The strong labor market and recent emerging data indicate that the first quarter’s poor economic performance was due to severe winter weather and a 2 month long west coast port strike that disrupted many manufacturing production schedules. Yet, despite such data, the financial media and many bloggers continue to fixate on the inability of the economy to shake off what appears to be “stall” speed, i.e., very slow economic growth, especially compared to other recoveries in the post-WWII period. For example, in the 5.5 years after the recession of ’82, the Compounded Annual Growth Rate (CAGR) of Real GDP was 4.7%. After a similar 5.5 years, it was 3.3% after the mild recession in ’90-’91. But, in the 5.5 years since the bottom of the financial crisis, the CAGR of Real GDP has only been 2.3% despite record low interest rates and massive monetary and fiscal stimulation. Many reasons are given in the financial blogosphere, the latest 3 being: 1) the lack of wage growth; 2) the strong dollar’s impact on corporate profits; and 3) trouble in the oil patch. Such excuses are ever changing, and the current few mentioned here are not powerful enough to have had the impact of lowering long-term economic growth by 100 to 200 basis points. Yet, there must be some underlying nugget of truth in the media’s fixation on the slow growth issue.
In my view, today’s economy is significantly structurally different than it was in the postwar period ending in ‘08. But today’s economists and the financial media are trying to apply the old structures and the ensuing economic reactions to various stimulations. Simply put, they no longer apply. What does apply is still not clear, as we have not yet run through a cycle.
What follows is my attempt to outline some of those structural changes and their consequences for economic growth.
The Dodd-Frank legislation (and the resulting and still emerging Volcker Rule) has restricted the large money center banks’ roles in the operation of the capital markets. The idea was that, since the banks all carried FDIC insured deposits, those banks should not be allowed to take undue risk with their capital, lest the taxpayers have to bail them out (again). As a result, all of the capital markets are much more thinly traded and have much less capital waiting in the wings than they did before the financial crisis. In his recent letter to shareholders of JPMorganChase, Jamie Dimon, the institution’s CEO, commented that the reduction in capital committed to the credit markets has significantly increased those markets’ volatility.
Last October 15 there was a one day 40 basis point drop in the 10 year T-Note yield. According to Dimon, statistically that is a 7-8 standard deviation move, an event that is only supposed to happen once in 3 billion years. Clearly, the historical data used to calculate the standard deviation no longer apply, as, today, we are dealing with an economy that is structurally different. Such a large move in yields in the marketplace will now occur much more frequently. It’s okay when everyone makes money, as happened in October, but it will be a different story when the move is in the opposite direction. This will be a big deal in the next financial crisis.
The Money Multiplier
Today, banks hold $2.7 trillion of “excess reserves.” Under the old structure, the banks had profit incentive to lend these reserves, and, as explained by the money multiplier of the pre-crisis economy, bank lending resulted in a 5 to 10 fold increase in the money supply (i.e., $2.7 trillion x 5 or x 10). Based on the old financial structure, it isn’t any wonder that the gold bugs have been expecting significant inflation. But, the money supply has simply not grown because the financial system is structurally different. Dimon points out that these so called “excess” reserves are not “excess” at all, but are required to maintain a bank’s newly mandated liquidity coverage ratio (a bank is now required to have 30 days of “liquid” assets on hand; and, of course, U.S. Treasuries count as 100% liquid, while private sector credits, like Walmart paper, only count as 50%!).
Structurally Low Interest Rates
In the changed economic structure, a form of mercantilism has emerged in which major foreign industrial economies all vie for increased exports by cheapening the value of their currencies, at least relative to the dollar. They print new money and exchange it in the forex market for dollars, thus depreciating their currency. With their newly acquired dollars, they purchase U.S. Treasury securities. In his shareholder letter, Mr. Dimon points out that of the $13 trillion of outstanding U.S. Treasuries, $6 trillion is now held by foreign central banks, $2.5 trillion by the Fed itself, and $0.5 trillion by U.S. Banks. The latter amount will soon rise significantly under the newly mandated liquidity rules. Dimon concludes that “there is a greatly reduced supply of Treasuries … [and] there may be a shortage of all forms of good collateral.” That implies that the U.S. debt and deficit are simply not large enough, a truly scary thought. But, for sure, because of these pressures, medium and long-term interest rates in the U.S. are going to stay low for a long period of time.
Vassals of the Government
The result that all of the capital and liquidity mandates make the banks “vassals” of the government in the sense that they are completely free to purchase “riskless” U.S. Treasury paper which requires no capital and are 100% liquid under the new rules. Compare this to making a loan or line of credit to the private sector which eats up bank capital and increases their liquidity requirements. Thus, under the new rules and regulations, banks are now biased toward purchasing U.S. Treasury securities and are less interested in making private sector loans. Have you noticed the rise in the payday lender industry?
The housing industry is also a victim of the changing financial structure. Under the old structure, record low interest rates, like we have today, would have induced very high volumes of home sales and new construction. But, we continue to watch the housing industry struggle to produce a viable upward trend. After the financial crisis, but especially beginning in 2011, short-sales and foreclosures were quite common. Fox News reported that in the post-crisis period, 7.3 million homeowners lost their homes to foreclosure or were short-sellers. Today, this very significant proportion of the home buying population cannot obtain financing. No government agency or portfolio lender will look at a loan where the borrower had a short-sale unless more than 4 years have passed.
Another seemingly structural change has occurred in the capital spending arena. The last 5 years have been the slowest capital spending growth period on record. Many have observed that U.S. corporations would rather use their cash to pay dividends or buy back stock than to invest in organic growth through capital expenditures (capex). While I cannot point to a specific structural change here, it is clear that the U.S. has failed to adjust its taxation laws to the changing tax structures in the rest of the world. As a result, the U.S. has one of the highest corporate tax rates in the industrialized world. Last summer, we heard the world “inversion” in the financial media which is the description of a U.S. company merging with a foreign entity (with the foreign entity as the survivor) in order to obtain a lower tax rate. So, it is clear here, that the U.S. tax structure has become a large impediment in the country’s economic growth potential.
Structural changes have contributed greatly to the slower growth in the post-crisis recovery. These include significant changes in the financial industry under which banks are required to buy and hold U.S. Treasury securities both because they require no capital and because they fulfill onerous liquidity requirements. As a result, loans to the private sector have been strangled. In addition, the housing market has been impacted by much stricter lending standards, effectively cutting off home ownership for 7.3 million households that had a short-sale as a result of the housing bubble. Finally, the archaic, stupendously complex, and high rate tax system in the U.S. has had an impact on capital spending which is currently showing up as falling labor productivity. All of these structural changes have worked together to keep interest rates low and to cause tepid economic growth in the post-crisis recovery which the media has fixated on. But the scariest implication of all is that there is the high probability that in the next financial crisis, the forced withdrawal of funding of the capital markets by the large financial institutions, mandated by legislation, will cause such high levels of volatility that asset values could instantly melt away.
Robert Barone, Ph.D.
Robert Barone (Ph.D., Economics, Georgetown University), an advisor representative of Concert Wealth Management, Inc., is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, Inc., a Registered Investment Advisor. Dr. Barone is available to discuss client investment needs. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources that Universal Value Advisors believes to be accurate and credible but makes no guarantee to their complete accuracy. A more detailed description of Concert Wealth Management, Inc., its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.