In anticipation of next week's nonfarm payroll number and the US unemployment rate, we thought this week, following the suggestion of another good credit friend, we would make a reference to Goodhart's law. Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure.
After a quick market overview where we will be looking at the implications of surging volatilities in the bond space spilling onto other asset classes (a point we touched recently), we would like to focus our attention on the broken credit transmission mechanism. Some punters have been putting the blame on QE recently, we think it has much more to do with global ZIRP. We will also discuss the issues we have with the Keynesian multiplier.
This week, we have continued to watch the moves in the MOVE index, which are going to spill no doubt to the CVIX index and most likely in the equity volatility indices space - source Bloomberg:
The divergence between VIX and its European equivalent V2X - Source Bloomberg:
Moving on to the subject of the Keynesian multiplier, in 1991, looking across 100 countries, Robert Barro of Harvard presented historical evidence that high government spending actually hurts economies in the long run by crowding out private spending and shifting resources to the uses preferred by politicians rather than consumers. There has also been a study by Valerie Ramey on the same subject.
Robert Barro’s work and research by Valerie Ramey, an economist at the University of California–San Diego, on how military spending influences GDP. Both studies found that government spending crowds out the private sector, at least a little. And both found multipliers close to one: Barro’s estimate is 0.8, while Ramey’s estimate is 1.2. Indicating that every dollar of government spending produces either less than a dollar of economic growth or just a little over a dollar.
Let's agree on one thing, governmnent spending comes from three sources, debt, new money, or taxes.
The Keynesian multiplier is normally supposed to be above 1 in order to justify an increase in government spending, if the multiplier is below 1, there is destruction of value, not creation of value.
Many seasoned economists, such as IMF Olivier Blanchard, have tackled the Keynesian multiplier and they have all come up with different results!
The link to a study of their calculations and different outcomes can be find here unfortunately it is in French but the results are on page 9 of the pdf:http://www.ofce.sciences-po.fr/pdf/revue/2-116.pdf
So you can do all the calculations you want, because if your model is flawed from inception due to wrong hypothesis to start with, so will be the results.
Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).
When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.
In 2008, we came very close to a global heart failure. The world had a stroke.
But what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.
Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain. Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession".
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story...
As we posited at the beginning of the conversation, we have argued that when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law, as reported by Simon Kennedy on the 24th of May in his Bloomberg article - Fed History Shows Punch Bowl Goes as Job Rise: