Trump Shock: Selgin,Coppola and Lambert

This article was first published by me on Talkmarkets:

The discussion of asset inflation and the failure to get money into the hands of real people takes on an ever more urgent conversation since Donald Trump has been elected president. The Trump Shock may be real. And if and when The Donald should stimulate the economy is a real issue as well, as we can see later in this article. But we have to know why asset purchasing by the Fed did little for main street.

George Selgin has discussed the problem of asset purchases on the CATO Alt-M blog. He essentially agrees with Frances Coppola, that asset purchases have not caused a broad prosperity as they should have. He gives a detailed explanation as to the reason for this. It all revolves around interest on reserves. He said:

As for interest on reserves, although it failed to establish an above-zero “lower bound” on the effective federal funds rate, as Fed officials originally hoped it would, the policy did succeed, in combination with the ongoing decline in market rates, in getting banks to hoard reserves instead of swapping them for interest-earning assets. The IOER rate has, for most of its existence, exceeded yields on most Treasury securities, allowing foreign banks in particular to profit by arbitraging the difference between the two rates, and making a general preference for reserves over Treasuries as means for meeting new regulatory liquidity needs a no-brainer. For these and other reasons, the Fed’s unprecedented asset purchases, which might ordinarily have been expected to result in roughly proportional increases in broad money, spending, inflation, and nominal interest rates, affected those variables only modestly, if at all, and did so for the most part by limiting their tendency to decline, rather than by raising them in an absolute sense.
Of course, Coppola would say the pushing M, base money, up through asset purchases, mainly sovereign bond purchases, does not impact broad money much anyway.

Selgin tells us not to forget that:

...rates originally crashed, not because monetary policy was too easy, but because it was too tight. The Fed erred, in other words, not by pushing rates down but by trying to prop them up in the months leading to Lehman’s collapse. Wicksell’s theory is once again relevant. Just as that theory holds that, in order to keep interest rates below their natural levels, a central bank must resort to ever more aggressive monetary expansion, it also implies that a central banks that strives to maintain an excessively high rate target will, by over-tightening, cause spending (or, if you prefer, aggregate demand) to decline. That decline will in turn place downward pressure on market rates, by reducing the nominal demand for funds. The pressure then inspires further tightening, and so on, until the central bank finally relents. The Fed’s efforts to keep rates from approaching the dreaded zero lower bound thus ended up backfiring. Like Oedipus, it appeared fated to achieve the very outcome it desperately wanted to avoid.
So, the Fed tightened and the Great Recession continued. Asset inflation failed to do anything much for main street as M, in the equation MV=PY, went into excess reserves in the TBTF banks and sits there while the banks receive interest on those reserves. There is a zombiness to all that base money just sitting around.

One big reason why broad money was not created on main street is the lack of robust growth of capacity utilization. The chart, which concerns economist Edward Lambert greatly, shows that capacity utilization plummeted in the Great Recession, expanded for a few years, and is slowing down again:

But now we have the potential Trump Shock. And this Trump shock will be laid on top of that capacity utilization decline. We are at 75 percent of utilization. Historically, that is pretty low. And the decline has always led to recession from the '70s onward, according to the chart.

Donald Trump has been elected president by the electoral college. At best, he is a shrewd businessman, and many voted for him because of that trait. At worst, he comes across as unstable human being to many people. The shock of his election will not soon wear off. Many people will feel emboldened to spend, believing that Donald Trump holds the secrets to an improved economy.

But many more believe that he will start trade wars, that he will offend other nations, that he will show instability through war. If you think your job or business is on the line because you import stuff,  you will pull back on spending and borrowing. Man consumers are simply scared out of their wits at the thought of Donald Trump as POTUS.

Donald Trump's behavior could have massive economic consequences. After a campaign that seemed to be over the top in its divisiveness, can he control himself or will people fear more and more as time goes on? Could that destroy whole industries dependent on consumer borrowing? Simon Johnson, former head of the IMF is deeply concerned about Trump as an economic shock. He said prior to the election:

Trump’s trade-led recession would tip Europe back into full-blown recession, which would likely precipitate a serious banking crisis. If this risk were not contained – and the probability of a European banking debacle is already disconcertingly high – there would be a further negative spiral. Either way, the effects on emerging markets and all lower-income countries would be dramatic.

How can we tell if Donald Trump's election is a real economic shock going forward? Well, it is important to understand what other economists like Edward Lambert are saying. It is important to watch capacity utilization as both an indicator of economic health and as a forecast for inflation. Clearly US capacity utilization is not showing there is inflation on the horizon. But it is not exactly showing mass prosperity either. How Donald Trump will impact that indicator will become very important.

 It would seem like the time is coming for Donald Trump to get money into the hands of main stream America. He will need to do this as recession takes hold. Edward Lambert has predicted recession before inflation.

Keep in mind that even if Trump gets money into the hands of the people by allowing M to penetrate into the real economy somehow (maybe helicopter money), or by massive government stimulus through deficit spending, people still may be afraid to borrow and spend because of his personality, appointees and policy going forward. The POTUS himself could be an adverse economic shock. We hope that is not the case.

Dr. Lambert shared this with me:

People will most likely wait to see the money before they spend it... right now, people for the most parts believe in a business boom... but underneath all that is a question of where the demand will come from... it seems the markets think that businesses will create demand for other businesses in capital formation... but ultimately the economy is driven by final consumption of goods.

If Trump thinks supply side ideas will get the job done in this environment he is likely swiping at windmills. 

While Hillary Clinton won the popular vote by almost 3 million, Donald Trump took 80 percent of the counties, most of the land mass of the nation. And most of the folks who live there can't be happy with the economic changes that have hit them in the last 20 years. But reinventing the small town will very difficult to do without massive subsidization of some kind.

And the Fed has said to congress to be careful of inflation due to nearly full employment. But is nearly full employment as relevant as the declining capacity utilization? Full employment and a slowing of CU happening at the same time not a good thing at all. It may be true that congress blew it and should have contributed more stimulus when Obama became president because that was the right time to do so, with high unemployment plaguing the US.

Yellen cautioned lawmakers that if they spend a lot on infrastructure and run up the debt, and then down the road the economy gets into trouble there could be fewer options. She said

"...there is not a lot of fiscal space should a shock to the economy occur, an adverse shock, that should require fiscal stimulus."

Trump probably will not have to wait too long to find the appropriate time to apply either monetary or fiscal stimulus. He may only have to wait a few months for the recession to materialize, as predicted by Edward Lambert. 

The new POTUS may want to keep most of those illegal aliens around, since there may not be enough warm bodies to boost capacity utilization if everyone is already employed. Trump would have to depend on anecdotal information about those still unemployed to get enough workers to really grow the economy like he wants to. If he proves insensitive to these things and the Euro banks there could be more trouble in the world than we have known since WW2.


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