Some interesting presimetrics

I did some interesting "Presimetrics" yesterday - the study of the economy under various presidential administrations and the title of a book written by Mike Kimel. Since I prefer to use Real GDP per Capita as a measurement for economic success and failure (a decline in annual Real GDP per Capita being my definition of a recession) I decided to check up on how the post-war presidents have performed. I don't know if Mike Kimel did this in his book (which I have sitting in a box in my garage) so please excuse me if I have discovered something that Mike has already pointed out.

My study started with the desire to measure economic performance under Obama against GW Bush. Of course the problem with such comparisons is that Obama has not been in office for as long as Bush had been, so I had to measure according to how many quarters each president had served and divide economic performance by those quarters. The result was very interesting - Real GDP per capita under Obama has grown by 0.29% per quarter while under GW Bush it grew by a paltry 0.19%. Encouraged by this interesting result (Newsflash: Economy growing faster under Obama than Bush!) I decided to go back and compare everyone since Eisenhower. This is the result:

By way of methodology, I access the data on Real GDP, then divided that number by the population at the end of each quarter (with 2011 population data being mid-monthly) to get a Real GDP per capita figure. I then measured the change in Real GDP per Capita from the first quarter of the president's first term in office against the final quarter of his final term in office. For Johnson and Ford, I measured the first quarter in office as the quarter they became president, which means that Kennedy's and Nixon's last quarter in office was followed by the quarter in which they ceased to be president. Once I measured the change in Real GDP per Capita as a percentage, I then divided it by how many quarters the president spent in office. So what do we find?

Obama - 0.29%
Too early to tell but there has certainly been a growth in Real GDP per Capita faster than Bush II. I am predicting another recession, so I expect this number to drop over time. Moreover Obama's result has the statistical advantage of an economic trough being followed by a recovery.

Bush II - 0.19%
His presidency was bookmarked by recessions and there is no doubt that the 2008 credit crisis affected his result badly. A quick check of the spreadsheet tells me that up until 2007 Q4, Bush's performance was 0.38% per quarter.

Clinton - 0.71%
Do we miss the 90s yet? In hindsight economic growth during Clinton's time in office was based upon the unsustainable dot-com bubble. if we measure Clinton's performance to 1994 Q4 (the quarter before the bubble began to expand), growth was lower at 0.56% which is, however, a reasonably good result.

Bush I - 0.18%
GHW Bush's result suffers from a recession at the middle and end of his single term, but even if we factor that out his performance from 1989 Q1 to 1990 Q2 the result is 0.31%. I'm wondering if GHW's figures suffer from a bust from the Reagan years (though some conservatives would argue that his "read my lips, no new taxes" taxes killed it)

Reagan - 0.62%
From memory, studies into Real GDP show that Reagan's years weren't that good. Per Capita, though, the results are worth talking about. Yet while Clinton's higher growth came at the expense of a sharemarket bubble, Reagan's growth came at the expense of the public debt. In essence, Reagan borrowed against the future to boost the present. Now that the present is Reagan's future, I would argue that we are reaping now what Reagan and congress sowed back in the 1980s. Also, let's not forget Paul Volcker - killing inflation really did stabilise the economy in the 80s.

Carter - 0.47%
Malaise never had it so good. The further into the future we get the more we realise that Carter's presidency was better than what was believed. "History's greatest monster" he was not. 0.47% growth was certainly not as good as other periods in postwar history (and certainly not as good as Reagan) but is certainly better than both Bushes, Ford and Nixon.

Ford - 0.42%
Not a great sample size admittedly (10 quarters, or 2½ years) so we could probably add this onto Nixon. Certainly not a great number compared to previous years but better than recent times.

Nixon - 0.44%
What happened here? Nixon inherited some of the strongest growth on record and managed to halve it. Two recessions (1970 and 1974) damaged it severely. We also shouldn't forget the first oil crisis as well. Barring any further evidence of economic stupidity, I don't think Nixon is responsible for such low growth in this period.

Johnson - 1.00%
The postwar US economy grew fastest on a per capita basis under Johnson. This was aided by two wars - the war in Vietnam and the war on poverty. While military expenditure created a demand for labour, conscription created a shortage of it. At the same time wealth was redistributed via poverty reducing policies and the creation of Medicare. And this was done without a huge increase in public debt.

Kennedy - 0.97%
Obviously the Johnson growth had its basis in Kennedy's 11 terms in office, though Vietnam was not as prominent in calculations here. We also need to factor in the effects of substantially better transport infrastructure, thanks to Eisenhower.

Eisenhower - 0.14%
This has to be one of the most interesting results of all. It is generally believed that the 50s saw an economic boom but what we see here is something different. Under Eisenhower, real GDP grew from $2.3484 to $2.8002 trillion, a total growth of 19.24%. But per capita figures divide this by population. Under Eisenhower, population grew from 159 million to 182 million, a total growth of 14.24%. So while the economy undoubtedly grew, the sheer number of baby boomers born in that period reduced GDP per capita something severe and thus skews the figures.

An analysis of the past 30 years

So I was playing around with my spreadsheet and some numbers recently and decided to work out just how much money has been invested in the sharemarket as a proportion of GDP. Of course we remember the time when the Dow hit 10,000 and unemployment was low - but it's currently over 10,000 and unemployment is high. This should indicate something strange going on, not to mention question the idea that the Dow represents the economy.

I couldn't use the Dow index, though. Instead I decided on the Wilshire 5000, which is an index that a) encompasses all shares in all publicly traded markets in the US, not just the top performing ones, and b) comes up with an index number that also closely approximates the dollar value of the entire sharemarket. For example, the W5000 index for 2011-08-18 (last Friday) closed at 11806.16, which approximates $11.8 Trillion. Historical numbers of this broad index can be found at St Louis, as always. So what happens when you look at this index and compare it to GDP? This:

By way of comparison, throughout the 1970s this index averaged around 56% of GDP, and swung between 38% and 83% of GDP. The 1980s and half the 1990s thus saw a W5000 performance not too different from previous experiences. Then from 1995 onwards we have the tech boom, which peaks in 2000 Q1 at over 140% of GDP. Yet there was no decline back to the sub 80s for the long term but a re-inflating of the bubble from 2003 Q1 onwards (which, by the way, occurs around the same time as the Federal Funds Rate drops from 1.75% to 1.25% and then 1.00% for the rest of 2003). A second, lower, peak is reached in 2007 Q2 (108%), which then plunges back down to 58% in 2009 Q1 as a natural result of the 2008 credit crisis. Since then it has re-inflated back up to 92% of GDP in 2011 Q2. Of course, there is a huge chance that this number is going to crash down again.

What appears to have happened is simple - there has been a sharemarket investment bubble that has inflated since 1995 and which has yet to be properly dealt with. My belief is that the higher the sharemarket value to GDP ratio is (as demonstrated by the graph above) the more chance there is of a bust and a damaging recession. Either the sharemarket needs to crash down or GDP has to increase to ensure a more sustainable level. Anything below 50% of GDP should be a policy goal. This can be achieved through a Tobin Tax or a Market Capitalisation Tax imposed upon the sharemarket - with taxation rates increasing the higher the ratio gets in order to prevent runaway over-investment.

This issue also reveals shortcomings in monetary policy. While monetary policy affects the entire market, it affects the financial market and its behaviour directly through its operations. If the market is in the process of over-investing, then all monetary policy ends up doing is re-inflating the bubble, rather than mitigating liquidity issues arising from a deflating bubble. Ideally monetary policy in this situation should create a "soft landing" for the deflating bubble - but in practice it has simply re-inflated the bubble and, as a result, postpones the bubble bursting to a later date.

This issue also reveals shortcomings in fiscal policy. Tax cuts for the rich have not resulted in a substantial increase in money velocity but rather a further investment into the share market.

Finally it also appears that our current economic state is the result of the tech boom's bust. We're paying now for decisions made by the financial market up to 16 years ago. While it is true that the 2008 credit crisis had a more damaging impact upon the economy and upon unemployment than the 2001 recession, we can trace back the credit crisis to the tech boom.

Now the second graph to look at concerns personal saving. I've based this upon the St Louis Fed PSAVE series which measure the dollar amount of personal saving. I've then compared it to GDP. What has happened since 1981? This:

By way of comparison, between 1951 and 1980, the ratio of personal savings to GDP averaged 6.04%, with the lowest being 3.86% in 1951 Q1 and the highest being 9.28% in 1975 Q2. The average between 1980 and today has been 4.27%.

So since 1980 personal savings as a percent of GDP has dropped. In fact it dropped below the 4% level on a more or less continual basis since... 1995 Q2. Now where have we heard of that quarter before? Oh yes... that was when the sharemarket tech bubble started. In recent years the savings ratio has tried desperately to rise above 5% but has gotten no further than 4.84%

My belief is that too much personal savings is bad, but that too little is bad as well. If we assume that the 1951-1980 period was a better period for personal saving then obviously it should increase in these times. But it hasn't. Why?

The first is that we need to look at personal saving at the same time as we look at sharemarket investing. As sharemarket investing has grown so has personal saving dropped. This indicates that people are investing more in the share market than they are in cash.

The second reason is that GDP has grown substantially in response to sharemarket investment. While it has created a "virtuous cycle" for part of that time, it means that ordinary people have had less money in proportion to GDP for them to save.

But here's another graph: Public debt.

One rule of thumb that people over the years have believed in is that when the government goes into debt, the private sector begins to save. Yet this doesn't appear to be true when it comes to personal saving. Since 1980 personal saving as proportion of GDP has decreased, while US government debt has increased. If the rule of thumb worked, then why wasn't there an increase in personal savings?

Well in one sense there was an increase in personal savings - investing in the share market. Share market investing, because it became so attractive, took money away from cash investment.

And the fourth graph is interesting too: The balance on the current account.

By way of comparison, the period between 1960 Q4 and 1979 Q4 saw an average current account surplus of 0.26% of GDP, with a high of 1.06% of GDP in 1975 Q4 and a low of -0.87% in 1978 Q3. Since 1980 the current account has averaged around -2.58% per year, with a high of 0.05% in 1991 Q4 and a low of -6.11% in 2006 Q3.

The first thing to note is that the first drop in the current account between 1984 and 1988 occurred during a time when the US Dollar increased in value. The Plaza accord was signed in 1985 Q3 to reduce the value of the US Dollar. This eventually saw the current account reach a trough in 1987 Q2 and begin to rise again.

The 1997 Asian financial crisis then saw a rush of investment into the US Dollar, which began rising again. By 1998 Q3 the current account had dropped past -2% of GDP. Since then the current account has been deeply negative.

We need to remember that the world cashed in on America's sharemarket boom as well. The current account deficit hid inflation and prevented any meaningful tightening of monetary policy to rein in the asset-price bubble that had formed.

In light of this, what would OSO do?

1. Institute a Tobin Tax or Market Capitalisation Tax to dissuade over-investment in the sharemarket. Rates would be increased the more the market over-invests. This money would, at the moment, be useful in paying off government debt.
2. Create a currency board to control US currency. This would not be an abandonment of a floating currency and nor would it be a return to Bretton Woods. Instead a currency board would act to ensure a balanced current account by entering the Forex market and either buying or selling US dollars in response to current account fluctuations. The US would also take the lead in creating a new world trade agreement to ensure that all major industrialised nations would institute currency boards to do the same thing for their own currency zones: ensure balanced current accounts (rather than current account deficits or surpluses). I go into more detail on this idea here.
3. Create more broad-based monetary policy to ensure a wider scope for its effect: Quantitative easing needs to do more than just buy back government bonds - it could also be used to directly fund treasury, to create banks or even be used in Keynesian stimulus programs.
4. Regulate the financial industry to dissuade the ponzi-like nature of modern financial investment. More details here.
5. Expand government services with a commensurate increase in taxation to create another "New Deal". A minor "Total War" economy needs to be examined again, though with money being spent on growth (and obviously the environment and global warming) rather than on military equipment and wars. More details here.
   

US Recession Indicators - August 2011 - Market turmoil edition

According to data from negative Real Interest Rates, another US recession is likely to occur between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely... See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has remained high at 572 in July 2011.

As a result of recent market turmoil the numbers for August will be very interesting indeed. Since a recession will not occur until this spread turns negative, and since one indicator shows that a recession will occur within 18 months, we can assume that this indicator will begin to drop down over the next few months. Inflation has already picked up again and, at 3.6%, is the highest it has been since October 2008.

Nevertheless since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

I have factored in recent market turmoil in this indicator. While July 2011 ended well with a reading of 293, the turmoil in recent weeks has seen 10 year bond rates drop nearly 100 basis points from 3.00% to 2.08% by the close of trading on 2011-08-18, which has led to a mid-monthly reading of 195. If this indicator stays true to its historical data, then there will be one of two events leading up to the beginning of the recession. The first is if the Federal Reserve will keep the Federal Funds rate effectively at zero, which it will do barring any major inflationary outbreak. If this occurs then 10 year bond rates will drop to zero as well, or at least converge to within a few basis points. This appears to be the situation currently. The second event will occur if the Federal Reserve increases rates in response to an outbreak of inflation. If this occurs then the Federal Funds rate will exceed the 10 year bond rate, thus placing the indicator into negative and presaging a recession. Inflation has been increasing markedly in the last six months, so this event may yet be the result. As far as I know, 6% inflation seems to be the new Fed goal so any change in the Federal Funds rate will have to see inflation increase beyond this amount.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Real ten year bond rates came in at -0.43% in July. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.
Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Market Capitalisation adjusted by USDX

This is a new index based on some playing around with a spreadsheet. The idea is to adjust the Russell 2000 - the indice that measure market capitalisation (amount of shares multiplied by share price) for the whole market - by the US Dollar Index. This would, in turn, measure the value of US market capitalisation throughout the world, rather than just the US.

As you can see there appears to be a "line of resistance" that has formed since 2000. The high of 532.12 was reached in August 2000. The second high of 417.43 was reached in May 2007 while the third high of 351.4 was reached in February 2011. The 2000 and 2007 highs were followed by a recession and it looks as though the 2011 high might be followed by a recession too.

I'm still trying to work out if this is just a coincidence so take this indicator under advisement. Before 2000 such "lines of resistance" didn't seem to apply when looking at recession indicators. Note also that the most recent index number (286.01) is a mid August figure based upon figures from close of trading 2011-08-18.

(The orange line is the recession line, the red line is the line of resistance)

Data Sources

US Dollar Index
Russell 2000

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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The Man in Me

Bob Dylan - The Man in Me - Lebowski from 43hk0804c26qsi8w on Vimeo.

Why not create new banks from QE3?

Banks are unique to an economy. They are the creators of money, via the fractional banking system. How banks use their money greatly affects the way the economy runs.

Currently banks are sitting on $1.6 trillion in excess reserves. Excess reserves have always been a part of the banking system but not in the amounts seen since 2008 Q4. The sheer size of these reserves has hobbled monetary policy - every dollar sat on by banks in excess reserves is a dollar that has effectively been removed from the economy.

Why are the banks sitting on so much money? The answer is that they are suffering from an increasing amount of insolvency. They are Zombie banks, whose net worth is negative but who continue to operate. As Paul Krugman and others have pointed out, monetary policy is only effective in a liquidity crisis, not a solvency crisis.

Obviously these banks need to stop sitting on their reserves and begin lending again. If they lent their money out, the fractional system would gear up, increase money velocity and create enough money for the banks to operate their way out of insolvency. Ironically, the banks' response to the crisis is, in effect, perpetuating the crisis.

But there is a solution - new banks must be formed.

New banks, created without any solvency issues, have no real reason to sit on excess reserves. But new banks are usually created by the market itself. Since the market isn't creating any new banks, then new ones must be created by government: Congress, Obama and the Federal Reserve acting together.

Now it's not as though the government would own these banks long term. The idea would be to create them and privatise them as quickly as is practicable: onto the share market within 12 months of their creation.

But where would this money come from? Are we going to increase government spending and thus taxes? Well if the Fed is going to indulge in QE3, it might as well use the money it creates out of thin air to create something solvent and profitable, rather than prop up institutions that are insolvent and unprofitable.

The Fed's Quantitative easing program involved the Fed creating money out of thin air (by fiat) and then using that money to buy back government securities. Yet this process was hobbled by the Zombie banks because much of the money created in this process ended up in excess reserves. QE2, for example, resulted in excess reserves increasing from $971 billion in November 2010 to nearly $1.6 trillion today: that's around $600 billion in fiat money - the entire QE2 amount - that went nowhere.

But what if that $600 billion was spent capitalising a series of new banks? With no solvency issues to encourage excess reserves, these banks would've used their capital more freely. With QE3 a distinct possibility, why not direct the money at creating new banks?

There is a historical precedent here: The First Bank of the United States, formed in 1791 by congress (see pic above). Although this bank was essentially an 18th century version of a central bank, it did have direct market operations in lending money to the market, borrowing money from the market, and taking deposits. It was also created to be purchased by the market in the form of shares. Moreover, the precedent of creating a bank, coming almost immediately out of the formation of the first congress by the founding fathers, should prevent any complaints by political conservatives that such an action would be unconstitutional.

If we assume that these new banks do get created through the QE process, what of the Zombie banks still out there in the marketplace? My suggestion is that they should be allowed to permanently die - to be declared insolvent and shut down, with deposits (backed by the government) being shifted to newer and/or more solvent banking institutions. While killing off a Zombie bank would have a negative effect upon the market if it was done in isolation, killing them off while new banks are growing and blooming would be more sustainable.

(I wrote about this before in November 2010)

The US Government needs more revenue

Oh dear, Standard and Poors rating agency has maligned the US by dropping its Triple-A bond rating. Strangely enough this event has brought both progressives and conservatives together in maligning the rating agency itself, which is a fair call considering the cluelessness of ratings agencies generally in failing when 2008 hit.

Nevertheless there is a rather huge reason for the US being downgraded. I just played around with another spreadsheet comparing US and Eurozone debt, and I get the following:

Okay, first of all you need to understand that this is an index - everything is assumed at 100 at the beginning.

Secondly, these numbers are based upon total government spending and revenue, which includes Federal, State and Local government. This is to ensure that US oranges are being measured against European oranges. You can find US figures here (on pages 345 & 347 of 360) and European figures here.

Thirdly, also understand that while these figures have been indexed, the difference between Eurozone and US revenue and spending as a percentage of GDP is substantial. In the Eurozone the two figures are around 50% of GDP spending and 44% revenue, while in the US, the figures are around 25% spending and 15% revenue.

Fourthly, the figures for EA17 and EU27 are pretty much the same, which is why I didn't include EA27 (the entire European Union) in the graph.

So what can we learn?

The most important line in that graph is Eurozone revenue, the orange line in the middle. Despite the onset of the GFC, despite the tumult at the so called "periphery", Eurozone revenue has only dipped slightly. This means that the deficit, the space between revenue and spending, has been mainly caused by increased spending. Thus in a recovery, spending would drop off as the unemployed return to work while revenue from income tax would increase.

The second most important line in that graph is US revenue. The financial crisis since 2008 has decimated US tax revenue. Previous to 2008, US revenue and spending were around the same level (though obviously with less revenue than spending) but since then there has been a massive drop off in revenue. And while State and Local governments have certainly added to this, the main offender is the Federal Government. A recovery, therefore, would have to be more substantial for the US to ensure that the deficit is paid down.

This is not to say that Europe isn't in trouble. Nor does it ignore the fact that certain European nations have huge problems. Nevertheless in light of the recent debt wrangles in Congress you can understand the fragility of the US economy, the downgrading of debt and China's angry response to the problem.

However the biggest problem here continues to be the Tea Party Republicans and their decision to flatly refuse any revenue raising policies. When seen in light of the graph above, such an extremist position is seen for what it is: madness.

There's one more piece of bad news: since the chances are high that another recession for the US is on its way, we can expect the US budget deficit to widen even further before the end of 2012. While the debt ceiling has been raised enough to prevent any congressional wranglings before next year's presidential election, the question now is whether the new recession will blow government finances out so badly that another debt ceiling vote is needed before the election. God help us.

Another recession? I told you so.

There have been some very severe financial fluctuations in the past 24 hours. I won't even bother linking to any news or financial sites because you know it already. Here in Australia a number of very respected people are saying that this is the beginning of another financial crisis that will inevitably lead to another recession.

At the risk of sounding unbearably smug I have been predicting such an event. To be honest, though, I didn't expect the sudden crunch happening now. Moreover I wasn't basing my prediction upon "gut feeling" but upon data.

It all started back on 2011-06-17 when I wrote a post entitled A Recession indicator has been triggered . This was not just an important predictive event but also an important step in my own understanding. The fact is that for some months now I have been publishing a series of posts called "Recession Indicators". What happened was that my own study of real interest rates seemed to prove conclusively that whenever real 10 year bond rates (10 year bond rates minus inflation) went negative, a recession was inevitable. This is what I said:

What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%... if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Then on 2011-06-24 I published the June 2011 recession indicators where I said

According to data from negative Real Interest Rates, another US recession is likely to occur between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely.

Then on 2011-06-29 I published another post entitled Real Interest Rates are predicting an upcoming recession. Between this post and the previous one I had refined my study of real 10 year bond rates - averaging them out over a 3 month period in order to iron out a statistical "bump" in the data (which turned out to be Hurricane Katrina). By comparing these results to GDP and unemployment data, I came up with the following  assertions:

• Once (real 10 year bond rates) turn negative, a recession occurs, on average, 8½ months later.
• The median is 6 months.
• Results vary between 4 months and 18 months.
• The highest unemployment rate during the recession is, on average, 1.8 times the unemployment rate of the month when real interest rates turn negative.
• The lowest increase is 1.32 times; the highest increase is 2.03 times.

Now the thing about this particular post is that the 3 month average had yet to turn negative, so I prefaced my pronouncement with the caveat that "if" rates went negative the following month, then:

A recession starting between 2011 Q4 and 2012 Q4, with 2012 Q1 (is) most likely.

Then on 2011-06-30 I wrote a lengthy piece about what was likely to occur between now and the recession entitled The events leading up to the coming downturn. The idea was that, because I had two other recession indicators that unerringly predicted past recessions in hindsight, then any potential recession coming up would also have to influence these indicators. I decided that there were going to be two possible situations occurring, an inflationary outcome or a deflationary outcome:

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase...

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows at 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession. A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic.

When I balanced the two out, I decided that the inflationary outcome was more likely. After yesterday's crashing market, there is a much higher likelihood of a deflationary one. To be honest, the thought of the 10 year bond rate dropping below 0.1% is quite frightening.

So they were my June predictions. What about July? On 2011-07-07, when 10 year bond data came out, I wrote an article titled The chance of avoiding another downturn is now almost impossible.

After having my views changed on austerity (namely that the economy was no longer able to produce jobs in a recovery), on 2011-07-09 I outlined "OSO's New Deal" in which I argued that the US Government needs to spend more and tax more in order to a) boost economic growth, and b) generate more revenue to pay off its already considerable debt. While this was not a predictor of events to come, it did outline what I thought (and still think) is the answer to our current economic woes.

On 2011-07-20 I published the next recession indicator series. I made the following points:

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Since then my blogging was mainly concerned with the US debt ceiling crisis. Since the resolution of this crisis, the markets have teetered and fallen. While I would no doubt agree that the debt crisis spooked the markets, I would argue, based upon the data and conclusions that I have been publishing since June, that a recession / downturn was always going to happen at some point. It seems like the debt ceiling crisis was the trigger for it happening sooner rather than later.

Now of course I need to add the disclaimer. We're not in another recession just yet - it is still too early to tell whether we are, at present, suffering another downturn. Moreover there is nothing to suggest that the current crisis in financial markets is going to continue like it was 2008. Markets just might do that, but then again they might not. I'm not going to predict how the markets are going to respond over the coming days weeks and months. Nevertheless I do think that there is enough evidence to show that another market downturn and another recession are going to happen within the next 18 months, and I will stick by that.

A Magical Method in the Money Making Madness

Inflation. No one likes too much of it, though there is some debate as to how much is good and how much is bad.

Inflation is often linked to money creation - though not always, since inflation can also result from supply shortages such as oil. Nevertheless history abounds with money printing experiments that ended up in hyperinflationary failure: Weimer Germany, Mugabe's Zimbabwe, Postwar Hungary and the Crisis of the Third Century being the best known ones.

Injudicious money creation will always create hyperinflation. If the Federal Reserve creates $1 out of thin air the amount of inflation it causes will be negligible. If it creates $1 Trillion the amount of inflation it causes will destroy the economy.

Of course money is created all the time through the fractional lending system. Most of this money is created by the commercial banking system. While some see conspiracies and unsustainability in this process, it has actually worked for millennia. Nevertheless the real heart of the fractional banking system is the role of the Central Bank, which, in the United States, is the Federal Reserve Bank.

Now I'm not going to go into the intricate details of how the system works. If you're unsure of how it works, go to the Wikipedia page. Using this as a basis, however, let me do some funny little experiments as to what injudicious money creation can theoretically do.

So here's graph no.1 showing how the system works in the United States. If we assume that the US economy is worth $1000 in total money supply, it looks like this:

This is, of course, identical to the Wikipedia page's graph.

But now let's begin playing. Let's say Congress and the President and the heads of the Fed suddenly suffer from a collective insanity... even more severe than the one they already have... and decide that they'll fix the deficit by simply creating money out of thin air. Now according to the latest data, the budget deficit is $1.2059 Trillion and represents around 8.11% of GDP. So what would happen if the powers that be decide to just create the money out of thin air, again assuming in our model that the US economy is worth $1000?

I've added the baseline there by way of comparison (the blue line). The yellow line represents the collectively insane decision.

That doesn't look too good does it? You're looking at a huge increase in the money supply and, as a result, a hyperinflationary situation probably similar to anything occurring through history.

But then let's take this even further. Let's say the US has been taken over by an Idiocracy... worse than the current mob... who decide that they'll just forget about taxes altogether and just create as much money as the government needs. Since the US Government represents about 25% of GDP, it would mean that an even greater amount of money would be added to the money supply:

Ouch. And that, my friends, is why money printing on the scale used by the Romans, the Germans, the Hungarians and Mugabe ends in abject failure.

But hang on, what's that thing called "The Reserve Rate"? - Well that's how much money commercial banks are forced to keep in reserve when lending. Adjusting the reserve rate is used by some nations (India and China for example) as a way of implementing monetary policy. If the reserve rate is increased, the money supply drops. If it is decreased, then the money supply is increased.

And so now my friends let me show you some real magic.

Let's go back to the US Government who wants to create money out of thin air simply to pay off the deficit, shown two graphs above, except this time we increase the reserve rate to 18.11%. Why 18.11%? Well it's the 10% reserve rate plus the 8.11% size of the deficit (in relation to GDP). So let's see what the outcome is:

What? Wait. Hang on? Is that possible? You're creating money out of thin air but not affecting the total money supply? Yes. How? By increasing the reserve rate.

Let me say this again: It is possible for large amounts of money to be created by fiat by a central bank and NOT induce inflation only if the reserve ratio is increased accordingly.

So what would happen in real life? Let's say the US Treasury, facing a shortfall in funds, approaches the Federal Reserve Bank for funds. The Fed then creates money by fiat, out of thin air, and gives it (not lends it) to Treasury. Treasury then uses this money to pay the bills. The Fed, however, increases the Reserve Rate accordingly to prevent the inflationary impact of this money creation.

Magic? No. Just a simple change to the equation - a change to the equation that was never thought of by Mugabe, Weimar Germany and others.

Don't believe me? Then do the spreadsheet yourself. Here is a screenshot of what I did with mine.

Long term readers of this blog might notice where I'm going here: My Zero Tax Idea. How would the graph look in the "Idiocracy" situation I described, where taxes are removed and the government is funded purely by money printing, except this time we adjust the Reserve Rate?

Yep. No increase in the total money supply and thus no inflation.

Is this mad? Does this completely misunderstand how the fractional banking system works? Or does this have the potential to revolutionise how governments work? It isn't Quantitative Easing, it's Quantitative Control.

Imagine: No taxes at all, but a completely functional government.

Note: This was discussed back in 2007 at Angry Bear. Megan McArdle at The Atlantic also examined it here. Since the math backs me up (as proven by the spreadsheet graphs), maybe we should seriously consider it?

EDIT: For nations that do not have a reserve rate (such as Australia) the baseline money creation would appear as a straight line going up at a 45% angle. In order for this system to work in countries that have no reserve rate, one must be introduced. This is how it would look:

But then what about nations with large governments? Take Denmark, for example, whose government represents 56.6% of economic output. How would this system react to such a large amount of central bank money? Would the fractional system still work? Yes:

Thoughts on the debt deal

This was definitely a compromise solution, but one in which each side calls the other the "winner".

I read quite a few lefty blogs, which is fine because, if you look at the graph showing my political and economic positions, I am a lefty. Now the lefty blogs are all saying that this is a victory for the Republicans. They're also critical of Obama. I've just watched John Stewart and that's pretty much what he said.

But I also check up on Redstate once in a while to look at how the other side feels and they are definitely unhappy too. "Cut, cap and balance" was their mantra and that was not achieved.

I guess the best place to check this is Wikipedia which, ironically (at least to many), has a more dispassionate and factual summary of what was achieved:

• Cut spending more than it increases the debt limit. In the first installment ("tranche"), $917 billion would be cut over 10 years in exchange for increasing the debt limit by $900 billion.
• The agreement establishes a joint committee of Congress that would produce debt reduction legislation by November 23, 2011 that would be immune from amendments or filibuster. The goal of the legislation is to cut at least $1.5 trillion over the coming 10 years and be passed by December 23, 2011. The committee would have 12 members, 6 from each party.
• Projected revenue from the committee's legislation must not exceed the revenue baseline produced by current law.
• The agreement specifies an incentive for Congress to act. If Congress fails to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress can grant a $1.2 trillion increase in the debt ceiling but this would trigger across the board cuts ("sequestration") of spending equally split between defense and non defense programs. The across the board cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee. The sequestration mechanism is the same as the Balanced Budget Act of 1997. There are exemptions—across the board cuts would apply to Medicare, but not to Social Security, Medicaid, civil and military employee pay, or veterans.
• Congress must vote on a Balanced Budget Amendment between October 1, 2011 and the end of the year
• The debt ceiling may be increased an additional $1.5 trillion if either one of the following two conditions are met:
  
  1. A balanced budget amendment is sent to the states
  2. The joint committee cuts spending by a greater amount than the requested debt ceiling increase.

My understanding is that cuts were achieved and this was done without increasing tax revenue. This is therefore a broad conservative political victory. Conservatives, nevertheless, do not see this as a victory because it doesn't go far enough.

The reason for conservative unhappiness has more to do with their extreme ideological position. Since the onset on the Tea Party and their influence on Republican Party politics, the GOP has, amazingly, become even more ideologically conservative. Minarchism is now the default position of conservatives, which means that any form of government spending outside of military spending and law enforcement must be excised. This form of ideology, however, is backed up by a crazy form of patriotism that sees minarchism as the intended model explicitly advocated by the "founding fathers", which means that any different position (whether it be left wing or centrist) is automatically branded a threat worth "watering the tree of liberty for" (ie the blood of tyrants and patriots resulting from an armed struggle). Add to this the peculiarities of the US congressional system and the only real compromise position is the one which was passed.

As far as the effect on the broader economy, my understanding is that most of the cuts will come in after a two year period, which theoretically allows Obama some breathing space to run for a second term in 2012. The debt limit has been increased to allow for borrowing in the meantime and, all things being equal, should not require another increase until after the 2012 elections. "All things being equal" though is not a good phrase in these dark economic days. I have already predicted that the US will enter another downturn in 2012 and if this occurs the debt ceiling may need to be increased before the election, especially if unemployment ends up in the mid-teens, thus reducing government income tax revenue.

As for the Keynesian approach of pump priming the economy via deficits, this piece of legislation is of no help. My own call for a "Total War / New Deal" type economy (whereby large increases in government spending in health, education and alternative energy are accompanied by large tax increases) is even less likely to occur. Since the US economy's many structural flaws have not been addressed since the credit crunch of 2008, I thus have little faith that the free market will be able to generate jobs and economic growth in the short-medium term.

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