Friday, March 29, 2013

The REAL Cult Of Equity | Macrofugue Analytics

The REAL Cult Of Equity

There has been a resurgence in recession calls after the past few months' soft data.  This is likely wrong.  None of the key recession-casting inputs (ISM: PMI 53.5, Real Retail Sales +3.5% y/y, Fixed Private Investment +10% y/y, Auto Sales +17.4%) signal US recession.

No great private imbalances exist.  There is no over-investment.  No great over-confidence in sentiment exists.  Marginal investment opportunities are fatter & juicier than at any other time in modern history.  With this back-drop, from where does a recession emerge?

Drawdown of PCE as a % of wages:


A nation does not spontaneously withdraw from working hard to pursue a better life for today (by consuming) and tomorrow (by investing).  The American dream is not dead: 82% of renters aged 25-34 want to own a house in the next 5 years, and that number represents a majority for every renting age group through 65.

As Conor Sen concluded in his June 25th piece, the capital structure impediments are receding into the a temporary demographic lull in housing bids.  The smaller Generation X has not been capable of picking up the slack left by the drying Boomer demand.  An under-appreciated fact is that the Millennial Generation is larger than the Boomers, and will likely be the largest and richest generation to walk the earth.


But even whilst we wait for the Millennial Generation to grow up and buy some houses, we are already seeing an emerging indication that the liquidation of housing inventory points to an end to the residential drag on GDP.  Since October of 2010, the pace of New One-Family Houses Sold has increased by 26.8%, and the Median Sale Price of New Homes Sold is up 14.8%.


This is not the sign of an economy that is teetering on recession.

Rather, the things that matter to the core economic engine of this country are on the up-swing.  Consider the Temporary Business & Professional payrolls, which substantially lead payrolls (and the economy) in aggregate:


It is much more difficult to forecast the marginal flows of economic activity (analog) than recession-casting (binary).  It seems unlikely that any one or institution has the ability to forecast whether we get 2% or 3% GDP to any degree of reliability.  Fortunately, for the moment, for the purposes of asset allocation, the extremes in valuation point to a very binary payoff.


We measure valuation here chiefly with two measurements of the Equity Risk Premium.  There are many different ways to measure it, but the most typical definition of the Equity Risk Premium is to subtract the 10-year US Treasury yield from the S&P 500 Earnings Yield (EY – 10y).  Whilst imperfect, previous plateaus and troughs in valuation have very neatly coincided with major turning-points in the US stock market.

The argument made against the Equity Risk Premium as calculated this way is that the Federal Reserve has artificially depressed the yields of risk-free instruments.  In order to present a view of the distorted premium on fixed cash-flows that the market has in an act of risk-aversion, rather than Fed intervention, we show a lesser-known measurement of the equity risk premium — the Levered Equity Risk Premium.  We calculate this by subtracting the Baa yield from the S&P 500 Earnings Yield (EY – Baa).  This premium on fixed cash-flows represents two markets the Federal Reserve does not participate in to form a more pure view.

If anything, it paints an even more convincing picture.  When LERP is at least 1.5%, the mean quarterly performance jumps from 1.6% to 2.76%.  Similarly, the mean 52-week return jumps from 8% to 15%.

Full sample When LERP >= 1.5%
6 month mean return 3.89% 8.23%
12 month mean return 7.9% 15.2%
24 month mean return 16.21% 28.85%
24 month minimum return -47.48% 6.28%

Perhaps what is most interesting – even more so than the roughly double average return expectancy – is the risk minimising effect buying at this extreme relative valuation threshold.

A combination of factors explain this out-performance.  The first, and most obvious, is the temporary and mean-reverting nature of risk-averse behaviour.  See the long-term chart of the bond:stock ratio with the S&P 500:


To solidify the view as to how mean-reverting this series really is, take this scatter-plot of the bond-stock ratio against forward 2-year returns:


Whilst imperfect, there is not much room for interpretation:  strong bids for bonds result in future equity gains.

The second supporting argument may be even more compelling:  whilst households tend to not correctly respond to economic incentives (evidenced by their herd-like behaviour in and out of asset classes), corporations rarely fail to take advantage of them.

The major driver is the cultural reverence for shareholders.  James Surowiecki wrote a piece in 2008 which contrasted Japanese with American business outcome optimisation.  He wrote:

In the 1990s, the average return on equity for the Nikkei was around four per cent, and in the second half of that decade and into the early years of this one it fell below two per cent. (In the U.S., the average R.O.E. is closer to eleven to twelve per cent.) According to this report, between 1998 and 2003, of all large-cap Japanese companies, only eight had an R.O.E. above ten per cent, which is a completely ordinary performance by U.S. standards. And even now, Japan's average R.O.E. is by far the lowest of any major economy.  What this means is that for much of the past two decades, Japanese companies have been destroying economic value for shareholders, using far more capital than they're generating.

And further on:

None of this is too surprising—historically, Japanese companies have been disdainful of the idea of shareholder value and of traditional profit metrics. In 1998, the chairman of Mitsubishi Heavy Industries famously said, "I openly brag that I don't cater to shareholders," and, even more amazingly, "We don't give a hoot about things like return on equity." In part, this is because companies' heavy reliance on debt financing and interlocking relationships meant that they felt they didn't need shareholders. It's also because many companies saw themselves as fulfilling a social role.

To accurately forecast the direction of security prices, we have to understand the motivations of the marginal players.  The purpose of capital, whether it's raised by debt or equity, is to seek a return.  Businesses have used external sources of capital for funding, which has provided them opportunity to spread the risk, and investors to achieve returns on their capital.


Something curious has happened in the past decade, however:  the business sector has become nearly self-funded.  They have been so saturated with the capital from retained earnings that external capital is converging on non-essential for running operations.

Instead, the corporate sector has increasingly been using it to conduct capital structure arbitrage — taking advantage of the extremely cheap debt capital to reward the more expensive equity capital holders.  This is the true cult of equity.

Households will probably continue to shed their equities for fixed income instruments.  Hedge funds will probably continue to be both the tail and the dog (and probably make no money in aggregate:  it's tough being the marginal player!).  But it's the shareholders, ultimately, that constitute the boards.  Unlike Japan, even without the need for outside capital, the deified shareholder class is still the ultimate stakeholder to satisfy, and CFOs will respond to the most obvious and strong incentives.

Companies have been buying back stock for decades without any immediate economic incentive.  When the Levered Equity Risk Premium is positive, that means that corporations can borrow at a lower rate than their own shares are yielding.  While borrowing to fund buy-backs actually increases returns on equity, we can expect CFOs to do it.

The lull between the Baby Boomer & Millennial generations has provided a volatile environment to own equities, and has driven an extreme concentration in equity ownership.  While the volatility may not be over, this unique capital structure arbitrage opportunity has provided a cushion for those who are amassing assets to ultimately sell to Millennials as they grow up, get high paying jobs, and start investing for their future.

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Calafia Beach Pundit: Corporate profits remain strong

Corporate profits remain strong

With today's release of revised GDP stats for Q4/12, we got our first look at corporate profits for the period. Although after-tax profits failed to post another record high, they have been increasing at a much faster pace than the overall economy for more than a decade. Since the end of 2001, profits are up 161%, for an annualized gain of 9.1%. In contrast, nominal GDP has grown by only 3.9% per year over that same period. It's rather amazing. Corporate profits have exceeded almost everyone's wildest dreams: since the end of 2008, profits have more than doubled.

I remember calculating back then that the market was priced to the expectation that about one-fourth of U.S. corporations would be bankrupt within 5 years, and that corporate profits would decline by almost two-thirds. In short, the market was priced to an end-of-the-world-as-we-know-it scenario. But here we are 4 years later, and instead of a huge collapse in profits, we have seen a doubling of profits! This explains the rise in the stock market in the past 4 years, even as the recovery has been the most miserable one on record: the future has turned out to be much better than expected.

But still the market remains pessimistic, extremely reluctant to believe the good times will last. Why? Here's one explanation: As the second chart above shows, profits have averaged just over 6% of nominal GDP for the past 50 years or so, and that has created the expectation that profits will inevitably revert to that mean.

The above chart shows the PE ratio of the U.S. stock market using total after-tax, adjusted corporate profits from the National Income and Product Accounts as the "E" and the S&P 500 index as the "P." (I've used a normalized S&P 500 index to make the ratio similar on average to the actual PE ratio of the S&P 500, which averaged a little over 16 during this same period.) Note that this measure of the PE ratio of U.S. corporations at the end of last year was about 30% below its long-term average. With the S&P 500 today reaching its former all-time closing high, and assuming corporate profits have not grown at all this quarter, this PE ratio today would be 11.8, still about 25% below the long-term average.

By this measure, stocks today are extremely attractive. (The conventional calculation of the PE ratio of the S&P 500, using 12-month trailing earnings, is 15.4 today, about 7% below its long-term average.)

What explains the undervaluation of stocks today? I think it's the expectation that corporate profits will revert to their historical average of about 6-6.5%% of GDP. This might take the form of corporate profits declining by one-third in the near term, or not growing at all for the next 10 years while nominal GDP posts average growth. Either scenario would qualify as extremely pessimistic, albeit consistent with a mean-reversion of profits relative to GDP.

Once again I'll advance the notion that while corporate profits appear to be unsustainably high relative to the size of the U.S. economy, they are at fairly average levels when compared to the size of the world economy. The U.S. economy today is much more integrated with the rest of the world than ever before, and for most large corporations, international sales are an increasingly important source of total profits. The global economy has grown much faster than the U.S. economy in recent decades, so it is only natural that U.S. corporate profits have also grown much faster than the U.S. economy. There needn't be a big mean reversion; profits might even continue to grow, or at least not decline relative to nominal GDP in the future.

Conventional thinking sees unsustainably high corporate profits and expects a reversion to the mean. Global thinking sees no a priori reason to worry at all.

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Thursday, March 28, 2013

Redefining labour | FT Alphaville

Redefining labour

This is the third installment in FT Alphaville's "Beyond Scarcity" series, a somewhat radical look at the impact of technological progress and efficiency on the volume of goods and services being produced by the system, asking whether "abundance" could now be a key determinant of deflationary forces in the western world.

On top of this, we have considered the role played by "artificial scarcity", whether imposed wittingly or unwittingly by industry participants as a counterweight to such deflation, and to what degree such measures could now be running into scalability issues. In short, whether there is a limit to how much artificial scarcity private organisations can impose to counteract deflationary forces of abundance, without experiencing diminishing returns.

In our first installment we explained (in fuzzy felt) why an abundance of goods is naturally deflationary unless accompanied by equal or greater credit expansion. Furthermore, we explained why the process can eventually lead to the decay of money itself.

In our second installment we looked at why the private sector has an incentive to counteract such forces — which ultimately threaten profit itself by compromising monetary stores of value — by making things artificially scarce. Such measures can include everything from destocking, unemployment, and capacity shutdown to the accumulation of dark inventory.

Now we look at what technologically-induced abundance does to our understanding and treatment of productivity and labour in its own right.

We go straight to anthropologist and author David Graeber who conveniently penned "Of Flying Cars and the Declining Rate of Profit" this week, a fascinating analysis of why much of the technological innovation we imagined when we were young is still not here.

His point, very generally, is that technological progress is not on track — despite a mass perception that it is accelerating. That somewhere along the way it was sabotaged by those who had an interest in slowing it down.

Graeber notes, for example, the awkward relationship between technology, profitability and human labour:

Marx argued that, for certain technical reasons, value—and therefore profits—can be extracted only from human labor. Competition forces factory owners to mechanize production, to reduce labor costs, but while this is to the short-term advantage of the firm, mechanization's effect is to drive down the general rate of profit.

For 150 years, economists have debated whether all this is true. But if it is true, then the decision by industrialists not to pour research funds into the invention of the robot factories that everyone was anticipating in the sixties, and instead to relocate their factories to labor-intensive, low-tech facilities in China or the Global South makes a great deal of sense.

As I've noted, there's reason to believe the pace of technological innovation in productive processes—the factories themselves—began to slow in the fifties and sixties, but the side effects of America's rivalry with the Soviet Union made innovation appear to accelerate. There was the awesome space race, alongside frenetic efforts by U.S. industrial planners to apply existing technologies to consumer purposes, to create an optimistic sense of burgeoning prosperity and guaranteed progress that would undercut the appeal of working-class politics.

So while much of the West was fooled into thinking that technology was progressing more and more quickly — due to unfair comparisons with Soviet Union — in reality, the private sector was investing in outdated (but cheap) human labour abroad rather than improving mechanical industrial processes.

With the private sector failing to support technology — if not sabotaging it outright — it's no surprise then that real innovation was left to government entites, who were much less concerned about profitability.

Indeed as Graeber notes:

One reason we don't have robot factories is because roughly 95 percent of robotics research funding has been channeled through the Pentagon, which is more interested in developing unmanned drones than in automating paper mills.

This, Graeber argues, explains the type of technologies we've seen developed: technologies focused on surveillance, work discipline and social control rather than medical or humanitarian advances.

Graeber goes on to have some strong opinions about why technology, even now, is failing to advance as quickly as it should. He posits that neo-liberal and capitalist forces may be misdirecting innovation into bureacratic technologies, which awkwardly offset efficiencies, rather than focusing on the sort of grandiose poetic projects that could serve humanity (Mars missions etc), which we could have expected of the Soviets.

Nevertheless, one thing is clear. For the first time in decades, those in the know say private sector technology is outpacing government technology. Meanwhile, no matter how much of an incentive corporations may have to sabotage such efforts, technology appears increasingly to be slipping out of their control. This is thanks largely to open source initiatives and a system which increasingly provides for people at a base level. Once base needs are met — due to a general abundance of goods — however they may be funded, people are free to dedicate themselves, if they wish, to the pursuit of nobler goals, technologies and academia. On the academic front, despite the increasing trend towards tuition fees, access to knowledge has ironically never been cheaper.

True, internet tutorials are no replacement for a medical degree, but there are ever more fields in which an internet connection and a (good) will (hunting) to learn is all that's needed to achieve the same academic grounding as a college degree.

Peter Thiel, meanwhile, is even famously paying students to drop out of university altogether.

All these developments suggest that technological advances could soon start flowing back into production and manufacturing circles compromising the current corporate grip which is restraining abundance even further.

When human labour is almost completely replaced my mechanised robotics, even on the services front, it's fair to assume the cost of labour, production and profitability may have to be re-evaluated completely.

After all, if robots are doing most of our work, a high employment rate becomes illogical in society. In fact, it even makes sense for some portion of civilisation not to work at all or shift their productivity into different areas. Meanwhile, how can corporations justifiably continue to charge for goods and/or continue to waste products (or withhold products from the market) just in order to squeeze out profits?

Is this not the crisis of capitalism envisioned by both Keynes and Marx?

If the system is capable of free production — constrained only by energy costs and resources — a base level of existence can be increasingly provided free of charge to an ever growing amount of people.

Some will utilise this new-found freedom from labour –  and their ability to enjoy a growing abundance of goods — to pursue nobler goals (possibly ones which allow society to advance even further) which will allow the individual to achieve a greater than base existence. Others, meanwhile, will be able to just enjoy what the system provides (albeit at a base level), though at no cost or disadvantage to those who contribute to it. Some others, meanwhile, might instead be able to dedicate themselves to voluntary pursuits they could never have done before.

Many will be tempted to identify these developments as Marxist. We'd argue this is not the case. Rather, we'd say, this is the inevitable consequence of outsourcing labour to a body of non-sentient robotised slaves.

On the subject of the robotisation of the American workforce, Parag and Ayesha Khanna, co-directors of the Hybrid Reality Institute, who have a new book out this week entitled Hybrid Reality – a look ahead to a future where humans might even merge with technology — made the following observation in a Forbes editorial this month:

America's transition away from manufacturing was supposed to mean that we all move into a higher-value service economy – jobs which couldn't be lost to outsourcing. Technology was considered only an asset to productivity, not a liability to employment. Yet the most recent Q1 data reveals that unemployment is steady at around 8.1% not because workers have found jobs, but because hundreds of thousands of people – 342,000 in April alone – have left the workforce altogether. Retirees and those returning to school provide at best a partial accounting. Automation is a major factor. Today America needs 5 million less workers to produce a greater value of goods and services than it did in December 2007 when the recession began.

We think these are important trends.

Importantly, they support the theory that abundance is now a key driver of an irreversible and global deflationary spiral that few economists and investors have yet to account for. A deflation which ironically leads only to further technological process and abundance — and thus a future where the need for savings, and stores of value, is increasingly diminished.

One just needs to look at the example of Japan's economic malaise in the context of the technological, savings and monetary trends which have accompanied it.

What's more, as the Khannas also observe, in an environment where robotised labour leads to an ever greater abundance of goods quality products and services, those services which can filter through abundance or personalise it will remain the last remaining profit zones.

This not only explains the strength of the luxury goods sector throughout the crisis but the move towards increased self-incorporation in areas where a vendor or service provider's quality, personalised skill and reputation is increasingly appreciated over what corporates can offer (note the power of reputation on Ebay, the power of personalisation and craft on Etsy, and so on).

As the Khannas note:

More fundamentally, we can transition to an economy where we work more for ourselves, each other, and in teams. A logical consequence of the financial crisis but also one that could be construed as a silver lining is the rapidly growing rate of self-incorporation. Over one-third of Americans are now registered as self-employed, becoming small businesses in a P2P economy of professional services and retail, or sub-contractors in growing sectors such as healthcare and data collection and analysis.

Our last observations are these:

If it is true that the system can increasingly provide a base level of existence for ever more people for almost no cost, should we be surprised that those western countries where a base level of existence is adequate — because of weather, surroundings and general environment — are the first to opt out of unnecessary human productivity?

Could the remarkable comeback of economies like Iceland post-bankruptcy be testament to the innate productivity of the system? Iceland's credit has already started to recover, a trend which suggests default stigma is much less important than you'd expect it to be.

Does bankruptcy even matter in an age of real abundance?

Might bankruptcy help to quash artificial scarcity, encouraging greater abundance and efficiencies, as people begin to see the merits of working for free?

Detractors of the theory will point to energy and resource constraints. But it's arguable that as more and more states are frozen out of global commerce they will increasingly look to each other to create their own barter-focused supply chains servicing their needs.

Meanwhile, there is some evidence to suggest that today's energy constraints are already not what they used to be. This is in part thanks to technological advances in such things as shale gas and is clearly demonstrated by the explosion of the natgas to oil ratio, the difference in the price of an energy resource which is routinely manipulated by a cartel around an artificial scarcity agenda and one which cannot be as easily bound in the same way.

We'll leave the discussion open.

We are keen, as ever, to hear your thoughts.

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The parable of water | FT Alphaville

The parable of water

Presenting an economic journey in felt, looking at whether the system's ails have more to do with an abundance of goods than a shortage of credit because of the system's technological advances and efficiencies. Move ahead to slide 20 for a snapshot of where we *think* we are today.

  • For water, read goods.
  • For receptacles, read money.
  • For receptacle production, read bonds.
  • For receptacle loans, read credit.
  • For ultimate receptacle authority, read government/central bank.

1) The water source.

Whilst the water flows, those who live nearest or those who have exclusive access to the water source are richest.

2) The water source stops.

When the water stops flowing all are equally unhappy. No one has an advantage.

3) Stores of water – receptacles – are invented.

While the water flows, those closest or with exclusive access are still richest.

4) Receptacles have value.

When the water stops flowing — in a scarcity environment — the man with the receptacles becomes richest and most powerful. He obtains his power and riches from having everything at a time when others have nothing.

5) Receptacles, receptacles, receptacles…

Those who live close to the water source, copy him and make their own receptacles. While the water flows, everyone near the source is equally happy.

6) My kingdom for a receptacle…

When the water stops, those with receptacles have an advantage over those who don't. Those with the most receptacles (including our original receptacle man) are the richest and most powerful.

7) The receptacle business

When everyone's receptacles run dry, only the man with the most receptacles is left in a position of power through his ownership of water. While the water has true value, the receptacles also develop value in their own right. Those with empty receptacles believe they are better off than those with no receptacles, since they can store water if and when it comes back. Those with surplus receptacles or the ability to create receptacles, meanwhile, induce demand for their own receptacles.

8) Receptacle growth.

Those with the ability to create receptacles can lend new receptacles to those prepared to return a portion of the water back when it is needed. Since there is a limited source of water, it makes sense for those who have water, and the means to create receptacles, to lend existing water only to those who can invest successfully in the production of more water.

The job of the receptacle creators thus becomes identification of those who will help restore production of water most quickly, but in a way that ensures they will get a share of the future flow of water.

Those with access to receptacles at no cost can choose whether or not to lend them out to people with no receptacles for a return.

9) Receptacle investment pays off.

When the water flows all are equally happy. All can participate in the collection of water. However, there is a caveat. Not all participants are equal. There are those who have their own receptacles (blue) and there are those who are using receptacles they have borrowed (green).

10) More receptacle growth, more happiness.

Because the man who has ability to create receptacles is not constrained in his ability to do so, he can keep lending receptacles to new participants. While the water flows everyone is happy.

11) Uh oh, not enough water — we have inflation!

If the man creates too many receptacles, he begins to threaten the water source. Since there are too many receptacles battling over the same water source, the flow of water becomes insufficient to fill all the receptacles to the top. Receptacle capacity isn't fully utilised.

The receptacle maker notices, and starts to think about ways he can forgo receptacles and control the water source directly for himself. Everyone, meanwhile, consumes as much as they can. There is a rush on the water source. The most powerful man diverts more flow towards himself, (possibly via an investment in a GSCI water fund that claims to have bought a reservoir.)

12) Receptacle debasement.

Everyone is less happy than when they had the ability to fill all receptacles to the top. As more and more water is cordoned off by "smart investors" there is even less water to go round, and ever emptier receptacles. The receptacles are debased. Even if you have a receptacle you can't fill it like you could before. Your receptacle will not be as useful to you as it was before.

12) Receptacle intervention!

In order to stop a receptacle crisis, the ultimate receptacle authority — empowered by the people — comes in to regulate affairs. He sees there are too many receptacles around the water source. He buys them to stop them being used. He encourages people to sell them to him by offering a return in water which is better than their current return. Those who have lent receptacles thus call in these receptacles. They then lend them or sell them to the ultimate receptacle authority for a better return. This is an attractive offer because the flow of water is much smaller now than it was before. They believe they will thus benefit from the claim to extra water in the future, since it will compensate for their inability to fill their receptacles to the top today.

This leaves those with receptacles happier. Their receptacles are getting fuller because less receptacles are competing over the same water source. They are also getting a better return on their investment than before.

Those without receptacles and without direct access to the water are very unhappy.

The gap between those who have and those who have not widens.

13) Investment in water flow.

When the water stops those with receptacles are happy. Those without receptacles once again look to borrow receptacles. Because there is no water the receptacle maker is encouraged to lend receptacles again in order for the water source to be revived.

14) The cycle repeats.

As the cycle repeats, more and more receptacles enter the system. They either circulate through the economy or sit unused at the ultimate receptacle authority. Either way the amount of water which is stored for when the source dries up increases. Collectively, there is a lot more access to water in the event that scarcity returns.

15) Collecting receptacle return.

While the water flows everyone is happy, especially those with their own receptacles. If the water stops, those with their own receptacles are happiest, since those who borrowed receptacles now owe them part of the water in their own receptacles.

16) The lower the rate of water, the greater the divide.

When the water rate falls, those with borrowed water receptacles will be left with nothing sooner than those with their own receptacles, since they owe a portion of their water to others.

17) Water returns.

Cycle repeats again. Even more receptacles enter the system. Every time they are created they allow more people to participate in the water source, and have the water for longer after it runs out. Those with their own receptacles get more and more powerful. As long as the number of receptacles is the system is managed in line with the water rate, the value of the receptacles remains a constant. There is equilibrium.

18) Water development beyond borders.

Soon enough others want to develop their own separate water sources, because they don't live near to the original water source. Since a lot of spare water and receptacles have been accumulated by the wealthy they are happy to lend beyond their borders for the prospect of greater returns, and the chance to diversify their water sources, to protect them in the event that their original source stops. Also since the recipients are poorer, and have no receptacles or water at all, they are prepared to forgo more of their water in return for the investment than local recipients.

Since this act depletes the number of receptacles and spare water in the original system, the ultimate receptacle authority steps in, releasing its own receptacles to the system, to keep that system in equilibrium.

19) Water, water everywhere.

As more and more receptacles are distributed through the system by the ultimate authority, and more and more water sources are developed, more people are able to participate in the flow of water when it comes on. More people are happier than ever before, as they all stand near to a potential water source and have a receptacle.

20) Depression

Those holding their own receptacles are less happy, because their advantage becomes less pronounced as more and more people get access to receptacles and a chance to participate in the water flow. They try to restore that advantage by buying up as many receptacles as possible, since it's all about who has most receptacles now. This prevents those people who worked on the water source from participating to its full capacity when it comes on.

The water capacity has been created but is not maximised because of a lack of receptacles.

21) Shortage of receptacles.

No matter how quickly the ultimate authority adds receptacles, the wealthy buy them up from the system just as quickly. As more and more full receptacles are hoarded by the wealthy for when the water runs out, their power increases. Those who stand near the water source with fewer receptacles, meanwhile, become increasingly less powerful. Instead of two receptacles per head, they now have to share two receptacles among six, which means some have everything, and some have nothing when it comes to satisfying needs at a time of scarcity.

Yet, for now the shortage of receptacles doesn't really matter because the water is still flowing. Everyone still has access to the water.

22) Fear of scarcity.

For as long as the water runs, it is the fear of scarcity in the future that drives those who have the means to collect and hoard as many receptacles as possible. Those who have previously lent receptacles call them back for fear they might not get them back otherwise. This contracts receptacle supply even more.

23) Things get complicated.

Since there is more than enough water flowing, no one with receptacles has an interest in developing yet more water sources, as this just dis-empowers their receptacles. They do, however, have an interest in more receptacles coming into the system, but only if they can be directed straight to them, rather than to those without.

Everyone is miserable because they think they won't have any receptacles for when the water runs out. The ultimate receptacle authority, meanwhile, cannot create receptacles quickly enough to compensate for those who contract and hoard supply. Fewer people near a water source have the means to store water.

As the flow of water picks up, more and more water is uncollected. More and more water goes to waste.

24) Abundance of water.

The problem for the receptacle holders is that the policy only works for as long as there is a fear of scarcity in the future.

If it becomes clear that the water source is not going to be depleted anytime soon, the cost of storing receptacles starts to increase, as they become increasingly irrelevant and less desirable.

In fact, because there is so much water, receptacle holders resort to creating artificial scarcity to restore the value of their receptacles.

They begin to block access to water sources in the mistaken belief that withholding supply will make their own receptacles more powerful when scarcity eventually arrives.

25) Austerity.

Eventually these endeavors manage to artificially contract the water supply enough to make the holders of receptacles appear very wealthy. The system prepares to reset, and new receptacle loans are called upon. But those with the ability to lend receptacles know that there is no incentive to invest in new water sources, because there is more than enough. The problem becomes an abundance of water.

They decline to make loans. More people go without. More people live directly from the source and learn not to depend on a store of water at all.

The ultimate receptacle authority tries to appease by pumping in new receptacles. But this threatens the value of the hoarded receptacles — a.k.a debasement of the full receptacles. Receptacle holders attempt to disempower the authority. They call for it to stop making new receptacles  on the basis that there is a scarcity of water and that borrowers will never pay back the premium they owe.

The authority cuts the premium and continues to pump receptacles.

The receptacle holders can no longer depend on a yield from their own receptacles, while the implied value of their receptacles goes down, even though there is no real scarcity.

They begin to support the value of their receptacles by releasing or contracting water supply. For this manipulation to be effective, the number of receptacles in the system must stay constant. They encourage the authority to stop manufacturing receptacles. On that basis the authority runs out of receptacles to lend to the system.

26) Time depreciation of receptacles.

All this time, however, the water keeps flowing. Water sources become ever more abundant and plentiful. It becomes increasingly difficult for the receptacle holders to constrain water supply and make it appear there is a water shortage.

With no water shortage, people depend on fewer receptacles. They begin to realise they don't need them. Holding receptacles itself becomes a burden. Not only do you get no return, you have to invest heavily in manipulating the water source to make it appear that the receptacles have value. This cost gets greater and greater as the abundance of water increases.

This cost is worth it, only if the water one day runs dry.

Inducing artificial scarcity becomes the order of the day.

In a last attempt to retain power, receptacle hoarders divert flows, create dams, destroy capacity, all the while encouraging as much water to go to waste as possible. They even start wars so as to encourage water to be redirected elsewhere, restoring genuine scarcity.

For a while people are duped by the false scarcity that's created, and the value of the water and the receptacles increases. Equilibrium is restored. A few become extremely wealthy.

27) Post-scarcity environment.

Yet if water abundance is great enough people will look around and see there is no scarcity. They will see they are better off than they have ever been.

Eventually, they will understand all the scarcity is artificial. They will also realise they have no need for receptacles, because receptacles have no value. You can live directly off the source.

As those with receptacles adjust to the realisation that they have no advantage over those with no receptacles, there is a crisis in the old system.

Ultimately, however, more people are provided with access to a constant supply of water than ever before, and on equal terms.

The crisis is only for those who used to have an advantage in the system.

Related links:
Space opera, beyond-finance edition – FT Alphaville
Debt jubilee for one and all — love, the Queen
– FT Alphaville
Post scarcity economy
- FT Alphaville

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Saturday, March 23, 2013

Stephen Williamson: New Monetarist Economics: The Balance Sheet and the Fed's Future

The Balance Sheet and the Fed's Future

The Fed's balance sheet has changed in important ways - both in size and composition - from what existed before the financial crisis. As well, other elements have been added to the policy mix. Most importantly, the Fed now pays interest on reserve balances. Taken together these changes work to make monetary policy work differently, in some respects. In other respects, policy actually works in roughly the same way, though one might think it would work differently. Changes in the balance sheet, and the payment of interest on reserves, will in the future matter for how policy decisions are made, and potentially for Fed independence. So it is important for us to figure out what is going on.

In January 2007, the Fed balance sheet looked like this (reporting only the essentials):

Total Balance Sheet, Jan. 2007: $859 billion
Currency: $820 billion
Reserves: $12 billion
T bills: $277 billion
T bonds: $502 billion

In the most recent (March 7, 2013) release it looked like this:

Total Balance Sheet, March 2013: $3,084 billion
Currency: $1,173 billion
Reserves: $1,748 billion
T Bills: $0
T Bonds: $1,756 billion
Mortgage-Backed Securities: $1,015 billion
Agency Debt: $74 billion

You can see clearly the nature of the changes in what our central bank is doing. The Fed is a financial intermediary - though it has some key properties that distinguish it from commercial banks, for example. Whatever intermediation the Fed is doing, there is much more of it now than in early 2007, as the size of the balance sheet has increased by a factor that is now getting close to 4. Indeed, if the Fed's current asset purchase program - which proceeds at the pace of $85 billion per month in purchases of long maturity Treasury debt and mortgage-backed securities (MBS) - continues until the end of the year, as expected, then the peak increase in the size of the balance sheet should be a factor of about 4.8 (nominal) using January 2007 as a base period.

As well, the composition of the balance sheet has changed - on the liabilities side, and on the asset side. In January 2007, the liabilities of the Fed consisted primarily of currency. Essentially, the Fed was providing a medium of exchange to people in the rest of the world (about 50% of the stock of U.S. currency is thought to be held abroad), drug dealers and other evasive types, and U.S. residents who still like to use currency in transactions. With the proceeds of currency issue, the Fed was financing a portfolio much more heavily-weighted (than is the case now) to short maturity government debt. In January 2007, the Fed held a substantial quantity of short-term T-bills, and the Treasury bonds it held were more concentrated than now in shorter maturities (average duration is not in the numbers above, but it has significantly increased).

In January 2007, a relatively small quantity ($12 billion) was held overnight in reserve accounts at the Fed. Reserves are used as a medium of exchange among financial institutions during the financial trading day. In January 2007, the average dollar quantity of transactions over Fedwire, the Fed's daylight payment system, was about $2.4 trillion per day, whereas annual nominal GDP in 2007 was about $14 trillion. If the average daylight quantity of reserves was $12 billion (not quite right, as $12 billion is overnight reserves, but it's in the right ballpark) in January 2007, then the transactions velocity of reserves at that time was 199. Compare that to an estimate of 1.5 for March 2013. This is the sense in which we are now awash in reserves. In January 2007, overnight reserves served no purpose but to fulfill reserve requirements, which banks were doing their best to avoid (through sweep accounts for example). With fed funds trading at 5.25% in January 2007, the opportunity cost of $12 billion in reserves held at 0% was substantial.

In January 2007, policy was implemented through the System Open Market Account (SOMA) as follows. The New York Fed would each day make a forecast of what the demand for reserves would be on that day, given the fed funds rate target it was attempting to hit, as per instructions from the FOMC. Then, the Fed would conduct open market operations - primarily using short-term government debt (even more specifically, primarily intervening in the overnight repo market). Thus, the idea was that moving the fed funds rate up, for example, required an open market sale of short-term government debt, adjusting for temporary and permanent shifts in the demand for reserves. A lot went into this intervention mechanism, including the cooperation of the Treasury in managing its reserve accounts with the Fed.

A key feature of the monetary regime that existed in January 2007 is that the size of the balance sheet mattered. Any asset purchase by the Fed would essentially be reflected ultimately in an increase in the stock of currency in circulation. The quantity theory of money was at work, with increases in the quantity of currency reflected ultimately in proportional increases in prices (everything else held constant). Of course there are short-run non-neutralities of money to worry about, and predictable and unpredictable shifts in the demand for currency. The latter factor explains why the Fed was in the business of targeting the fed funds rate and not some monetary quantity in order to control inflation.

It's also important to emphasize why monetary policy mattered - fundamentally - in January 2007. As mentioned above, the Fed is a financial intermediary, indeed a large one relative to other financial intermediaries that are active in US financial markets. Suppose, however, that the Fed had the same technology, and operated under the same regulatory constraints as private financial intermediaries. For example, suppose that the Fed were operating in early 19th century Scotland, or in Canada before 1935. Under those monetary regimes, private banks were permitted to issue circulating paper currency. If a central bank were to set itself up in such a monetary regime, and it were to issue currency as liabilities in order to buy government debt, that should have no important effects. Why? Because the central bank would have no special advantage in that type of financial intermediation over private sector intermediaries. Any actions by the central bank would be undone by profit-maximizing private banks.

Why did monetary policy matter in January 2007? Because the Fed has a monopoly over the issue of circulating currency. If the Fed essentially issued currency to buy government debt in January 2007, that would have been an activity that private financial intermediaries could not engage in. Explicitly or implicitly (there's some subtlety I won't get into here), private financial intermediaries cannot issue liabilities that look like Federal Reserve notes, or the stuff produced by the U.S. Mint.

Long-maturity government debt, while comprising a large fraction of the Fed's asset portfolio, did not play an important role in Fed policy in January 2007. The Fed would typically buy new bonds as old ones matured, and did not do much to manipulate the average duration of the SOMA bond portfolio (here I'm doing some guessing, as I have not seen the numbers).

Fast forward to March 2013. As mentioned above, the balance sheet is much larger than it was earlier, there are no T-bills on the balance sheet, currency has grown but reserves have grown enormously, T-bonds of longer duration play an important role in the portfolio, and the Fed is holding a large stock of MBS which are backed by private mortgages. The Fed not only looks like a bank - it's also an important mortgage lender. As well, since October 2008, the Fed has been paying interest on reserves at 0.25%.

What's important about the changes we have seen since before the financial crisis? I'll organize this as a series of questions, and the answers to those questions.

How does monetary policy work now? There's a sense now in which, at the margin, the size of the balance sheet does not matter. If the interest rate on reserves (IROR) stays fixed, then if the Fed purchases T-bills with reserves, that increases the size of the balance sheet, but should be irrelevant. That's a liquidity trap, which exists if there is a positive stock of excess reserves, whether the IROR is 0.25%, 5%, 10% - whatever. Why is there a liquidity trap? We're currently operating under a floor system, in which the IROR essentially determines the overnight interest rate - with some arbitrage frictions for institutional reasons - but in any case the IROR is currently determining short-term nominal interest rates. What's determining prices then? First, under this regime, short-term government debt is roughly identical to reserves held overnight, so think of those two assets as perfect substitutes. Further, reserves are convertible one-for-one into currency (by banks holding reserve accounts). Thus, in spite of the fact that reserves and short government debt bear interest (more as the IROR rises), all of those assets are essentially perfect substitutes given the IROR. Thus, think of the price level as being determined by the demand and supply for currency+reserves+short-term government debt. With a fixed IROR, an open market purchase of T-bills does not change the supply of the relevant asset quantity, and so nothing happens. However, increasing the IROR increases the demand for the relevant asset and reduces the price level. That's how we get inflation control in the current context. But notice something else important. If the Treasury increases the quantity of T-bills in circulation, that increases the price level. Under a floor system, fiscal policy actions have consequences for inflation, though of course that can be offset if the Fed moves the IROR in response - more T-bills, higher IROR.

But what if the Fed buys T-bonds with reserves, as it is currently doing on a regular basis? Clearly the T-bonds don't look like T-bills, which look like reserves. T-bonds yield a flow of future coupon payments, and a face value at maturity, which could be up to 30 years from now. But it's straighforward for a private financial intermediary to turn the T-bond into something that looks like T-bills and reserves. A special purpose vehicle (SPV), for example, could be set up by a private financial intermediary which purchases T-bonds, and finances its portfolio with overnight repos, that it rolls over. Those overnight repos look a lot like reserve accounts.

So, recall my argument from above about why monetary policy mattered in January 2007. It mattered because the Fed could do something the private sector was incapable of, or prevented from doing. Is the private sector capable of turning T-bonds into overnight assets in basically the same way the Fed does it? You bet. Future research might reveal an explanation, but none of the excuses to date for quantitative easing (QE) - e.g. "preferred habitat," "portfolio balance," "you just see it in the data" - hold water. If QE doesn't matter, then that's even more striking than the liquidity trap phenomenon I discussed above. What determines the price level in a floor system is the demand and supply of all assets that can be intermediated and transformed into assets that are used in exchange. Thus, asset swaps of reserves for government debt (of any kind) are irrelevant in a floor system, and the IROR is the only monetary policy instrument we should be concerned about.

The Fed's current predicament is that it has determined that the inflation rate is too low, but if the only policy instrument available is the IROR, there is nowhere to go if the Fed won't reduce the IROR below 0.25%. Even if it reduced the IROR to zero, that would have little effect. Mike Woodford is correct in recognizing that "forward guidance" is the only game in town right now for monetary policy, if the Fed wants more accommodation. However, Woodford's ideas are different from mine concerning how monetary policy works, and where the key current economic inefficiency lies. Our key problem is that there is a high demand for the whole spectrum of U.S. consolidated government debt - currency, reserves, short-term debt, long-term debt - relative to supply. The demand is high because the supplies of other safe assets in the world - asset-backed securities, the sovereign debt of other countries - have been destroyed, and are coming back very slowly. What is needed is a large increase in the stock of U.S. government debt outstanding. But that increase should be temporary, much like the temporary liquidity injections by central banks that solve short-term financial market problems. So what we would like is a deft injection of government debt, which can be withdrawn when the time is appropriate. Of course, this is just wishful thinking, as the U.S. Congress could not be characterized as deft.

Does the size of the Fed's balance sheet matter now? If we confine attention to pure economics, the answer is no. To start, one concern that seems to be floating about is that having the Fed pay interest on a large stock of reserves presents a problem, in part because the Fed is giving something away to private financial institutions - somehow subsidizing them. However, part (if not the only) motivation for paying interest on reserves is efficiency. Though the banking sector is highly distorted for various reasons, presumably paying interest on reserves increases economic welfare by removing a distortion. Are interest payments on reserves a subsidy? No more than the interest payments on the government debt represent a subsidy. Suppose, for example, that the IROR is 5%, in which case we would expect T-bills to be trading at an implicit interest rate of slightly less than 5%. If the Fed then swaps reserves for T-bills, basically the same financial institutions which were holding the T-bills would then be holding reserves, and there would be no economic consequences. However, the Fed would be paying more interest to those financial institutions, and the Treasury would be paying less. In terms of the flow of interest payments from the consolidated fiscal and monetary authorities (Fed and Treasury) nothing has changed.

The same arguments apply to purchases of long-term Treasury debt, though here the argument is a little more complicated. As discussed above, to a first approximation swaps of reserves for long-maturity government debt are irrelevant under a floor system. Thus, the size of the balance sheet is irrelevant - economically.

But the payment of interest on reserves matters for the flow of income from the Fed to the Treasury. The Fed is a bank that is in the business of managing its SOMA portfolio, maintaining the stock of currency, clearing some checks (a declining activity), and employing economists. The Fed is profitable - it pays its expenses, and basically returns what is left over to the U.S. Treasury. But historically most of the Fed's liabilities have been currency, which pays zero interest. In the past, issuing currency to buy T-bills would in itself turn a handsome profit, let alone purchasing long-maturity government debt. This leads to...

But is there risk associated with the current state of the Fed's balance sheet? Yes, but possibly not for the reasons you think. The Fed is currently even more profitable than it was pre-financial crisis. While the Fed is paying interest on a large stock of reserves, and the yields on the bonds in its portfolio are historically low, the IROR is only 0.25%, the Fed's asset portfolio is much larger, and the average duration of the portfolio is much higher, thus exploiting the upward-sloping yield curve.

If the Fed were a private bank, we might worry about what it is doing. The Fed is intermediating across maturities, and is now facing greater maturity risk than previously, given the longer average duration of its asset portfolio. But the Fed is not a private bank, and its liabilities are not standard debt claims. Neither currency nor reserves are a claim to anything. The Fed's "liabilities" are not promises of any kind, and so there are no promises to break - the Fed cannot default. Indeed, currency and reserves are more like private stock, with zero dividends. Just as with private stock, the Fed can buy back currency and reserves, by selling assets, and such buybacks will affect the value of the outstanding "shares."

But what happens if the Fed needs to tighten, increasing IROR? Is is possible that the Fed's income transfer to the Treasury could fall to zero? If so, for how long, and why would this matter? Fortunately, the Fed is thinking about this problem too. A recent paper written at the Board of Governors supplies the relevant institutional details, and gives projections of Fed income under particular assumptions about future interest rates and Fed asset purchases and sales. According to the projections, which possibly are too optimistic, the Fed will face a two or three-year period starting within a few years where transfers from the Fed to the Treasury fall to zero. If this happens, the Fed will begin booking "deferred assets," which are basically accounting entries so that the Fed's books balance. What will actually be happening is that the Fed will be relying on its ability to print money to pay its bills.

All of this is economically irrelevant, for reasons stated above. But of course it's not politically irrelevant. The Fed has enemies in Congress who would be all too willing to pillory the money-losing Fed and to curtail its power. The Fed understands this of course, and will do all it can to keep its income high. But that might mean holding the IROR at too low a level for too long, and thus risking excessive inflation.

Thus, the Fed has put itself between the rock and the hard place, and has gained little in the process. The expansion of the balance sheet through various rounds of QE and twisting has accomplished essentially nothing, and now the Fed could be faced with an unhappy short-run tradeoff - the risk of loss of independence vs. the risk of inflation.

Is higher inflation really a risk? If it were, why hasn't it reared its ugly head? Given my discussion above, we will get more inflation when the demand for total consolidated-government debt (currency, reserves, government debt) falls. This will happen as the prices of real estate increase in the U.S., the U.S. economy recovers further making bank lending more attractive, and as European governments in particular get their fiscal houses in order. All of this is occurring much more slowly than I think anyone expected, which is why we're not seeing a higher inflation rate. Perhaps the Fed is tougher than I think it is. Maybe that's why typical measures of anticipated inflation show no cause for alarm. But the majority of FOMC opinion seems on the reckless side to me - there's a willingness to experiment with grandiose policies which, in the case of large-scale asset purchases, have dubious science behind them.

What about targeted asset purchases? Charles Plosser, Philadelphia Fed President, has spoken (see this speech and this one) about the dangers of expansion in the Fed's perception of its mission. The Fed now has in excess of $1 trillion in MBS on its balance sheet - a quantity that exceeds the total value of the SOMA portfolio held in January 2007. Plosser - I think correctly - points out that the purchase of what are essentially private assets (MBS issued by Fannie Mae and Freddie Mac, with the MBS representing claims on underlying private mortgages) is dangerous for a central bank. If MBS purchases work as intended, then those purchases will act to redirect credit and resources away from other sectors and toward the housing sector. These obvious redistributional effects open the door for lobbying from various private-sector industries and individual corporations for help from the Fed. Either the Fed gives in to demands like that, or members of Congress and the Executive Branch could intervene to accomplish goals through Fed action rather than - more appropriately - Congressional action.

The Fed may yet dig itself out - those people are pretty smart. But I think there is plenty of cause for concern. I'm as interested as you are in the outcomes.

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Calafia Beach Pundit: The Fed is not "printing money"

The Fed is not "printing money"

The idea that the Fed is "printing money" with abandon, and that this is seriously debasing the U.S. dollar, is a fiction borne of ignorance of how monetary policy actually works. Fed policy may indeed pose the risk of serious debasement in the future, but to date there is little or no evidence to suggest that this has occurred.

The above chart is a graphical depiction of how the Fed's balance sheet (in simplified form) has changed over the past six years, from a time in early 2007 when the economy was growing normally (although the housing correction was just beginning), to the situation today. The major changes: on the liability side, relatively normal growth of currency in circulation (see below for details), and gigantic growth in bank reserves; on the asset side, the elimination of T-bills, strong growth in T-bonds, and unprecedented growth and holdings of MBS and Agency securities. Put another way, the Fed has purchased about $2.36 trillion of T-bonds, MBS, and Agency securities, shed about $280 billion of T-bills, and in the process created $420 billion of new currency and $1.7 trillion of new bank reserves.

As the chart above shows, currency has grown at a 6.8% annualized rate since early 2007, the same rate that we have seen for the past 20 years. Currency actually grew at a faster rate from 1993 through 2003 than it has in the past six years, and the former was a period when inflation averaged 2.5%. In the past six years, inflation has averaged about 2.2%. So the recent growth in currency is nothing out of the ordinary, and does not necessarily imply higher inflation than what we have seen in recent decades. It is also important to note that the Fed only supplies currency on demand, in exchange for bank reserves. Thus, the Fed cannot "force-feed" currency to the world. The world holds only as much currency as it wants to hold, so growth in currency is not necessarily inflationary at all.

In addition to currency in circulation, the other major component of the Federal Reserve's liabilities is bank reserves, shown in the chart above. Here we see enormous growth, orders of magnitude in excess of historical experience. In fact, the Fed has expanded bank reserves by a factor of 18 in the past six years. Isn't this the same as "printing money?" No, because bank reserves aren't "money" and can't be spent anywhere. Bank reserves exist only as a liability on the Fed's balance sheet. Banks can exchange their reserves for currency, and currency can be spent, but as we saw above, currency has not grown by any unusual amount. Banks have instead been content to hold on to the majority of the reserves the Fed has created. This is due to the fact that the Fed started paying interest on reserves in 2008, which makes reserves functionally equivalent to T-bills, and the fact that banks have wanted to increase their capital and fortify their balance sheets, and bank reserves fit that bill.

In effect, the Fed has been doing nothing more than swapping newly-created bank reserves for bonds and currency, and the world and the banking system have been happy to participate in the swap. The Fed has taken duration risk out of the market and supplied low-risk and highly liquid assets in return. In a post last December, I described how in a way the Fed has been acting like the world's biggest hedge fund.

Banks can exchange their reserves for currency if the public demands it, or banks can hold on to their reserves if they want to increase their capital and fortify their balance sheets. The only other thing banks can do with their reserves is to support an increase in their deposits. In our fractional reserve banking system, banks must hold about one dollar of reserves for each ten dollars of deposits. Banks are the only ones who can "print money," and that is done by extending credit to borrowers. Given the increase in bank reserves, banks could theoretically have increased their lending and their deposits (which currently total about $8.7 trillion) by a factor of 18, or over $150 trillion. Obviously, nothing of the sort has happened.

As the chart above shows, the M2 measure of the money supply has grown only slightly more than 6% per year for the past 18 years. Since early 2007, M2 has grown at an annualized rate of 6.5%, about the same as currency. Again, there is no sign here of any usually fast growth as a result of the Fed's enormous expansion of bank reserves.

The proof is in the pudding: inflation by any measure has been averaging between 2 and 2.5% for the past six years, with no signs of any acceleration. We are thus forced to the conclusion that the Fed has not allowed any undue expansion of the money supply. Whatever growth in the amount of money there has been has only been slightly in excess of the world's increased demand for money and money equivalents, and that is why inflation has been relatively low.

As the chart above shows, the world's demand for M2 money has been extraordinarily strong in recent years. Since early 2007, M2 has grown 26% more than nominal GDP, with the result that the ratio of M2 to nominal GDP has reached its highest level since the late 1950s. Monetary policy has been enormously accommodative, but at the same time money demand has been exceptionally strong. It follows that if the Fed hadn't been so accommodative, we could have suffered deflation and/or a weak economy, since the economy would have been starved for liquidity.

Since November 2008, the fastest-growing component of the U.S. money supply has been savings deposits, which have increased 68%, from $4 trillion to $6.7 trillion. The enormous growth in savings deposits has almost certainly not been driven by their attractive yields (which have been close to zero), so it must be due to an overwhelming desire for liquidity and safety. Consumers have been deleveraging and increasing their money balances to an exceptional degree because they have become more risk-averse. Most of the growth in the money supply has been due to an increased demand for money and safety.

And just as consumers have worked hard to increase their money balances, banks have been very willing to hold on to the extra bank reserves the Fed has created, as they have struggled to boost their reserves and fortify their balance sheets.

In a sense, the Fed has spent most of the past 5-6 years responding to an unprecedented increase in risk aversion, which has manifested itself in a tremendous increase in the demand for cash, cash equivalents, deposits, and bank reserves. This increased demand for safety and liquidity has been the flip side of an equally unprecedented decline in confidence and an increase in risk aversion.

All of this leads to the following conclusion: since the Fed's quantitative easing efforts to date have been only sufficient to satisfy a huge increase in the demand for cash, cash equivalents, and bank reserves, what will happen when the demand for safe and liquid assets declines? When confidence in the future returns? When risk aversion declines? Will the Fed be able to reverse its quantitative easing efforts in a timely fashion, before an excess of reserves and a declining demand for cash pushes inflation higher? As I mentioned in a post last December,

... the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

Stephen Williamson discusses this same issue in great detail here, but from a slightly different perspective. The common thread we share is that the thing to worry about going forward is a declining demand for cash, cash equivalents, and bank reserves, since that could result in higher inflation if the Fed fails to take offsetting measures (e.g., draining reserves and/or increasing the interest it pays on reserves) in a timely and potentially aggressive fashion. There is no a priori reason to think they can't, but there is certainly reason to be worried, since we are sailing in uncharted monetary waters.

Unfortunately, it's ironic and paradoxical that the Fed's efforts to supply additional reserves to the banking system—at a time when the banks have many times more reserves than they could possibly want—may be doing just the opposite of what the Fed intends. Instead of boosting confidence, the Fed may be contributing to worries about the future course of inflation and interest rates. More reserves are not going to increase bank lending, since banks already face zero constraint on that score. Will more reserves increase confidence, or will they just increase concerns about the future?

It's not clear at this point what will happen as the Fed increases its purchases of Treasuries and MBS and creates more bank reserves in the process. But as long as uncertainty exists—and the Cyprus bank deposit fiasco threatens to increase risk aversion in the Eurozone—the demand for reserves is likely to remain strong and inflation is likely to remain subdued. As for the economy, it looks like it is slowly healing and taking care of itself.

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Thursday, March 7, 2013

Where Are The Jobs? | Via Meadia

Where Are The Jobs?

One of the things they teach you in survivor school is that the wilderness is often full of food that city dwellers either don't recognize or are culturally conditioned to ignore.  Seeing a box turtle plodding through a forest glade, a fallen log teeming with termite grubs or a field of dandelions, the average city dweller doesn't instantly think "Lunch!"

America doesn't need to start eating turtles and bugs, but we do need a quick course in survival school.  We have wandered into new and uncharted economic territory.  Manufacturing jobs, once the mainstay of the American middle class, are hard to find — the foods we know best and like most aren't around.  Many people think that there are no more good jobs to be had and that in the absence of mass manufacturing employment we are doomed.

Some very troubling statistics give weight to these fears.  The Wall Street Journal reports that the total number of private sector jobs in the country fell by almost two million in the last ten years.  Citing a McKinsey survey that predicts — in its best case scenario — a net growth of zero jobs in US manufacturing through 2020, the Financial Times' John Gapper warns that labor market unhappiness could be here to stay.

The case for doom gets even stronger.  As Nobel prize-winning economist Michael Spence points out in the current issue of Foreign Affairs (paywall alert), a substantial share of American job growth in recent years has come from government and healthcare.  That can't last; government at all levels is cutting back, and the escalating costs of healthcare will force basic change in that system sooner rather than later.

It looks as if we are trapped: globalization is killing job growth in the tradable sector and we can't all work for the government or in healthcare.  Burger flipping, many conclude, is the wave of the future; the middle class is doomed, and American standards of living are bound to decline.

That could not be more wrong.  We haven't strayed into an economic Death Valley where only vulture funds and poisonous reptiles (like lawyers and hedge fund operators?) can thrive; we have entered a land of milk and honey — if we can only recognize the opportunities on every side.

There is much more room for growth in non-traded services than people think.  Last spring Matt Yglesias had an important post that offered a glimpse of the promised land.
In "The Yoga Instructor Economy" Yglesias pointed out that there will be a rising demand for personal services that can't be outsourced.  Dinners in fancy restaurants are more labor-intensive than burgers at McDonald's.  Yglesias continues:

Artisanal cheese is more labor-intensive to produce than industrial cheese. More people will hire interior designers and people will get their kitchens redone more often. There will be more personal shoppers and more policemen. People will get fancier haircuts.

That makes it sound like the new economy will be all about frills, but in reality much more serious forces are at work. Three in particular need to be taken into account: we are developing a surplus of both educated and uneducated labor, making workers relatively cheap; the drastic decline in the prices of computing power and bandwidth has changed our relationship to the world of information; the rise of the two-career family and the growing demands of the professional workplace have created a substantial group of families who are, comparatively speaking, money rich and time poor.

The internet made its appearance as a job-destroying engine of disintermediation.  America used to be full of travel agents.  Today many of them have closed their doors; with the internet, passengers could learn about potential destinations and book flights on their own.  But travelers did not want to be left on their own with the web.  Services like Orbitz and Priceline grew up, and we are now seeing the rise of 'vacation counselors' who help travelers plan richer and more rewarding vacations than they could have done on their own.

The explosion of data that is now available on the internet is not the same thing as an explosion of knowledge.  I can now access all kinds of information about any conceivable travel destination in the world, but much of this information is useless; I want someone to help me make sense of it all and to do it fast because I have no time to waste.

In the travel business,  the internet first killed off many of the old style travel agents but ultimately created a demand for value-added intermediation: someone who can distill the fire hose of information coming at you into something you can use.

Something similar is happening in the world of college admissions.  The internet has made it much easier to learn about and apply to colleges all over the country; it has also made it harder to choose the right one — and, thanks to the increased competition, the internet has made it harder for many students to get into the college of their choice.  First among the very rich and now spreading into the upper middle class, we are seeing the rise of a new profession of private college counselors who help steer families through this difficult process.

Value added intermediation is the rationale for a whole range of services that entrepreneurs will be building in coming years.  You might have a family tech agent that for some reasonable fee reviews and manages your communications life: helping you select the right phone package for your family's patterns and needs, advising you about major electronic purchases, making sure you get the most out of your equipment and software, serving as your tech back up and troubleshooting.  When something goes wrong you don't call New Delhi; you call the people down the street.

Similarly, many people would benefit from someone to help them navigate the healthcare system; somebody who understood your insurance, knew their way around the local medical system and was committed to helping you get the best treatment at the best price.  Many parents would like professional help at navigating the local school system: matching students with the right schools, navigating the intricacies of getting in, finding the right teachers, monitoring progress, troubleshooting, and otherwise helping their kids get the most out of their years in school.

Many people would like a much richer world of advice than they now get when they move to a new city or state.  Like a buyer's agent only more so, a relocation consultant would give you the advantage of a local's knowledge of your new home, and help you zero in on possible purchases that matched your criteria whatever those might be (potential for appreciation, protection from development, commuting time, good schools, proximity to recreation services and so on).  They would connect you with well regarded help ranging from painters to plumbers, provide support during the move — and perhaps give your kids some tips about how to fit in in a new environment.

It's also likely that many people will want to find fee-for-service financial help — people who do more than manage portfolios.  A full service financial person would advise you about everything from banking and credit cards to identity protection to insurance:  Do you save more with Geico, Allstate or Progressive?  Many people simply don't have the time to handle all this.  Somebody else might provide objective recommendations about major purchases like cars and appliances tailored to your specific circumstances and priorities — and make sure you get the best model at the best price.

There are other niches where businesses of this kind could flourish.  Older people could have increasing support in their efforts to stay in their homes.  Governments might contract small firms to provide assistance to the disabled or to those with special needs.

Value added intermediation in all these cases has the potential to make life easier and smoother for clients — while creating new categories of professional employment for the self-employed entrepreneur.  Whether you are a children's birthday party planner, a personal infotech manager with a string of clients or a family office providing a range of financial, notarial and legal services to middle and upper middle class families, you are earning an independent living by building, marketing and using your skills.

The internet and the knowledge revolution allows these new professionals to acquire knowledge cheaply on the net, add that to their knowledge of their clients' needs and their experience with similar problems and then go on to produce information of a quality and usefulness that clients could only duplicate by investing a lot of effort and time.

In past years, this kind of personal help was available to the super rich, many of whom maintain family offices.  Historically progress comes as goods and services once reserved to the wealthy become available to broader segments of the population.  The industrialization of knowledge on the internet now makes it possible for middle income families to get far more help far more cheaply than ever before.

These jobs will be in non-traded services and they will often be locally based.  The neighbor who perhaps runs one of these businesses as a family enterprise out of their home gets and keeps clients based on personality, familiarity with local conditions and the ability to provide a good product at a fair cost.  There will be different skill levels involved; it's likely that a healthy small business in one of these fields would have several employees at various skill levels and different levels of seniority.

Thanks to the steady declines in computing and bandwidth prices, these businesses do not need to be highly capitalized.  With a computer, a good internet connection, and a home office, you are well on your way.  The low capital cost plus the importance of local knowledge and deep familiarity with the needs of your customers makes this field a natural one for entrepreneurial start ups.

Families will not be the only customers for small, locally-oriented knowledge-based companies.  Small business consultants can do everything from helping small businesses get the most out of technology to helping them source purchases or market to specific local communities.  More and more sophisticated and useful accounting, marketing, planning and management techniques can be made available to smaller businesses at less cost as time goes by.  The key once again is value added intermediation.  The intermediary specializes in recognizing, evaluating and acting on information and so is able to find useful information for the client faster and more cheaply than the client can do on his own; that difference in costs makes profitable B2B web based services practical.

It is likely over time that many of these businesses will become very sophisticated — and that their proprietors will be well compensated for their expertise.  Medical service groups in particular have the ability to grow into very successful practices while improving patient lives and medical outcomes. In some cases this business model might become the kernel of a new kind of medical practice, with licensed medical practitioners at various levels helping clients review their options and cope with what is certain to become a much more complicated and expensive medical process as time moves on.

The model of value added intermediation may also provide a business model for small law practices looking for new ways to thrive in a changing profession.  Putting legal advice into a package with other kinds of advice and information would help firms attract a larger customer base than the law alone.

Yglesias' yoga instructors, chefs and artisanal cheese makers will be part of the growth in the new service sector, but they won't be alone.  The internet has destroyed a whole series of professions and profoundly transformed others.  It is also creating opportunities for new and unfamiliar business models and professional practices that the next American generation will need to explore.

These may not look much like the jobs we are used to, but if we learn to recognize and exploit the opportunities around us, we will soon become much more comfortable in this strange new land we've reached.

(This post is the first in a series looking at the future of the American middle class.  As always, the responses of readers to this blog will help me think through and review these ideas.)

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