God is a Capitalist

Saturday, October 12, 2013

Fed Fail!



With Ben Bernanke's departure, it’s time to grade his portfolio of work. Ben invented new methods to expand the money supply, including buying non-government issued debt. Mainstream economists credit him with having rescued the economy from the latest recession. The economy has recovered slowly in the past five years, but should we give all the glory to the Fed? These charts should answer those questions: 




The first chart shows year-to-year changes in the money stock measure M2. The second shows year-to-year changes in GDP. Why are the charts important? Mainstream economic theory insists that a collapse in aggregate demand, mainly consumer spending, causes recessions. Creating money out of thin air should cause consumers to begin spending again and ignite the recovery. So if Fed money printing caused the tepid recovery, we should see a correlation between growth in the money supply and growth in the economy.
Here is the time line of Ben’s major policy decisions:
  •  November, 2008, the Ben decided to purchase up to $600 billion in agency mortgage-backed securities (MBS) and agency debt.
  • By December, 2008 Ben had pushed the Federal Funds rate to below 0.25% where it has remained.
  • March 18, 2009, he expanded QE by $750 billion in purchases of agency MBS and agency debt and $300 billion in Treasuries.
  • November, 2010 – June, 2011 the Fed purchased $600 billion of longer dated treasuries, at a rate of $75 billion per month.
  • September, 2011 he launched Operation Twist, a purchase of $400 billion of bonds.
  • September, 2012 unleashed QE3 to purchase $40 billion agency mortgage-backed securities per month until the labor market improves.
  • December, 2012 Ben added $45 billion worth of longer-term Treasury securities per month to QE3.
Clearly, the economy began recovering before the money supply began to grow, but then flattened. GDP has not responded to increases or decreases in the money supply. But more importantly, the money supply has not responded to Fed policy as mainstream economists predicted.

The money supply did not begin to grow until two years after Ben cranked up his money presses. It grew rapidly for two years and then failed again. The money supply growth rate declined throughout 2012 and 2013 in spite of QE3 and its expansion.
We could learn a lot of lessons from Ben’s tenure. One is the lag between policy and effect. But one of the most important is the affirmation of the principle of diminishing marginal returns. That principle says you get the biggest bang for your buck in the early stages of any plan and the benefits fall off rapidly afterwards. We see that principle at work in the money supply as Ben’s increasingly desperate efforts to boost GDP through money printing have have failed in 2012 and 2013.

What does that mean for investors? Money printing boosts the stock market as most of the newly minted money goes into investment in stocks. However, the stock market ultimately has to follow the economy. The declining growth rate for M2 signals a slowing economy which may tip into recession early next year. When the next recession hits, the stock market will collapse as investors flee for safety.

2 comments:

TireGuru said...

So when do we need to pull out our money, even from the banks?

Roger McKinney said...

I would get out of the stock market. It may go a little higher but investors are better off leaving a little on the table now instead of losing a lot when a recession hits. However, there shouldn't be any banking crises this time around.