lost large parts and some all of their net worth in holdings of stock in the companies where they worked and preservation of capital was a critical effort in private financial institutions but disregarded in Fannie and Freddie.
The proposal of the regulatory view is to strengthen Basel III capital requirements with: (1) elimination of hybrid instruments allegedly confusing debt and equity in counting Tier 1 capital; (2) capital buffers to prevent lending declines during crises; (3) higher capital charges on riskier derivatives and trading; and (4) an international leverage ratio (Bair op.cit.). The regulatory view chooses benign measurements of the impact of capital requirements on borrowing costs of financial institutions and global economic growth. Technical, timely, suggestive and pioneering works on measuring this impact encounter the difficulty in simulating the effects of policy because economic agents, such as borrowers and lenders, adjust their preferences in response to anticipation of policies while the models assume immutable preferences (works by Robert Lucas, Finn Kyndland and Edward Prescott cited in Pelaez and Pelaez, Regulation of Banks and Finance, 112-6). It is revealing to focus on specific segments of financial business, which is difficult because regulatory rules based on the Dodd-Frank bill are still not known. An important regulation already implemented is the Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CARD) (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). CARD was signed into law on May 22, 2009, and entered into effect on February 22, 2010. CARD harmed the credit card industry and its users who are nearly everybody. The WSJ quotes the Nilson Report (http://www.nilsonreport.com/ ) that credit card loans outstanding fell by 10 percent in 2009 to $772.2 billion (http://professional.wsj.com/article/SB10001424052748704094704575443402132987676.html?mod=wsjproe_hps_MIDDLEFifthNews ). An independent consultant estimates that regulation will reduce revenues of the credit card companies by $11 billion in the next five years but higher interest charges and fees will recover only 25 percent of that loss (Ibid). Credit card companies had nine months to lower credit volumes and increase interest rates. CARD caused what economists could call “Pareto harm,” as opposed to “Pareto improvement,” in that most users lost by higher interest rates and reduced credit limits in credit cards but no consumer gained except in costly fake transparency rules. In a vote along partisan lines, the Securities and Exchange Commission (SEC) changed proxy access rules to replace corporate directors to ease the capacity of groups of shareholders in changing the composition of corporate boards for their interests but not necessarily those of all shareholders and the economy. The measure could benefit actions by trade-union militants, advocates of shareholder rights, trial attorneys and government, as analyzed by a former SEC commissioner (http://professional.wsj.com/article/SB20001424052748703632304575451343422958522.html ). These firm and industry level regulatory shocks actually increase premiums required by investors, reducing capital in key segments of economic activity and spreading the uncertainty originating in the restructuring of the entire economy that frustrates current operating business models during an incipient recovery with high unemployment.
An interpretation of the Great Depression is that “in 1929, the collapse and extreme volatility of stock prices led consumers and firms to simply stop spending” (Romer, op. cit, 2). Investment and spending decisions by households and business have paused in 2010 because of inopportune legislative and regulatory shocks that have created “elevated” uncertainty about decisions in business models. A simple calculation of the fiscal projection for the next ten years by comparing the actual departing dates for 2009 relative to 2008 finds an increase in government spending of $4.4 trillion (http://professional.wsj.com/article/SB10001424052748704476104575439543402718272.html?mod=WSJ_hpp_RIGHTTopCarousel_3 ). The government spending curve was tilted upwardly. Forecast deficits keep on rising after every revision because of the uncertainty of future revenue depending on economic growth that is decelerating. There is doubt if the deficits will again be below one trillion dollars. Income and costs of business and households become uncertain because of the expectation of massive increases in taxes and abrupt reduction of expenditures in a debt crisis that can cause another economic contraction. The combined pressure of the deficit, the eventual unwinding of two trillion dollars of long-term securities held by the Fed and deep restructuring of business models inhibit growth and perpetuate 27 million persons unemployed, underemployed, marginally attached to the labor force or discouraged that they can find a job.
IV Limitations of Monetary Policy. In one of the most watched and expected speeches, Fed Chairman Bernanke outlined the available policies should the economy worsen significantly: “(1) conducting additional purchases of long-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves” (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm ). These policies are discussed briefly in turn. Chairman Bernanke identified two difficulties in further easing by purchases of long-term securities: (1) the difficulty in quantifying or “calibrating” the purchases of securities and their structure because of lack of past experience and knowledge on the impact of the Fed’s portfolio on financial markets and the economy; and (2) the risks of unwinding of the portfolio even with the design and tests of exit instruments. Alan Blinder, who served as Vice Chairman of the Board of the Fed, provides perceptive analysis of the Fed’s options in an article for the WSJ (http://professional.wsj.com/article/SB10001424052748703846604575448022122679194.html?mod=wsjproe_hps_TopMoreNews
). The initial objective of long-term purchases of mortgage-backed securities was to lower their risk spread relative to Treasuries, which Blinder finds to have been highly successful in promoting stability in mortgage financing and thus in recovering the economy. A doubt on this success is that the survey of weekly mortgage applications of the Mortgage Bankers Association registers an increase in the refinancing index of 5.7 percent relative to the earlier week while the purchase index rose by only 0.6 percent. The unadjusted purchase index dropped 1.1 percent from the previous week and 38.8 percent from the same week a year earlier (http://www.mortgagebankers.org/NewsandMedia/PressCenter/73783.htm ). Lower mortgage rates, even if entirely attributed to Fed policy, have not resulted in increasing house purchases perhaps because of the “elevated” economic/regulatory uncertainty. There may be an effect of higher after-mortgage income of households because of refinancing that could improve consumption but weak labor markets and uncertainty about legislative restructurings and increases in taxes and interest rates may channel funds into precautionary savings instead of consumption. The new policy of reinvesting maturing securities in the Fed portfolio in long-term Treasuries acts to flatten the yield curve of Treasuries and may be harmful because of the already low yield of bonds in general. It may be added that lowering yields of high-duration securities creates major risks of capital losses in bond portfolios as discussed in the following section on financial turbulence. What securities will the Fed buy and what will the impact be on financial markets and the economy? Can the Fed manage effectively and with desired impact a diversified portfolio of asset-backed securities on corporate loans, credit-card receivables, auto loans and the like? Should the Fed interfere with the determination of risk spreads among asset classes? Changing the wording of the FOMC guidance on low rates may not help much because the statement and policy can change according to the unpredictable economic/financial environment. If economists and the Fed could predict accurately six months ahead, there would not be uncertainty, which is not the case in reality. Lowering the interest rates on bank reserves deposited at the Fed from the current 25 basis points to zero is not likely to have significant effects. Innovation in policy tools and analysis is indispensable but there may be limits as to what can be done in practice when interest rates are at the “zero bound” (http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm ). The insistence on zero interest rates and forward guidance could merely repeat the distortion of risk/return decisions by business, household and government as in the earlier episode in 2003.
V Financial Turbulence. Financial turbulence continued in the week of Aug 27. Most major stock indexes shown in Table 2 lost value in the week with the low magnitudes masking significant fluctuations in thin markets partly because of vacations before the end of the summer in Europe and the US. Commodities fluctuated with a small gain in the week and oil moved toward the level of $75/barrel.
Table 2, Stocks, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | % Trough | % 8/27 | Week 8/27 | |
| DJIA | 26-Apr | 2-Jul | -13.6 | -9.4 | -0.6 |
| S&P 500 | 23-Apr | 2-Jul | -16 | -12.5 | -0.7 |
| NYSE Financial | 15-Apr | 2-Jul | -20.3 | -16.3 | -0.4 |
| Dow Global | 15-Apr | 2-Jul | -18.4 | -14.1 | -1.0 |
| Asia Pacific | 15-Apr | 2-Jul | -12.5 | -8.5 | -1.2 |
| Shanghai | 15-Apr | 2-Jul | -24.7 | -17.5 | -1.2 |
| Europe STOXX | 15-Apr | 2-Jul | -15.3 | -9.7 | -0.5 |
| Dollar | 25-Nov | 25-Jun | 22.3 | 18.5 | -0.5 |
| DJ USB Com | 6-Jan | 2-Jul | -14.5 | -9.3 | 0.2 |
| 10 Year T | 5-Apr | 27-Aug | 3.986 | 2.647 |
Source: http://online.wsj.com/mdc/page/marketsdata.html
The 10-year Treasury maturing in 08/2020 with coupon of 2.63 was priced on Aug 27 at a yield of 2.647 percent or equivalently at a price of 99.78 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-270810 ). Bonds are trading at extremely low yields, raising concerns in a WSJ article by Jeremy Siegel and Jeremy Schwartz (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html) If yields of the 10-year Treasury were to increase to 3.98 percent, the actual recent peak on Apr 5, the price for settlement on Monday Aug 30, 2010, would be 88.976, for a capital loss of 10.8 percent, reflecting the risk that Siegel and Schwartz label as “the great American bond bubble.” Increasing the existing Fed portfolio of long-term Treasuries could further lower yields, creating the possibility of a duration trap of major capital losses in bond portfolios that raises doubts on the painless exit from quantitative easing, which is merely a new term for printing money to buy long-term bonds. The Fed may have placed itself in a tough policy corner, failing to reignite mortgage purchases while creating exposure to major disorderly increases in all interest rates. To be sure, Treasury yields are not likely to backup immediately from 3.647 percent to 3.98 percent but jumps are quite likely as bond portfolio managers unload duration and leverage with fire-sale effects throughout all bond segments.
VI Interest Rates. The US yield curve shifted upward for the first time in weeks. The 10-year US Treasury traded at 2.65 percent on Aug 20, which was higher than 2.62 percent a week before but still much lower than 3 percent a month earlier. The 10-year government bond of Germany traded at 2.21 percent, for a high negative spread of 44 basis points relative to the US 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1283005655785 ). On Apr 4, the 10-year German government bond traded at a yield of 3 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-040810 ). The price of the 10-year Treasury at the yield of 3.00 percent a month ago for settlement on Aug 30 would be 96.831, which would result in a capital loss of 3 percent relative to the price of 99.78 on Aug 27, causing an absurd loss with leverage of 10:1 common in Treasuries.
VII Conclusion. The joint massive fiscal/monetary stimulus and legislative restructurings and regulatory shocks have inhibited economic growth and job creation. The economy is slowing while 27 million people are unemployed or underemployed and declines in the jobless rate are mainly accounting exit of people from the labor force. Policy must be shifted to recover confidence that can reignite domestic demand by investment and consumption. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)
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