From Terminal Velocity (3) – “The Pyramid Scheme”[i]:
Reading between the lines, it is clear that the Fed intends to maintain a large balance sheet of assets for some time; even after interest rates have begun to normalize. The Fed will then use a rolling form of Operation Twist, across the Yield Curve and across asset classes, in order to target particular areas that it believes need influencing. The overall size of the balance sheet and its composition will then be managed, to achieve a background of benchmark interest rates for specific capital market sectors and the economy in general. This balance sheet management will involve increases and decreases in overall size, in addition to substitution of different assets and maturities. In this way, the Fed intends to anticipate and prevent bubbles or excessive tightness in liquidity from occurring.
It therefore looks as though the Fed will allow QE to roll off via expiry; and that it is quite prepared to provide specific monetary support to specific credit instruments, even as interest rates are rising in general. The intention and capability are to make the economic recovery sustainable during the rising rate environment.
It has taken the market commentators several months to pick up on the first signal, presented by Jeremy Stein[ii] on February 7th, which was explained in Terminal Velocity (3). Stein drew attention to the intentions and capabilities of the Fed to employ an extensive range of microeconomic policy tools to normalize interest rates, whilst maintaining an expanded balance sheet. CNBC[iii] began to break this story on May 6th. To emphasize the point, even a notorious Fed Hawk has recently emphasized this new Fed policy and strategy. Jeffrey Lacker is an alleged Hawk, who is famous for his dissent on QE. His latest speech signals a subtle change in his outlook and behaviour[iv]. He advocates tapering MBA purchases; however he would replace these securities with Treasuries. The nuance is subtle but powerful. Clearly Lacker has accepted the indefinite balance sheet expansion; and he has also accepted the microeconomic manipulation of various asset classes in this expanded portfolio to achieve the Fed’s objectives. Lacker’s conversion is a major event; and a major achievement in evolving Fed consensus and policy. Having achieved internal consensus, the Fed can now project it externally. Public opinion is now being prepared to accept the fact that the Fed will have an indefinitely expanded balance sheet, even as interest rates normalize. The next step is to prepare the public for “Bernanke’s Helicopter”; which is the corollary of this expanded balance sheet in the real economy.
The Commerce Department recently opened the hangar doors for “Bernanke’s Helicopter”, EDT late July 2013. By the time that Jackson Hole rolls around, the markets will have had several months to discount the indefinitely expanded balance sheet news; so that the “Helicopter” will be much less of a shock to the system when it is announced.
The latest Bureau of Economic Analysis (BEA) announcement, that it will be changing the way that GDP is reported, has just changed the game. It will add an immense 3% to GDP, in the last week of July; which is equivalent to an extra per capita expenditure of $1,500 per annum. The BEA will now account for intangibles in corporate expenditure as capital investment, rather than as costs. Currently costs are subtracted from GDP calculation invoices and investments are added. Applying this new accounting rule, R&D is an investment rather than a company’s expenditure (cost). Intellectual and artistic capital, such as paintings, films, programmes, commercials, adverts and series will now be accounted for as an investment in the GDP calculation. The change from R&D alone is expected to add at least 2% to GDP. The hidden value in American intellectual property is just about to be re-valued higher.
According to the latest GDP estimate, Q1 GDP grew 2.5% to $16.01 Trillion. The new revision would lead to an addition of $500 billion, to make the new number approximately $16.5 Trillion. If this was not enough, the BEA claims to be able to go back all the way to 1929 and extrapolate this revision backwards. Where they get all the invoices and bills, for all these transactions from, is anybody’s guess. As Churchill observed, history is kind to those who write it.
The base line for this forward and backward extrapolation is 2007; which is the little give- away as to why this new accounting trick is being deployed. 2007 was the peak of the last bubble. The big dip in GDP since then can therefore be corrected upwards, so that it looks like there has been no dip at all. The second cheat, comes from the fact that two thirds of the alleged GDP changes will come from the private sector and one third from the public sector. Thus as fiscal austerity has cut public sector expenditure dramatically and hence GDP, then this new increase in private sector accounting will make up for the loss.
Brent Moulton, head of national accounts at the BEA, attempted to hide this new form of “Voodoo Accounting”, when he said in its defence that:
“The world economy is changing and there’s greater and greater recognition that things like intangible assets are very important in the modern economy and play a role similar to tangible capital that was captured in the past.”
An analysis of the results of this new accounting trick will explain why it is being used.
First, as stated above, policy makers can lie about economic performance since 2007. In addition, they can claim that the productivity miracle in the recovery, involving assets and not people, has boosted GDP.
Second, Debt/GDP Ratios at the Federal level shrink even further. America can now borrow and spend even more. The excuse for more deficit spending has just been created.
Third, in the private sector, companies and sell-side analysts can now raise corporate valuations based on intangible values. The Stock Market is thus cheap today; especially the NASDAQ, where R&D and intangibles make up most of the enterprise value. Media and Technology shares are therefore going to experience the kind of P/E multiple expansion last seen at the height of the Dot.com Bubble. “NASDAQ 40,000” and “Google $1,000” are headlines waiting in the RSS feed-prompt!!! Imagine the sudden boost in value of media companies with back catalogues of series and films; and also imagine the value of back catalogues of music. Imagine the values of Itunes, Disney, Pixar and Viacom etc. The BEA values investment in artistic original content at $70 billion in 2007. It’s pure guesswork of course; and wide-open to abuse and manipulation ….. and therefore to fraud. The “Voodoo” drumbeat does not stop with intellectual property however.
Fourth, the beat goes on with pension accounting. Currently, pensions are accounted for by the real Dollars that get contributed to a plan (or not, as has been the case in the majority of companies). Under the new system, the value of what the company promises to pay in the future will become the new number. Clearly, defined benefit plans that are un/under-funded now boost GDP, rather than threaten it. Suddenly, the unfunded pension liability issue is a blessing rather than a curse. Companies will also account for it on their books, as a blessing that increases the value of the company’s shares. Pension black-holes become hidden asset values. As the shares in companies rally to reflect the new accounting game, they will then trigger a real un-realised gain in the assets of the pension funds that have invested in their shares. The reader will notice a kind of pyramid scheme being operated by this form of accounting.
Fifth, the banks get to participate in the great equity revaluation game. Services that banks currently don’t charge a fee for, such as making an internet banking payment, suddenly get valued. Imagine the shareholder value “creation” associated with placing a value on the billions of internet speed wire transactions that go on every day, which are currently being ignored. Imagine how a bank with a fast computer, to multiply the number of these transactions on its system, may abuse this valuation methodology.
Sixth, the housing sector gets a boost. Currently transactions costs are accounted for as exactly that … a cost. In the new system, they will be accounted for as part of the capital investment made in real estate. So by extension, all the litigation and transactions associated with the recent foreclosures become an investment in America’s future. A housing crisis is therefore an investment boom …. it’s absurd.
We could go on, but by now the reader can see how the trick works. The service sector of the US economy is re-valued higher to create a larger GDP number. Asset liquidations are now re-classified and accounted for as investments. We would not be surprised to see the tax code change also; so that capital losses are re-classified as investment gains. Imagine a market in which the worst asset managers and traders were re-classified as the best investors. Mediocrity and economic underachievement now get rewarded and incentivized by the new accounting system. More worryingly this mediocrity and underachievement is re-valued higher as over-achievement and outperformance. A Lost Decade, that was experienced, therefore becomes a Booming Decade that is recorded and published. It all looks and reads like ENRON’s “mark to market” accounting system; except in this case no auditor is signing off on the fraud. As Jim Chanos says, when something looks too good to be true it usually is.
So what’s the catch?
The catch is that prices of intangibles and services, especially in technology and media, can fall by a great degree over time after they have been created. As the new software, App, game, movie or song is replaced with the latest version it suddenly loses value at an exponential rate. The product cycle drives deflation. It also drives innovation. Technology creates price deflation with enormous economies of scale at the speed of light; even Alan Greenspan saw this. Having allegedly boosted GDP from 2007 to date, Technology may then crush it in the new product innovation cycles of the future.
Observers will look for “tangible” evidence of this sudden “intangible” jump of GDP in July; or else the policy makers will risk being called charlatans with great justification. This is where it gets interesting. Having suddenly made the denominator of the Debt/GDP Ratio increase, the Federal Government can boost borrowing (and spending), so that the tangible effects of this alleged increase in growth are visible. In addition, the Fed will have a cover story to print more money; and even to fly “Bernanke’s Helicopter” under. Only money, literally given away, can create the kind of GDP boost that is being considered here. And it is this observation that is the biggest clue of all, as to what is really going on here.
The intentions and capabilities of the Federal authorities are to create an inflation, which can be used to boost the prices of the inputs to the new GDP fudge calculations. The BEA has just facilitated this process, by providing the historic precedent and intellectual justification for this policy.
By the time they have finished, America’s “intangible” (and inflated) GDP will dwarf that of its nearest challenger China; where there is no “intangible” capital but “tangibly” lots of people and empty buildings.
Professor Amir Sufi, a participant at Jackson Hole last year, was also putting his intellectual weight into opening the hangar door recently[v]. His analysis echoes that of the New York Fed and Sarah Bloom Raskin[vi], on the asymmetrical effects of the wealth effect on consumer behaviour. Since the Credit Crunch, Sufi estimates that each dollar increase in housing wealth only lifts consumer spending by one cent, as compared with three to five cents before the recession. Lending standards are so tight that borrowers can’t qualify for loans. More worryingly however is the fact that consumers, who are deleveraging, are reducing their credit scores at the same time that the banks are raising lending standards. There is therefore a widening gap, between the deleveraging consumer and the abstemious bankers, that needs to be bridged. Sufi found that low credit score borrowers were the ones taking out home equity during the bubble; and that now this constituency has been foreclosed upon. In addition those low credit score consumers who try to improve their financial position, through deleveraging, actually put themselves at a bigger disadvantage; because deleveraging actually lowers credit scores. Consumers with high credit scores, didn’t raise their borrowings in the bubble; and have certainly not gone more into debt during the crash and weak recovery. The result is that both highly leveraged and unleveraged consumers don’t take out more debt; thereby slowing the economy down. In addition, highly leveraged borrowers have their debts liquidated; so there is an additional negative impact on the economy.
The “Wealth Effect”, as it was known and understood by the Fed, therefore no longer applies. The penny has dropped at the Fed, that it is not just the transmission mechanism that is broken; but that it is the consumer himself that is broken. A strong monetary stimulus therefore needs to be applied directly to the consumer to break this spending inertia.
Prior monetary stimulus, in the form of QE, clearly doesn’t work as the graph above shows. QE has not been multiplied by the banks into economic activity; instead it has been multiplied as asset price multiples.
A quick look at the latest Corporate Profit Data (above) signals that returns on capital are much higher than returns on labour. In fact, returns on capital have never been higher. Companies have adjusted to life at the “Zero Bound”, by applying productivity strategies to increase shareholder value. These productivity strategies involve less employment and less aggregate employee compensation. Consumers who work therefore, do not have the improving salaries to prompt them to go further into debt, with rising credit scores that have been boosted by rising compensation. There is therefore no existing “Wealth Effect”; and no prospect of creating it from first principles with rising wages.
In short, an agency is needed to substitute for the lack of rising wages in the US Economy. The vehicle of this agency has been named the “Helicopter”.
Before the “Helicopter” can fly, we theorised that some credit event would be needed as the catalyst. The intellectual papers from Professor Sufi, Bloom Raskin[vii] and even Michael Woodford[viii] himself are not credit events of sufficient magnitude. It was suggested that the consummate credit event would be provided by the Eurozone. Currently, the EU is trying to quietly move the goalposts on insolvency, so that depositors (EU Nationals) are protected and unsecured creditors get liquidated first in the next crisis[ix]. Without a central resolution authority however, all this will go on at national levels in a cascading domino effect. Once this becomes evident to the speculators, European sovereign and corporate debt instruments will be exited at great speed. Those that do not exit in time will get liquidated. The issue of whether the ECB’s vast intervention bond-holdings get liquidated will become an interesting point along the way. Going forward, the Eurozone will then have to rely on internal financing. Banks will then have to lend against their deposits, assuming they still have any; so there will have been a collapse of credit. The crisis will thus come in two stages; first a debt crisis and then a banking crisis.
It is accepted conventional wisdom that Developed Market Central Banks have become what is euphemistically termed “politicised”. In practice this means that they are directly under political control, perhaps with the exception of the ECB for now, so that their existing independent mandates are an anachronism. Independence came about as a consequence of the inflationary consequences of the original political control of the central banks.
It can be argued, that so successful have these independent central banks been in fighting inflation, that they have created an innate deflation bias in developed economies. This deflation would be a stable platform for economic growth, if there was no debt. Unfortunately however, debt levels are so high that deflation actually makes the system even less stable and more prone to depression. The experience of Japan over the last twenty years has proven this case. We believe that leaders in central banking theory, like Woodford, now subscribe to the view that a return to the inflationary conditions of the 1970’s is the only solution. They probably only want to return to a little bit of the 1970’s inflation; and think that they have the tools to get there. Having seen how successful that they have been in killing inflation, one has to believe that they will be as successful creating inflation. Unfortunately however, they were a little overzealous on the deflation side; so we expect them to also overshoot on the inflation side.