Kasriel s Parting Thoughts

Transcription

1 Northern Trust Global Economic Research 50 South LaSalle Chicago, Illinois northerntrust.com Paul L. Kasriel Chief Economist fax Kasriel s Parting Thoughts Before retiring on April 30, 2012, Northern Trust s award-winning Chief Economist Paul L. Kasriel wrote a few commentaries containing his signature wit and economic wisdom as parting thoughts, which are compiled here. Paul L. Kasriel Chief Economist Paul joined the economic research unit of The Northern Trust Company in Paul is a recipient of the annual Lawrence R. Klein Award for having the most accurate economic forecast over a four-year period among the Blue Chip survey participants. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often non-consensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern Trust s economic Website was listed as one of the top 10 most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets. Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the Northwestern University Kellogg Graduate School of Management and at the DePaul University Kellstadt Graduate School of Business. Paul has served on the Economic Advisory Committee of the American Bankers Association. March 29, 2012 Mary Matalin s Economics March 30, 2012 Money Is Starting to Burn a Hole in Households Pockets A Note on Velocity of Money April 3, 2012 April 4, 2012 April 13, 2012 Has the Fed Boosted the Stock Market? We Will Repeat One of the Silliest Market Rites on Wednesday? Why Should Not Stocks Have Done Well? or Business, With Enemies Like This, Who Needs Friends? Recent Federal Budgetary Trends: Facts, Not Opinions April 16, 2012 The Cyclical Macroeconomic Impact of Taxmageddon 2013 Seniors Worried about the Debt They Are Passing on to Their Heirs? We Have Met the Enemy and It Is Us! April 23, 2012 April 30, 2012 Mortgage Refinancing: Stimulative or Redistributive? How Do Higher Gasoline Prices Reduce Real GDP Growth? Don t End the Fed, Mend the Fed

2 March 29, 2012 Mary Matalin s Economics As many of you know, I will be retiring from The Northern Trust Company on April 30. In the few remaining days of my tenure, I will be sharing with you some of my parting thoughts with regard to economics as time permits and the spirit moves me. By the way, after April 30, my Northern Trust address will disappear into the ether, but I hope I will not follow it there. If you feel the need to contact me after April 30, and I cannot imagine why you would, I have established a personal address, which has gone live: econtrarian@gmail.com. Now, on to Mary Matalin. I saw her on one of the cable news shows on Wednesday defending Republican presidential candidate Mitt Romney s planned car elevator in his new La Jolla home in terms of job creation. Ms. Matalin argued that by installing this elevator, Romney would be creating new jobs for the economy. How might Bastiat, the 19 th century French political economist, have reacted to Ms. Matalin s argument? My suspicion is that he would have made a distinction between what Ms. Matalin sees and what is unseen. Ms. Matalin sees the additional workers manufacturing and installing the elevator. What she apparently does not see are the workers who otherwise would have been hired for some other unrelated project had Mr. Romney forgone the installation of the elevator and rather invested, or saved, these elevator funds. Ms. Matalin, a Republican partisan, appears to have bought into the Keynesian fallacy often trumpeted by Democratic (or is it Democrat?) partisans that an increase in saving implies less total spending in the economy and diminished job creation. If Mr. Romney chooses to forgo the installation of a car elevator in favor of, say, purchasing some additional financial assets, in effect, he is transferring some of his purchasing power to another entity a business, another household or a governmental body that has a greater urgency to spend currently than does Mr. Romney. So, although Mr. Romney would be hiring fewer workers to manufacture and install a car elevator, the recipient of Mr. Romney s investment funds would be hiring additional workers to produce whatever they were purchasing. (This concept of transfer credit comes from the Austrian school of economics, whose pupils greatly admire Bastiat.)The only way Mr. Romney s decision to forgo the installation of a car elevator would not lead to a creation of jobs is if Mr. Romney chose to increase his saving by holding more bank deposits and/or currency, in which case would result in a decline in the velocity of money. So, boys and girls, like Bastiat, keep your eyes open. Try to see everything when analyzing economic issues. Ms. Matalin was not incorrect to argue that Mr. Romney s decision to install a car elevator in his new abode would create new jobs. But what she apparently failed to see is that new jobs would have also been created if Mr. Romney had chosen to forgo the purchase of the car elevator and instead invested those funds. Increased saving in general does not result in decreased aggregate spending. Rather, it merely changes the composition of who is engaging in the new spending.

3 March 30, 2012 Money Is Starting to Burn a Hole in Households Pockets February personal consumption expenditures (PCE) increased 0.8% month-to-month in nominal terms and 0.5% in real terms. In real terms, the February PCE increase was the strongest since last September. From some of the naysayers out there (David), we keep hearing that the economic green shoots that have emerged this past winter were due to the unusually mild temperatures. Really? One area of consumer expenditures that has not been boosted by the mild temperatures is electricity and natural gas. In the four months ended January, real PCE for electricity and natural gas contracted at a seasonally-adjusted annualized rate of 36%. (In February, growth in real PCE on electricity and natural gas exploded at a seasonally-adjusted annual rate of 96%!) Now, of course, the savings that households experienced on their winter utilities bills could have been spent on more discretionary goods/services, such as ski vacations. Oh, I forgot, there was not a lot of good snow for skiing this winter. Perhaps households could have used these utilities savings for more mundane expenditures such as snow removal services or new snow blowers. Oh, I forgot, there was not a lot of snow this winter. Chart 1 shows month-to-month percentage changes in total real PCE and real PCE excluding electricity and natural gas. Notice that starting in September 2011 through January 2012, growth in real PCE excluding electricity and natural gas exceeded growth in total real PCE. So, evidently, households chose not to spend all of their savings on winter utilities bills. Chart Personal Consumption Expenditures % Change - Period to Period SAAR, Mil.Chn.2005.$ Pers. Consumption Expend. ex Electricity and Natural Gas % Change - Period to Period SAAR, Mil.Chn.2005 $ MAR APR MAY JUN JUL 11 Source: Haver Analytics AUG SEP OCT NOV DEC JAN FEB -0.2

4 It would appear that households preferred to simply hold on to more cash rather than spend their utilities savings on other goods and services. Chart 2 shows the ratio of nominal PCE to the nominal M2 money supply. This is akin to the concept of the velocity of money. A decline in the ratio plotted in Chart 2 means that households prefer to hold more M2 money per dollar of their expenditures on consumer goods and services. The decline in this concept of money velocity started this past summer, becoming more pronounced this past fall through January. In February, this money velocity rose. I think, as the old saying goes, this money savings from lower winter utilities bills is starting to burn a hole in households pockets. Chart 2 Nominal Personal Consumption Expenditures / Nominal M2 Money Supply MAR APR MAY JUN JUL 11 Source: Haver Analytics AUG SEP OCT NOV DEC JAN FEB 1.10

5 A Note on the Velocity of Money In my March 29 commentary, I said that an increase in household saving would not lead to a decrease in aggregate spending unless that increased saving took the form of increased deposits and currency held by households. An increased demand to hold deposits and currency is the same thing as a decrease in the velocity of money, very similar to what I have discussed today in the section above. All else the same, a decrease in the velocity of money will lead to a decrease in total spending in the economy. Why? Won t my increased deposits give my bank more funds with which to lend to other spenders? Yes, my bank will have more deposits. But from where did my bank s deposits come? From someone else s deposits. For example, I get paid this week. My deposits rise and my employer s deposits fall by a like amount. If I bank at a different institution than my employer, then the bank of my employer loses the funds that my bank receives. If we happen to both bank at the same institution, then our bank neither gains nor loses funds. If I choose to increase my saving by purchasing new bonds, then my spending goes down, but the bond-issuer s spending goes up. If, however, I choose to increase my saving by holding more deposits, then my spending goes down and no other entity s spending goes up. The banking system does not gain any additional funds to make new loans by me choosing to hold more deposits.

6 April 3, 2012 Has the Fed Boosted the Stock Market? You bet. And aggregate demand for goods and services, too. If the Fed had not expanded its balance sheet in the past few years, the weakest U.S. economic recovery in the post-wwii era would have been even weaker and U.S. stock prices would have suffered. Chart 1 shows the year-over-year percent changes in monetary financial institution (MFI) credit. Private MFI credit is made up of the sum of loans and securities of commercial banks, savings & loan associations and credit unions. Total MFI credit is private MFI credit plus assets on the books of the Federal Reserve, i.e., Fed credit. The median year-over-year change in private MFI credit from Q1:1953 through Q4:2011 was 7.5%. In 2009, private MFI credit began what turned out to be its most severe contraction since the early 1930s. Although private MFI credit resumed growth in the second half of 2010, the rate of growth has been far below its long-run median rate of 7.5%. Even with the Fed s second round of quantitative easing QE) from November 2010 through June 2011, total MFI credit, private plus Fed, has been growing well below the long-run median rate for private MFI credit. But without QE2, credit creation for the U.S. economy would have been even weaker. So, yes, the Federal Reserve s actions have benefited the stock market as well as aggregate demand for goods and services in the U.S. economy. You got a problem with that?

7 Would you have preferred that the Fed sit idle as it did in the early 1930s, with likely similar results for the stock market and the economy in recent years as occurred at that time? The Fed has simply provided some of the credit to the economy that the private MFI system would have had it not been crippled with loan losses. And even with the Fed s additional credit creation, total MFI credit growth has fallen short of the long-run normal credit creation of private MFIs. I understand the frustration of those who argue that the stock market is being boosted artificially by the Fed. I, too, get frustrated when my forecasts are incorrect! We Will Repeat One of the Silliest Market Rites on Wednesday ADP Tomorrow, Wednesday, April 4, the ADP estimate of private nonfarm payrolls will be released. Media will report that private payrolls in March increased/decreased by X thousands. Really? Is the ADP s estimate what the actual change was in private nonfarm payrolls? Suppose you knew on Wednesday what the BLS was going to report as the change in March private nonfarm payrolls on Friday. Which estimate would you trade off of, that of ADP or BLS? Most people would trade off the BLS estimate. But we can t constrain ourselves from trading off the ADP estimate. If the ADP estimates were good predictors of the BLS estimates, I might see the logic of this. Are the ADP estimates very good predictors? You can decide from the information in Chart 2. Mind you, this history of ADP estimates has been sanitized. That is, the ADP historical March figures match the BLS historical March figures because ADP figures are benchmarked to BLS levels in March. So the median miss of the ADP estimate to the BLS estimate of 55 K in absolute terms would likely have been even larger had not the ADP estimates been revised to comport with past March BLS estimates.

8 To add to the silliness, the media will report that the ADP change came in above or below economists forecast of the ADP change. Why do we economists waste our time even attempting to forecast a number that will quickly fade into oblivion two days later? How much effort do most economists actually put forth in forecasting this number? Actually, I know why. Because the media survey us on this forecast. And we don t have the courage to tell the media that this is an exercise that is a waste of everyone s time.

9 April 4, 2012 Why Should Not Stocks Have Done Well? or Business, With Enemies Like This, Who Needs Friends?

10 April 13, 2012 Recent Federal Budgetary Trends: Facts, Not Opinions The federal budget deficit reached its widest gap on a 12-month moving total basis in February 2010 at $1.478 trillion. Although remaining at astronomical levels, the budget deficit has been trending lower and stood at $1.246 trillion in March The year-over-year growth in the 12-month moving total of federal outlays peaked at 19.7% in July In March 2012, the year-over-year change in the 12-month moving total of federal outlays was minus 1.1%. The median growth in the year-over-year moving total of federal outlays from December 1955 through March 2012 is 6.6%. Starting in March 2010, growth in federal outlays has been below the long-term median. The year-over-year change in the 12-month moving total of federal receipts reached a nadir of minus 17.6% in November In March 2012, the year-over-year growth in the 12-month moving total of federal receipts was 5.4%. The median growth in the year-over-year 12-month moving total of federal receipts from December 1955 through March 2012 is 7.4%. Starting in September 2011, growth in federal receipts has been below the long-term median. It would appear that what accounts more for the persistence of large federal deficits is weak growth in receipts rather than strong growth in expenditures. Chart 1

11 April 16, 2012 The Cyclical Macroeconomic Impact of Taxmageddon 2013 As you file your 2011 federal income taxes, you are being bombarded in the media with frightening talk about an impending Taxmageddon befalling us as we wake up on January 1, Of course, if some of the more apocalyptic predictions of the coming end on December 21, 2012, of the Long Count Mayan calendar come to pass, then we will not have to concern ourselves with Taxmageddon But assuming that most of us will be around for January 1, 2013, what is Taxmageddon all about and what will be its cyclical macroeconomic impact on the U.S. economy? At midnight on December 31, 2012, the current federal personal income tax rate structure will revert to the structure that prevailed at the close of the Clinton administration. And among other things, tax rates also will go up because of the additional taxes on investment income as part of the Affordable (Health) Care Act. All told, tax revenues will increase by about $500 billion in 2013, which is about 3.2% of the Blue Chip survey average forecast of 2012 nominal GDP. Moreover, because of the federal budget agreement, more like, disagreement, arrived at by Congress toward the end of 2011, federal discretionary outlays, including defense outlays, will be pared significantly beginning in calendar Wow, sucking this much money from the economy via revenue increases and expenditure decreases is a Keynesian s worst macroeconomic nightmare. But, if you are not a Keynesian and follow the money, you will have sweet dreams. To simplify things a bit, let s assume that the folks paying more taxes in 2013 were the same folks who would have bought the US bonds in 2013 to finance federal spending. Instead of lining up to purchase as many bonds in 2013, they purchase $500 billion less but pay $500 billion more in taxes. Either way, they were going to cut back their spending by $500 billion. Either way, won t that $500 billion being sucked out of the economy lead to lower total spending in the economy? Not unless the Treasury decides to let its cash balances increase by $500 billion. But, assuming the Treasury spends the $500 billion, then it will be recycled back into the economy. The net effect of all this on total spending in the economy? Zero! But wait. Because of the legislated cutbacks in federal spending, the Treasury will not spend the full $500 billion it sucks out of the economy through increased taxes. Yes it will. What it won t do is borrow as much if it cuts back on spending. So, those folks who otherwise were going to lend to the Treasury in 2013 will now find themselves with excess investable funds on their hands. They have three choices with which to do with these excess funds. Choice One would be to lend these funds to some other entity a household, a business or a state/local government that wanted to buy something. Choice Two would be for the potential lender to decide just buy something herself. Or Choice Three, just hold on to the funds via a deposit at Northern Trust. Only Choice Three would result in a net decline in spending in the economy if the federal government spends and borrow less. Now, of course, I have simplified the argument in order to show the macroeconomic impact on total spending in the economy. If you had not intended to contribute to the federal

12 government s solicitation of funds via bond auctions in 2013 and instead are coerced into contributing via a higher tax rate, then you might see 2013 as Taxmageddon. But when we sum across all yous, it is a wash when it comes to the macroeconomic impact on total spending on the economy. Those who are forecasting much slower growth in US GDP in 2013 could turn out to be correct, but not because of Taxmageddon Seniors Worried about the Debt They Are Passing on to Their Heirs? We Have Met the Enemy and It Is Us! I recently celebrated my 65th birthday, which allowed me to become eligible for Medicare. On May 1, I will begin collecting Social Security benefits. I was curious to see what has been happening to combined federal expenditures on Social Security and Medicare in relation to total federal expenditures excluding those for national defense. My curiosity was satisfied by the data in Chart 1. Back in FY 1979, combined Social Security and Medicare expenditures represented 33.7% of total federal nondefense expenditures. In FY 2011, this percentage had risen to 42%. Using current law, the Congressional Budget Office projects that in FY 2022, combined Social Security and Medicare expenditures will represent 51% of total federal nondefense expenditures. So, we seniors have been in recent years and will continue to account for larger and larger absolute and relative amounts of federal government expenditures.

13 At the same time that we seniors are accounting for more government spending, our tax burdens have fallen. The effective federal tax rates for the middle, second highest (fourth) and highest quintiles of household income are shown in Chart 2. (Effective federal tax rates measure the tax burden on households. These rates are calculated by dividing taxes paid by or imputed to households by their comprehensive household income. Federal taxes include individual income, corporate income, payroll and excise taxes. Individual income taxes are generally distributed directly to households paying those taxes. Social insurance, or payroll, taxes are distributed to households paying those taxes directly or paying them indirectly through their employers. Corporate income taxes are distributed to households according to their share of capital income. Federal excise taxes are distributed to them according to their consumption of the taxed good or service.) For the middle and fourth quintile household incomes, effective taxes are near the lowest in the post-wwii era. For the highest quintile household income, the only time in the post-wwii era the effective tax rate was lower was during the Reagan administration.

14 Chart 3 shows the total federal debt divided by the number of U.S. residents under the age of 65. In a sense, it is the federal debt we seniors are leaving to each of our children and grandchildren. Back in 1979, seniors left about $4.2 thousand of federal debt to each of their children and grandchildren. By 2011, we seniors had left about $55.9 thousand of federal debt to each of our children and grandchildren. So, although I am worried about the federal debt I am saddling my descendants with, I am playing a large role in the cause of my worry through the collection of Social Security and Medicare benefits and the historically low tax rate I am paying. What s a worried senior to do? Leave the kids and grandkids a big inheritance. In other words, stay at home in the winter rather than taking that cruise and eat at home more rather than hitting the early-bird special at your local dining establishment. Because I am the beneficiary of the increased federal debt that is being piled up, perhaps I should be the one to sacrifice a little today for my beneficiaries of tomorrow. Nah. It is more fun to complain.

15 April 23, 2012 Mortgage Refinancing: Stimulative or Redistributive? This etude has nothing to do with today s economic or market events. Rather, it is a little acorn for you to bury today and dig up in the future when some partial-equilibrium yahoo on CNBC says that total spending in the economy will get a boost as households refinance their mortgages at lower interest rates. Yes, the folks doing the refinancing will now have more income left over after making their monthly mortgage payment to spend on other things. But what about the ultimate lender who has had his higher-interest security called away from her? She was earning 6% on her loan but now is able to earn only 4% on the same type of loan. All else the same, has not her income gone down by the same amount as the refinancer s after-interest disposable income gone up? Yes. Thus, while the refinancer is able to go out to dinner more, the refinance will be dining out less. You do not have to fall into the trap of partial-equilibrium analysis. Do as Bastiat suggests. Take into account the effects of not only what is seen, but those effects that must be foreseen. How Do Higher Gasoline Prices Reduce Real GDP Growth? Another acorn. We often hear that higher gasoline prices will reduce real GDP growth. Why? When I spend more at the pump, the producers of gasoline receive higher revenues. What do they do with these revenues? I would argue that the gasoline producers spend them in one way or another. They may spend the revenues by hiring more geologists in order to find more crude oil. They may increase their dividend to their stockholders. They may repurchase some of their stock in the open market. Thus, so far, what is seen is a redistribution of total income in the economy, not a decline in total income. But what must be foreseen is what a deficiency of gasoline implies for the total production of goods and services in the economy. Just as labor is required to produce goods and services, so too, is energy. If there is a reduction in the supply of crude oil, and hence, gasoline, then not only will the price of these energy products rise, but the reduced supply of these products will imply a reduced ability to produce all manner of goods and services in the economy. Think of a reduction in the supply of crude oil as something akin to a pandemic. If a pandemic were to result in a reduction in the labor force, then not only would wage rates rise, but total output in the economy would fall because of a reduction in the number of people on assembly lines and in offices. Thus, the negative impact on real GDP growth from an increase in crude oil/gasoline prices results from aggregate supply side effects, not aggregate demand-side effects. But what if gasoline prices are rising, not because the supply of gasoline is falling, but because the demand for gasoline is rising? What would be the impact on real GDP growth in this case? It s all relative. That is, the demand for gasoline is rising faster than the supply of gasoline. There is a relative deficiency of gasoline. This implies that the growth in real GDP will slow relative to what it would have been had increases in the supply of gasoline kept up with increases in the demand for gasoline.

16 April 30, 2012 Don t End the Fed, Mend the Fed Congressman Ron Paul has written a book entitled End the Fed. I have to admit that I have not read his book. But I have read many of Congressman Paul s excellent (in my opinion) essays on monetary theory and policy. Based on the essays I have read, Congressman Paul likely argues in End the Fed that the Fed and other central banks have created monetary mischief in the past and are likely to continue to do so in the future. Because of this monetary mischief, I assume that Congressman Paul would like to replace the Fed and other central banks with some form of a gold standard. I share Congressman Paul s sentiments. But I am no Don Quixote. Although the return to a gold standard for our monetary system has much appeal, it is unlikely to occur. So, let s not let the perfect be the enemy of the good. Perhaps there is second-best monetary policy approach to the gold standard that might achieve most of the desirable outcomes of a gold standard but might have a greater probability of actually being adopted. Such an approach is what I am proposing in my final Northern Trust Econtrarian (but perhaps not my final Econtrarian). My suggested approach is very similar to one advocated by Milton Friedman at least 60 years ago. The more things change, the more they stay the same, I guess. I am proposing that the Federal Reserve target and control growth in the sum of credit created by private monetary financial institutions (commercial banks, S&Ls and credit unions) and the credit created by the Fed itself. I believe that this approach to monetary policy would reduce the amplitude of business cycles, would prevent sustained rapid increases in the prices of goods/services and would prevent asset-price bubbles of the magnitude of the recent NASDAQ and housing experiences. Milton Friedman, the father of modern monetarism, advocated that the Federal Reserve should abandon its obsession with control of the price of credit, i.e., the interest rate, but rather should concentrate on controlling the quantity of money. Friedman s definition of money was currency held by the public and the liabilities of depository institutions (e.g., commercial banks, S&Ls and credit unions) that were redeemable at par and were redeemable on demand, or with a relatively short waiting period. Friedman s definition of money is closely related to what today is defined as the M2 money supply. Fifty years ago, Friedman s proposal and mine were very similar inasmuch as M2-type deposits represented over 90% of the loans and securities on the books of private monetary financial institutions. As shown in Chart 1, by 2007, however, this percentage had dropped to 52, rising back to only 68 in 2011 in the aftermath of the financial crisis. Since 1959, private monetary financial institutions have steadily changed the composition of their funding away from M2-type deposits.

17 Chart 1 M2 Deposits as a % of Loans/Securities of Private Monetary Financial Institutions* % percent % percent % * Loans/securities on books of commercial banks, S&Ls and credit unions. 50 Although my proposal for how the Fed should conduct monetary policy is similar to Friedman s in that the Fed should concentrate on quantities rather than the price of credit, the genesis of my proposal is more aligned with the Austrian school of monetary theory than the monetarist. (I personally, do not believe that there is that much difference between the Austrians and the monetarists when it comes to monetary theory, but if you disagree in a disagreeable manner, send your flaming s to plk1@ntrs.com.) The Austrians separated credit into two categories, created credit and transfer credit. Created credit is credit that figuratively is created out of thin air. When credit is created out of thin air, the recipient of this credit can increase his/her spending while no other entity in the economy needs to cut back on its current spending. Thus, under most circumstances, when there is an increase in thin air or created credit, there will generally be a net increase in nominal aggregate spending in the economy. In contrast, transfer credit arises from the ultimate grantor of credit curtailing his/her current spending relative to his/her current income and transferring purchasing power to another entity that has a greater urgency to spend currently than does the grantor. Thus, when there is an increase in transfer credit there is not a net increase in nominal aggregate spending in the economy, but rather a change in the composition of spending. The grantor of transfer credit curtails his/her current spending; the recipient of transfer credit increases

18 his/her current spending. The credit issued by the Fed and private monetary financial institutions is of the created variety, i.e., created figuratively out of thin air. As mentioned above, an increase in thin air credit will generally result in a net increase in nominal aggregate spending nominal spending on currently-produced goods/services and/or existing assets, be they physical assets or financial instruments. Depending on supply conditions, this increased spending resulting from the increased thin air credit can lead to an increase in the current production of goods/services, an increase in the prices of currentlyproduced goods/services, an increase in the prices of existing assets or some combination of these outcomes. Nominal gross domestic purchases measures the nominal expenditures on currently-produced goods and services by domestic households, businesses and governments. Some of these goods/services are produced domestically; some are imported. A change in nominal gross domestic purchases represents a change in the prices of and/or real quantities purchased of currently-produced goods and services. An increase in thin air credit might result in an increase in nominal expenditures on existing assets. An increase in expenditures on something existing and, therefore, something whose supply is fixed, must, by definition, imply an increase in the price of that something. One way to measure these price increases on existing assets is to calculate households holding gains on assets. In order to capture the effects of changes in thin air credit, I have created a series that is the sum of the year-over-year percent change in nominal gross domestic purchases and households holding gains on assets as a percent of household net worth. Shown in Chart 2 is this sum along with its components from 1953 through 2011.

19 Chart 2 Yr./Yr. % Chg. in Nominal Gross Domestic Purch., HH Holding Gains as % of Net Worth, Sum of % Chg. in Gross Domestic Purch. and HH Gains as % of Net Worth Sum Dom Purch. Gains-to-Net Worth Chart 3 shows the relationship between growth in total monetary financial institution credit (Fed credit plus private monetary financial institution credit) and the sum of growth in gross domestic purchases and households holding gains on assets as a percent of household net worth. The correlation between the two series from 1953 through 2007, before the onset of the recent financial crisis, is 0.70 out of maximum possible Thus, during this period, changes in total MFI credit appear to explain a large proportion of the behavior of changes in nominal domestic expenditures on currently-produced goods/services and the behavior of changes in the prices of existing assets. The correlation coefficient declines to 0.60 when the period is extended to include that of the recent financial crisis.

20 Chart 3 Nominal Gross Domestic Purchases plus HH Capital Gains* vs. Total MFI Credit** r = 0.60 ( ) r= 0.70 ( ) percent 4 4 percent Purchases+Gains Total MFI Credit * Sum of yr./yr. % change in nominal Gross Domestic Purchases plus household capital gains as a % of household net worth. ** Total Monetary Financial Institution (MFI) credit is the sum of outstanding credit created by the Fed, commercial banks, S&Ls and credit unions. Plotted is the yr./yr. % change in total MFI credit. My hypothesis as to why the correlation between changes in total MFI credit and growth in nominal domestic expenditures plus capital gains declines after 2007 is that recipients of Federal Reserve credit that was created in 2008 and 2009 chose to hold a large amount of the funds obtained from the Fed as deposits rather than relending them to some other entity or spending them. As shown in Chart 4, growth in total deposits at private monetary financial institutions did not fall commensurate with the slower growth/contraction in private MFI credit in 2008 and In those years, had it not been for large increases in the Fed s balance sheet, growth in total MFI credit would have been weaker, resembling that of the growth/contraction in private MFI credit. For example, if the Fed purchases securities in the open market from the nonbank public, all else the same, there will be a net increase in total deposits in the economy the deposits of the seller of securities to the Fed. Under normal

21 circumstances, the seller of these securities to the Fed would then lend these deposits to some other entity that desired to increase its current spending. But in times of increased economic and financial stress, as what occurred in 2009, the seller of securities to the Fed might choose to simply hold on to the deposits rather than lending them or spending them. In this case, there could be an increase in total MFI credit emanating from the Fed, but no commensurate increase in nominal aggregate spending in the economy. Chart 4 Private MFI Credit, Total MFI Credit and Total Private MFI Deposits year-over-year percent change percent percent Prvt. MFI Cred. Ttl. Dep. Ttl. MFI Cred So, we have learned that there is a high correlation between behavior of total MFI credit and nominal aggregate domestic spending, including holding gains on household assets. Thus, it appears that the behavior of total MFI credit plays a critical role in determining the cyclical behavior of the economy and in determining the asset-price inflation. If the Fed were to stabilize the growth in total MFI credit at some relatively low rate, there is high probability that the amplitude of business cycles would be damped, that the rapid increases in the prices of goods/service as experienced in the 1970s could be avoided in the future and that the magnitude of the asset-price bubbles as experienced during the Greenspan-Fed era also could be avoided in the future. If severe asset-price bubbles could be avoided, then there is a high probability that financial crises such as we recently experienced could be avoided.

22 What would be the appropriate annual rate of growth in total MFI credit? The answer to this is above my pay grade. Austrians might argue that the proper rate of growth in total MFI credit is zero, or perhaps, the rate of growth in the population. Others might argue that the proper rate of growth in total MFI credit is the potential real rate of growth in the economy, whatever that is. Over the past 59 years, the median annual rate of growth in total MFI credit was 7.3%. I would argue that this is too high if goods/service-price and asset-price inflation is to be avoided. But again, achieving a steady rate of growth in total MFI credit is as important as determining the correct rate of growth. I would suggest to Congressman Paul that he stop wasting his time trying to end the Fed. Rather, he should sponsor legislation that would specify a single mandate for Federal Reserve policy achieving a steady and low rate of growth in total MFI credit. If the Fed were to successfully execute this policy, it might not produce economic outcomes as good as a gold standard would, but I believe it would produce economic outcomes considerably better than what has occurred since the early 1970s. In closing, I want to thank the stockholders and senior management of the Northern Trust Company for allowing me to write these commentaries over the past 25 years. I hope that the readers learned a fraction of the macroeconomics that I learned in writing them. That s all folks. Paul L. Kasriel Econtrarian@gmail.com