Economic Commentary
Daniel Laufenberg, Ph.D.

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Numerous economic data series are released between the publication dates of the Laufenberg Economic Quarterly (LEQ). Therefore, this page is designed to provide commentary on the more recent data and their implications for the economic outlook.

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Optimism, not irrational exuberance
(October 15, 2012)

I am optimistic about the near-term outlook for the U.S. economy, but far from irrationally exuberant. Much of my optimism comes from the belief that Winston Churchill was correct when he said “you can always count on Americans to do the right thing—after they’ve tried everything else.” I expect that policymakers will do the right thing after all else fails.

I have long been labeled as an optimist, but as an economic forecaster it has paid over the last forty years (my career) to be biased in that direction. After all, during that period, the economy has grown far more often than not, the stock market has increased far more often than not, and the standard of living in the U.S. has risen far more often than not. A key factor driving these outcomes has been the dream of individuals to succeed rather than the hope that others fail. An old joke about the difference between the former Soviet Union and the U.S. was that in the U.S. if your neighbor had two horses and you only had one, you would work harder to get a second horse, whereas in the Soviet Union if your neighbor had two horses and you only had one, you would petition the government to shoot one of your neighbors horses. Sometimes I feel that the U.S. is moving away from the economic system that encourages people to work harder and smarter, and closer to the economic system that shoots horses. I expect—not just hope—that policymakers eventually will do the right thing and reverse this recent trend. And it is more a function of allowing people the opportunity to succeed than implementing new government programs.

In this regard, I read an article in a recent issue of The Economist about India and how it needs its own version of America’s dream to fulfill its promise of growth and prosperity. According to this article, India “must commit itself not to just political and civic freedoms, but also to the economic liberalism that will allow it to build a productive, competitive and open economy, and give every Indian a greater chance of prosperity.” 1 This may be an appropriate lesson for India but it also should be a reminder to us that we need to protect the American dream and not let it die in the name of social, economic or regulatory reform. Do not misunderstand, I think the government sector should be proportional to the economy—that is, a large government may be appropriate for a large economy. The problem arises when the government becomes too big relative to the economy that is asked to support it. I do not think we are there yet, but what bothers me is that we seem to be moving in that direction.

As in India, the U.S. needs politicians who recognize the direction fiscal and regulatory policies need to take, understand the sometimes difficult steps required to get there, and can persuade the electorate that the journey will be worthwhile.2 Indeed, some things are universal given that the same could be said for nearly every country in the world, including Europe, China and Japan, and their own version of a dream.

Quantitative easing

As many of you know, I have never been a big fan of quantitative easing (QE). My skepticism about such a policy has many aspects, many of which I have never shared in writing. The purpose of this section is to discuss the pros and cons of QE. On balance, I contend that at this point in the business cycle, the cons far outweigh the pros.

Benefits of QE: The primary goal of QE is to push long-term interest rates even lower, which reduces the cost of capital to businesses, which may encourage them to invest in more capital projects. The argument is that with increased real fixed investment—both business and residential—more jobs would follow. Also, lower interest rates due to the increased liquidity associated with QE is expected to reduce the cost of servicing the federal debt, making it easier for policymakers to approve more deficit spending to provide further government stimulus to the economy. As far as I can tell, this is the complete list of potential benefits of more QE. Unfortunately, I doubt that lower long-term interest rates will give businesses much of a boost when rates are already at record low levels, the slow recovery of residential investment (housing) is certainly not because of a lack of liquidity, and lowering the cost of servicing federal debt gives policymakers an excuse to add more to an already high level of debt.

Costs of QE: In the current stage of the business cycle and with interest rates already very low, there are potential costs associated with more QE. First, as mentioned above, lower long-term interest rates or more liquidity in financial markets most likely will not encourage increased real fixed investment. I contend that more liquidity is unnecessary—excess reserves at financial institutions, which are reserves held at the Fed above those required to be held against deposits, are up to $1.5 trillion from about $1.5 billion in 2007. This is not a typo—it is trillion and not billion. Clearly financial institutions have the wherewithal to lend if not the will. It is unclear to me how adding even more liquidity to an already highly liquid market would help the economy. This is reminiscent of the proverbial “liquidity trap” in which monetary policymakers find themselves pushing on a string. In this case, the Federal Reserve can do very little, yet we continue to expect them to do something.

This concern was echoed in a recent speech by Charles Plosser, President of the Philadelphia Fed, in which he noted that the Fed’s action in September to increase monetary policy accommodation was “neither appropriate nor likely to be very effective in the current environment.”3 He went on to say that every policy action has costs and benefits and that he was concerned that the potential costs and risks associated with the Fed’s latest action outweigh the potential benefits. In the end, he seemed to be concerned that by “conveying the idea that such an action will speed up the recovery risks the Fed’s credibility.”

For the most part, I am less concerned about the Fed’s credibility and more concerned about the Fed’s resolve to reverse course when necessary. After all, financial market participants have become addicted to QE. It is perceived to be the quick-fix needed to keep financial markets on the upswing. Like all addictions, the risk of an overdose increases with usage. I am worried that the Fed may have provided an overdose of liquidity that will be very difficult politically to reverse. In this case, the penalty may not be just the Fed’s credibility but its independence.

I firmly believe in an independent central bank because it often must make politically unpopular decisions. However, if the Fed waits to take away the punch bowl until it is clear that the party is booming, it will be too late. And the more punch on the table, the more difficult it will be to remove it, even gradually. Of course, the political pressure on the Fed to stay the course will be intense because anything less would be interpreted as a Fed fighting inflation that does not exist, or a Fed that is anti-labor, anti-housing, anti-growth—take your pick.

Also, President Plosser noted that QE is something the Fed has not done before, which means that unwinding it is something the Fed has not done before either. In this case, the claim by the Fed that they know how to fight inflation may not apply to the current policy stance since they have never been here before. period

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1 “In search of a dream,” The Economist, September 29th-October 5th, 2012, p. 13.
2 Ibid.
3 Charles I. Plosser, President, Federal Reserve Bank of Philadelphia, “Economic Outlook and the
Limits of Monetary Policy,” Southern Chester County Chamber of Commerce, October 11, 2012.

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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

Dlaufenberg@stonebridgecap.com

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


2012 Commentary

Optimism, not irrational exuberance (current article)
-- October 15, 2012

Disappointing but far from disasterous
-- July 31, 2012

Assessing the recent weak economic data
-- June 8, 2012

Consensus too pessimistic about everything
-- April 16, 2012

Risks to the forecast
-- March 7, 2012

A good finish to 2011 but still not good enough
-- January 27, 2012

2011 Commentary

More evidence of a strong finish
-- December 22, 2011

Finishing Strong
-- October 14, 2011

Living in interesting times
-- September 8, 2011

A not so pleasant surprise!
-- September 2, 2011

Surprise!
-- August 16, 2011

Debt ceiling politics
-- July 25, 2011

Q2 growth: Another disappointment likely
-- July 14, 2011

Interpreting the ISM manufacturing index and the employment situation report for May
-- June 4, 2011

A slower start to 2011 than anticipated earlier
-- April 14, 2011

Is the dollar's status as the reserve currency at risk?
-- March 21, 2011

More trouble in the Middle East
-- February 26, 2011

Searching for the next debt crisis
-- January 13, 2011

2010 Commentary

What's going on?
-- October 15, 2010

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