It’s The Demand, Stupid

Things are not looking very good. When we have luminaries such as Greenspan and Rubin agreeing that the economy is weak, but that it will get through this minor lull in good shape, we have to worry. Neither of them has much credibility any more, so I take their unanimity on the positive outlook as a bad sign: the economy must be getting weaker.

In any case the data seems to suggest we have hit a tough patch. How tough is all we are debating.

The problem is that I don’t think there’s any way to tell exactly where this slide will end up. It is easy to make the case that GDP could continue to drop back into negative territory. It is also easy to argue that we will pull put of the dive before we hit the ground. My own view is that the evidence suggests a rocky second half with very low growth, but growth nonetheless. This is small comfort to the unemployed: it would be no surprise at all were unemployment to creep up as the swoon continues.

It is remarkable how quickly the discussion has turned to towards trying to size up the decline. Only a few months ago those of us who warned of a tough road ahead were being called unduly pessimistic. After all profits were rebounding, manufacturing was on the up, productivity was rising, and even housing had a semblance of life. Only profits remain healthy. Everything else has hit the proverbial bump in the road.

If you recall my view of 2010 was conditioned by the oddity or imbalance of the spurt in activity that generated all that hope. There was a genuine rebound from the depths of 2007/2008, especially later last and early this year. My issue was with the froth over and above that base rebound. A big inventory cycle reversal and the benefits of the stimulus, neither of which were permanent features of the ongoing economy, made it very difficult to determine just how robust the recovery was.

We are now finding out.

Which brings us to the question of what policy should be going forward.

The main line of attack should be supportive. Of that there is no doubt. Now is far too early to start any tightening. In fact, while I have argued against tightening throughout the past few months, that position is even more important now.

The Fed acknowledged as much yesterday with its begrudging approach to the money supply. As I predicted, the Fed basically avoided making any move in either direction, it stayed pat. It accomplished this by announcing that it would reinvest the proceeds of any maturities in its portfolio back into more investments. This means that it is not reducing its level of support for the economy. Nor is it adding anything.

Meanwhile the war amongst various policy camps rages on.

There are those who argue we should reduce or simply get rid of the stimulus since it has not achieved a total reversal of the crisis. This is, of course, nonsense. I agree that the stimulus failed to turn the unemployment situation around. But that was entirely predictable. It was too small to begin with. What the stimulus achieved was a far more limited goal: it stopped us falling into depression. So far anyway. The notion that we should look to investment activity and business to lead the way is totally without credibility. Yet this is the alternative being pressed by those who opposed the stimulus. Their line of attack is that we should reduce regulation and other ‘encumbrances’ on business. We should reduce the uncertainty in the business environment. We should subsidize investment. We should throw tax breaks to businesses. And, most of all, we should get rid of any silly notions of government interference in the ‘natural’ workings of the economy. Once this is all done, the sun will rise again, the birds will sing and we will emerge into a re-run of the good old days. Oh and there will be plenty of jobs in this rediscovered capitalist nirvana.

This sort of reasoning is the time honored approach adopted by all right of center thinkers. It can be summed up as: ‘get government out of the way and we’ll be fine’.

The problem I have with this is that all the evidence contradicts it.

Profits are strong. Companies have cash to spend. Interest rates are very low, which means that borrowing is cheap, and that even marginal investments will make a profit. Project hurdle rates are minimal. The economy is awash with cash – if it isn’t why are people concerned about the inflationary impact of the money supply?

Yet despite all this, business is still retrenching or standing still. The investment environment is strong. Why aren’t we seeing a surge of construction, development or expansion?

It’s the demand stupid!

Demand is weak.

That reduces the prospect for sales and so offsets the low cost of capital. This weak sales outlook cripples business expectations. And as any Keynesian will tell you: the most volatile component of the economy is business investment based upon those expectations. Until demand picks up even ridiculously low interest rates and the total elimination of regulation will not be sufficient to spur investment.

Which also undermines the parallel argument we hear from the same analysts that all that government debt implied by the stimulus soaks up the available savings and so ‘crowds out’ private investors from the credit markets. This is specious for the same reasoning. We are suffering from excess savings not insufficient savings. There has been a remarkable collapse in business investment. So there is no demand for capital coming from that quarter. In any case profits have recovered, so businesses are generating capital from internal cash flows. They don’t need, necessarily, to borrow. That represents a problem for the capital markets: where does the cash all go, if not into private investment? Into government. All that is happening at the moment is that the government is borrowing instead of the private sector, and spending, instead of the private sector, because the private sector has no intention of doing so.

Were the government deficits crowding out the private sector we should be seeing interest rates rising in response to the capital squeeze. But they are falling, not rising. If the prospect of government debt inundating the market was as awful as the deficit hawks tell us it is, those fears would be translated into higher rates, not lower rates.

The point is simple: all the signs are that the credit market fears continued decline more than it fears the bloating of government debt. This makes perfect sense when we look at the cost of lost wealth from recession/depression versus the cost of debt accumulation. The cost of carrying debt is far less than the cost of all that lost wealth from our failure to reignite the economy. The tradeoff is simple and the credit market is voting with its feet for more stimulus and more debt. Despite all the bleak words flowing from the denizens of the market. Plus, once we get GDP rising at reasonable rates we can run deficits for long periods and still lighten the debt load. This is because of basic math: as long as the increase in GDP outpaces the increase in debt, the debt load and its cost as a percentage of GDP goes down.

The goal has to be getting GDP going at decent rates. Not managing the debt downwards.

To put this in perspective: the rate on inflation proofed government five year bonds fell below zero this week. Think about that. There are sufficient investors, with enough cash, who are so concerned about the economy’s prospects that they will pay the government to keep their cash safe rather than look for an opportunity to invest it at higher rates. That’s what a negative rate implies.In other words business expectations are so bleak that the government could borrow almost endlessly at almost zero cost and still not absorb all the money looking for a safe home.

There is a savings glut.

We are in a liquidity trap.

The only exit is through more expansive government activity.

There is only one target for policy:

It’s the demand stupid!