Courtesy of Tyler Durden
In his latest letter Van Hoisington cuts through the bullshit and asks the number one question (rhetorically): why are bank excess reserves (aka the ugly, liability side of Quantitative Easing) still so high. He answers: “Either the banks: 1) are not in a position to put additional capital at risk because their balance sheets are shaky; 2) are continuing to experience large write-downs on commercial and residential mortgages, as well as on a wide variety of other loans; or 3) customers may not have the balance sheet capacity or the need to take on additional debt. They could also see no expansionary prospects, or fear an uncertain regulatory future. In other words, no viable outlets exist for banks to loan funds.” Which leads him to conclude quite simply that while risk assets may hit all time highs courtesy of free liquidity, the economy, also known as the middle class, will be stuck exactly where it was before QE2… and QE1. Van also looks at that other critical variable: velocity of money – “Velocity is primarily determined by the following: 1) financial innovation; 2) leverage, provided that the debt is for worthwhile projects and the borrowing is not of the Ponzi finance variety; and 3) numerous volatile short-term considerations.” As an uptick in velocity is critical for any wholesale reflation (as opposed to merely hyperinflation) plan to work, this is one metric Van is unhappy with. Lastly, Hoisington also looks at the fiscal headwinds facing the country (which more so than anything terrify the Goldman economics team), and presents his vision on the bond-bubble argument.
Hoisington Investment Management
By Lacy Hunt and Van Hoisington
October 8, 2010
Despite extreme economic intervention by federal authorities, real GDP has increased by a paltry 3% since the recession ended in June 2009, less than half the 6.6% average growth in the comparable periods of the prior ten recoveries.
Inventory investment, a trendless component of GDP, has accounted for nearly two-thirds of the entire rebound in economic activity from the worst economic contraction since World War II. Over the past four quarters, inventory investment has moved from contracting real GDP at a 5% annual rate to boosting it at a 2% annual rate. Real final sales (GDP less inventory investment) grew at a very meager pace of 1.1%, less than one-fourth the average 4.5% rate of increase in the comparable rebounds. Whether measured by GDP or final sales, economic growth needs to expand at least at the pace of population growth to sustain a steady standard of living. In this rebound, per capita real final sales grew by 0.2%, much lower than the earlier ten postwar expansions when the growth in real per capita sales was a robust 3.2%. Thus, the U.S. standard of living has remained stagnant at a very depressed level. The upward inventory thrust is complete, and probably over-extended (Chart 1).
The problem with the U.S. economy is fourfold: 1) The economy is grossly overleveraged, with many asset prices falling; 2) fiscal policy is counter-productive and debilitating to economic growth as government expenditure multipliers are near zero; 3) proposed tax increases are already curtailing economic activity and tax multipliers approach -3%; and 4) increased bureaucracy with many new and yet unwritten regulations from the Dodd-Frank bill, along with health care regulations, make business planning nearly impossible.
With existing excess liquidity in banks and companies, and the above-mentioned key economic problems, it should be clear that QE2 and the purchases of additional assets by the Fed will, like previous purchases in QE1, serve only to bloat excess reserves without advancing income, spending, or jobs. From this point in the cycle, for QE2 to generate expansion, money growth and therefore debt levels would have to rise.
According to economist Hyman Minsky, there are three phases of credit extension: hedge finance, speculative finance, and Ponzi finance. In view of the extremely leveraged conditions, additional credit would be almost exclusively of the Ponzi finance variety – loans with no reasonable prospect of repayment. Indeed, Ponzi finance appears to typify the bulk of the loans being made by the Federal Housing Authority to unqualified home buyers, replicating the practices underwritten by FNMA and Freddie Mac during the heyday of the sub-prime lending extravaganza whose consequences linger. But, for the purpose of argument let’s assume that with additional excess reserves the banks lend to other potential Ponzi-like borrowers. This could lead to an increase in the money supply, but the net result may still not stimulate faster growth in GDP because velocity would fall, as it did from 1997 to 2007 (Chart 3).
The Velocity Impediment
For a rise in excess reserves to boost GDP, two conditions must be met. First, the money multiplier must become stable. Second, the velocity of money must not decline. The second condition is not likely in view of the theory and history of velocity. Velocity is primarily determined by the following: 1) financial innovation; 2) leverage, provided that the debt is for worthwhile projects and the borrowing is not of the Ponzi finance variety; and 3) numerous volatile short-term considerations.
Since 1900, M2 velocity has averaged 1.67, and has demonstrated distinct mean reverting tendencies (Chart 3). Velocity has been declining irregularly since Ponzi finance took over in the late 1990s. For leverage to lead to an expansion of velocity the loans must meet the requirement of hedge finance, i.e., where there is a reasonable expectation that the borrower can repay both principal and interest.
Fundamentally, the secular prospects for velocity have not improved even though velocity recovered by 2.1% in the past four quarters. This marginal uptick in velocity reflected an assist in federal spending along with the unparalleled recovery in inventory investment discussed previously. Without the gain in these two GDP components, velocity was unchanged over the past four quarters (Table 1).
Based on the Fisher equation’s superior analytic approach for determining value in the bond market, investors are still able to purchase long-term Treasury securities at prices which do not yet reflect their positive long-run potential.
Van R. Hoisington
Lacy H. Hunt, Ph.D.