Why the US Fed is Powerless to Save the US Economy
The United States is living through a new depression that began in 2007.
It’s part of a larger global depression; the first since the 1930s. And this New Depression will continue indefinitely unless policy changes are made in the years ahead.
That statement may shock you.
Calling the current economic malaise a depression comes as a surprise to most investors I speak to. They have been told that the economy is in a recovery that started in 2009. Technically, yes, the economy has ‘recovered’.
But as I hope to show you today, I have a sound basis to argue that we’re experiencing a new depression.
Of course, mainstream economists and TV talking heads never refer to a depression.
Economists don’t like the word ‘depression’ because it does not have an exact mathematical definition.
For economists, anything that cannot be quantified does not exist. This view is one of the many failings of modern economics.
And no one under the age of 90 has ever had any experience with what most consider depression-like conditions.
If you’re like most investors, you have no working knowledge of what a depression is or how it affects asset values.
Furthermore, economists and policymakers are engaged in a conspiracy of silence on the subject. It’s no wonder investors are confused.
Again, you might not feel like you’re living in a depression. Where are the soup lines, after all? Where’s the 20% unemployment most people associate with a depression?
If those are your criteria for a depression, then I agree — we’re not in a depression.
But the starting place for understanding depression is to get the definition right.
You may think of depression as a continuous decline in GDP. The standard definition of a recession is two or more consecutive quarters of declining GDP and rising unemployment.
Since a depression is understood to be something worse than a recession, investors think it must mean an extra-long period of decline.
But that is not the definition of depression.
The best definition ever offered came from John Maynard Keynes in his 1936 classic, The General Theory of Employment, Interest and Money.
Keynes said a depression is ‘a chronic condition of subnormal activity for a considerable period without any marked tendency towards recovery or towards complete collapse.’
Keynes did not refer to declining GDP; he talked about ‘subnormal’ activity. In other words, it’s entirely possible to have growth in a depression. The problem is that the growth is below trend.
It is weak growth that does not do the job of providing enough jobs or staying ahead of the national debt. That is exactly what the US is experiencing today.
The long-term growth trend for US GDP is about 3%. Higher growth is possible for short periods of time. It could be caused by new technology that improves worker productivity. Or, it could be due to new entrants into the workforce. From 1994 to 2000, the heart of the Clinton boom, growth in the US economy averaged over 4% per year.
For a three-year stretch from 1983 to 1985, during the heart of the Reagan boom, growth in the US economy averaged over 5.5% per year.
These two periods were unusually strong, but they show what the US economy can do with the right policies. By contrast, growth in the US from 2007 through 2017 has averaged about 2% per year.
Growth in the first quarter of 2017 was worse — 1.4%. It picked up in the second quarter, although the overall number is still sub-trend.
That is the meaning of depression. It is not negative growth, but it is below-trend growth. The past seven years of roughly 2% growth — when the historical growth rate is 3% — is a depression, exactly as Keynes defined it.
Again, I realise that talk of a new depression seems confusing at best and disconcerting at worst. But we are not seeing the type of growth that will sustain an economic recovery.
Other observers point to declining unemployment and rising stock prices as evidence that we are not in a depression.
They miss the fact that unemployment can fall and stocks can go up during a depression. The Great Depression lasted from 1929 to 1940. It consisted of two technical recessions from 1929–1932 and again from 1937–1938.
The periods 1933–1936 and 1939–1940 were technically economic expansions.
Unemployment fell and stock prices rose. But the depression continued because the US did not return to its potential growth rate until 1941. Stock and real estate prices did not fully recover their 1929 highs until 1954, a quarter century after the depression started.
Growth today isn’t strong, because the problem in the economy is not monetary — it is structural.
The point is that GDP growth, rising stock prices and falling unemployment can all occur during depressions, as they do today.
What makes it a depression is ongoing below-trend growth that never gets back to its potential. That is exactly what the US economy is experiencing. The New Depression is here.
Lost US economic output is now over $4 trillion and getting worse all the time. It will never be recovered.
Investors are also confused about depression dynamics because they are continually told the US is in a ‘recovery’.
Year after year, forecasters at the Federal Reserve, the International Monetary Fund and on Wall Street crank out forecasts of robust growth.
And year after year, they are disappointed. The recovery never seems to get traction. First there are some signs of growth, then the economy quickly slips back into low-growth or no-growth mode.
The reason is simple. Typically, a recovery is driven by the Federal Reserve expanding credit and rising wages.
When inflation gets too high or labour markets get too tight, the Fed raises rates. That results in tightening credit and increasing unemployment. This normal expansion-contraction dynamic has happened repeatedly since the Second World War.
It’s usually engineered by the Federal Reserve in order to avoid inflation during expansions and alleviate unemployment during contractions.
The result is a predictable wave of expansion and contraction driven by monetary conditions. Investors and the Fed have been expecting another strong expansion since 2009, but it’s barely materialised.
That’s the real difference between a recession and a depression. Recessions are cyclical and monetary in nature. Depressions are persistent and structural in nature. Structural problems cannot be solved with cyclical solutions.
This is why the Fed has not ended the depression. The Fed has no power to make structural changes.
What do I mean by ‘structural changes’?
Shifts in fiscal and regulatory policies. The list is long, but would include things like lower taxes, the repeal of Obamacare, expanded oil and gas production, fewer government regulations, and an improved business climate in areas such as labour laws, litigation reform and the environment.
Power to make structural changes lies with the Congress and the White House. Of course, those two branches of government are barely on speaking terms, and especially so under Trump.
It’s difficult to envision Trump getting any meaningful legislation passed, given the hostility he faces not only from Democrats, but from his own party. And we’ll have to see how much of his tax plan actually survives once it goes through the congressional meat grinder.
But until the structural changes I described are enacted by law, this new depression will continue. And the Fed is powerless to change that.
Contributing Editor, The Daily Reckoning Australia