Board of Scholars

Did I Miss Something?

Did I miss something?

In my outlook letter at the start of this year I expressed concern with the ongoing federal budget deficit and high outstanding public debt.  A large body of economic theory and evidence from around the world shows that high-levels of public debt lead to extended periods of slow economic growth.

The U.S. economy is not immune to these effects.  Since 2010 U.S. real gross domestic product has grown at an average annual rate of 2 percent, compared to an average of 3 percent in the decade prior to the global financial crisis.[1]

A one percent difference may not seem like much, but the massive build-up in federal debt during 2009 and after has long-term consequences.  When the economy grows at 3 percent per year the living standards of the young are twice that of their parents.  But when the economy grows at only 2 percent it takes two generations before living standards double. Slow economic growth can result in a “lost generation.”

As we enter the last quarter of this year economic and financial market indicators suggest my concerns may be unwarranted. Labor market conditions are improving, bond prices indicate low inflation expectations, and stock prices reflect relatively high expectations for earnings growth. I may have missed something.

At 5.9 percent, the U.S. unemployment rate is now in the range (4 – 6 percent) that many economists consider normal. There is always some unemployment as new businesses start and old close, leading to displacement of some workers. A five percent rate seems normal.

However, when you couple a declining unemployment rate with a declining labor force participation rate the situation is less promising. The percentage of U.S. adults in the workforce has declined from 66 percent in 2007 to less than 63 percent today. In the last seven years only 1 million new jobs have been created despite an increase in population of nearly 18 million.[2]

There also doesn’t seem to be an inflation problem. Interest rates on U.S. Treasury bills, notes, and bonds remain well below historical levels. The yield spread, or difference between rates on short-term and long-term U.S. debt, predicts relatively low inflation for the next decade. [3]

Meanwhile, stock prices as measured by the Dow Jones Industrial Average are 20 percent above the highs reached in 2007, and stock valuations are above historical averages. Higher stock valuations indicate expectations for faster economic growth.

These financial market indicators are just as misleading as the low unemployment rate.  Low interest rates are the result of financial repression on the part of monetary officials and U.S. stock prices are additionally supported by higher than average capital flows from foreign investors.

Financial repression occurs when government authorities channel funds from one area of the economy to another, often the government’s own debt. Since 2008, large purchases by the Federal Reserve and increasing federal government debt have suppressed risk measures in the stock market and created a high level of uncertainty in the overall economy.

After their most recent meeting, the Federal Reserve’s Open Market Committee announced the end of a large bond purchasing program known as quantitative easing. The Fed said it will, however, continue to keep short-term interest rates near zero for a “considerable time.”[4]

These low short-term rates should create strong incentives for borrowing, investment, and consumption, but monetary policy is not as effective as many believe The Fed can affect what is called the monetary base, but this may or may not change the money supply. Since 2007 the monetary base has increased nearly fivefold[5], but the money supply has risen only 63 percent.[6]

The Fed is still pushing on a string. No matter how low rates stay and no matter how many bonds the Fed does or does not buy, monetary policy will always be an imperfect tool.

While the Fed supports bond prices foreign investors are pushing up stock prices. The most recent data on foreign investment shows that the U.S. is a favored destination for capital. The value of foreign holdings of U.S. equity securities has more than doubled since 2007. As a percent of total outstanding, foreign holdings of U.S. equities grew from 9.2 to nearly 13.7 percent.[7]

Funds are flowing to the capital markets of the United States because the outlook for economic growth is worse elsewhere. Financial repression is even higher in Japan and the Eurozone, while also rising in the developing markets of China and elsewhere.

Indicators in the U.S. labor, bond, and stock markets may all look good relative to historical averages, but a deeper look tells a different story. The debt problem remains. For conditions in these markets to improve, and economic growth return to its 3 percent long-run average, fundamental policy changes are needed.

We didn’t miss anything. When government spending and public debt start declining, the labor and financial markets will reflect a truly healthy economy.

Peter R. Crabb, Ph.D.Peter R. Crabb, Ph.D.
Professor of Finance and Economics
[email protected] and @prcrabb

The views expressed here are those of solely of the author and do not represent Northwest Nazarene University.

[1] http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

[2] http://www.bls.gov/news.release/empsit.nr0.htm

[3] http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/default.aspx

[4] http://www.federalreserve.gov/newsevents/press/monetary/20140917a.htm

[5] http://research.stlouisfed.org/fred2/series/BASE

[6] http://research.stlouisfed.org/fred2/series/M2

[7] http://www.treasury.gov/ticdata/Publish/shla2013r.pdf