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Wednesday, January 30, 2013 – GDP Shrinks, Fed Stands Pat

GDP Shrinks, Fed Stands Pat
by Sinclair Noe
DOW – 44 = 13,910
SPX – 5 = 1501
NAS – 11 = 3142
10 YR YLD + .02 = 2.01
OIL + .46 = 98.03
GOLD + 12.50 = 1677.40
SILV + .64 = 32.12
GDP shrank in the fourth quarter, and we had that report on the same day as the Fed wraps up an FOMC meeting. So, I’ve been reading a bunch o’ blogs and articles about how the Fed has been printing money, expanding its balance sheet to more than $3 trillion, failing to generate economic growth, failing to generate jobs, diluting the dollar, and generally condemning the American economy to the inevitable tortures of hyper-inflation. The internets are offering up the full spectrum of opinions: from the idea that the GDP Shows Federal Reserve Just Screwing the Average American to the apologetic Five Reasons the GDP Report is Misleading (hint: the economy will bounce back in a heartbeat, by golly gosh) to Fed Stays the Course: Is Its Monetary Policy Wrong?
Let’s start with the GDP report. The economy shrank from October through December for the first time since the recession officially ended, hurt by the biggest cut in defense spending in 40 years, fewer exports and sluggish growth in company stockpiles. The Commerce Department said the economy contracted at an annual rate of 0.1 percent in the fourth quarter. That’s a sharp slowdown from the 3.1 percent growth rate in the July-September quarter, and well below expectations of 1% growth.
The weakness may be because of one-time factors. Government spending cuts and slower inventory growth subtracted a total of 2.6 percentage points from growth; and don’t forget Hurricane Sandy, which cut into GDP. The slower growth in stockpiles comes after a big jump in the third quarter. Companies frequently cut back on inventories if they anticipate a slowdown in sales. Slower inventory growth means factories likely produced less. Those categories offset faster growth in consumer spending, business investment and housing; the economy’s core drivers of growth.
Let’s look at some numbers. Residential investment jumped 15.3 percent, a sign that the housing sector continues to recover, for one. Similarly, investment in equipment and software by businesses rose 12.4 percent, an indicator that companies are still spending.  The 22.2 percent drop in military spending, the sharpest quarterly drop in more than four decades, along with the drop in inventories and exports overwhelmed more positive indicators in the private sector.
Subpar growth has held back hiring. The economy has created about 150,000 jobs a month, on average, for the past two years. That’s barely enough to reduce the unemployment rate, which has been 7.8 percent for the past two months. We’ll see the January jobs report on Friday.
The economy may stay weak at the start of the year because an increase in Social Security taxes is cutting into take-home pay. Tax hikes combined with cuts in government spending is an easy formula for negative growth. Another positive aspect of the report: For all of 2012, the economy expanded 2.2 percent, better than 2011′s growth of 1.8 percent.
Bottom line is that the GDP report was lousy. Which leads to the inevitable question, what went wrong? If the Federal Reserve policy of printing money to get us back into growth was working, trillions should have bought us the biggest expansion in history. Instead it bought us negative growth and 8% unemployment. At what point does the Federal Reserve admit they are wrong? Which probably isn’t the right question, but let’s look at it anyway.
The Fed wrapped up their FOMC meeting, and they did not admit the error of their ways. The Fed attributed the pause in growth to the impact of Hurricane Sandy and other “transitory factors,” and it said that there were some signs of increased strength in areas including consumer spending and housing.
The Fed affirmed the stimulus program it announced in December, saying that it would hold short-term interest rates near zero at least until the unemployment rate fell below 6.5 percent and expand its holdings of Treasury securities and mortgage-backed securities by $85 billion each month. Keep in mind, QE 4 – To Infinity and Beyond – is a fairly fresh program. The Fed says: “The committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline.”
Still, you have to admit that $85 billion a month starts to add up; 40 billion here; 45 billion there; after a while you’re talking about real money. And still no signs of the demon inflation nor economic growth. What does this really tell us? More than likely, the problems with the economy and with the financial sector were and are far worse than the attempted cures. The cesspool of toxic assets still being purged from banks’ balance sheets was much bigger than anyone has been willing to admit. The banks have been unwinding their derivatives positions but not eliminating them, and those derivatives were massive; probably somewhere north of $700 trillion dollars, which is a really big number.
To put it into perspective, we should note that the gross domestic product of the entire world stands at around just 60 trillion dollars.  The US residential real estate market is worth 23 trillion dollars.  The total value of all the US stock markets is a mere 16 trillion dollars.  The value of the entire world’s stock markets is about 50 trillion dollars. 
A derivative is essentially a bet.  They were used responsibly in business for centuries as insurance against loss.  For example, in a simple derivative contract a farmer might bet against the success of his own crop to insure that if his crop fails he will not be at a total loss.  If the crop is productive that year, he loses the bet but reaps a profit from sale of his product.  If the crop fails, on the other hand, he can collect on the bet and make up for his loss of profit.  Derivatives provide a way to produce even returns in markets that are subject to uneven productivity.
One of the problems with today’s derivatives market is that it has expanded from its initial purpose of hedging and simple speculation to allow for betting on just about anything financial.  During the housing bubble we saw banks like Goldman Sachs betting on the failure of the very products they were selling as “AAA” rated safe investments.  They made a ton of money on the failure of their own financial products in this way, which represents just a little bit of a conflict of interest. While the housing-related derivatives have taken up less of the overall market, the overall market continues to grow. Today’s synthetic derivatives market even allows for betting on other people’s bets. This has created a multi-level ponzi scheme of derivatives that are based on the success of other derivatives, using huge degrees of leverage at every layer. In addition to remaining vastly unregulated and opaque, the market for the creation and exchange of derivative contracts operates much like the roulette wheel at a Las Vegas casino.

Basically, there is no other game in town to realize the kind of profits banks and their clients demand these days, so the roulette table is the place to be. Part of the attraction for the banks is that derivatives are traded over the counter, not through regulated exchanges, and the notional value of derivatives is recorded OFF the balance sheet of an institution, although the market value of derivatives is recorded ON the balance sheet. Attempts at regulation have been effectively blocked. So, we don’t really know how much of the Federal Reserve’s stimulus has gone into the Black Hole which represents the big banks gambling addiction in derivatives.
Where else has all the Fed stimulus money been going? The Fed is exchanging about $4 billion in newly created money every business day for various types of bonds. All else being equal, the Fed’s bond buying puts more money in investors’ hands to buy other assets, including stocks.
So let us follow that newly created money. The major dealers who sell the bonds to the Fed can take that money and buy other bonds in the open market. The new seller then gets paid with that newly created money, which in the bank clearing system, acts just the same as money you and I work for.
To make this really simple, the Fed creates $4 billion a day and eventually some of that money goes into equities. And that, of course, helps keep stock prices elevated. So it doesn’t matter that we are having major problems with the underlying economy and markets that normally would depress stock prices. This is why you don’t fight the Fed.
So, a large, not-quite-sure-how-much, but large amount of the Fed’s stimulus efforts went to making sure the derivatives Black Hole did not swallow the entire universe; and that hasn’t happened yet, so good job. Another large chuck of change goes to propping up bonds and equities and the Wall Street traders that trade them; and the major market indices are close to record highs, so good job. But the broader economy sucks; so in this regard the Federal Reserve gets very low marks indeed.
America cannot succeed when a shrinking few do very well and a growing many barely make it. Yet that continues to be the direction we’re heading in. The top 1 percent of earners’ real wages grew 8.2 percent from 2009 to 2011, yet the real annual wages of Americans in the bottom 90 percent have continued to decline in the recovery, dropping 1.2 percent between 2009 and 2011. In other words, we’re back to the widening inequality we had before the debt bubble burst in 2008 and the economy crashed. Not even the very wealthy can continue to succeed without a broader-based prosperity. That’s a big reason why the recovery has been so weak; why the economy shrank in the fourth quarter.
Of course, fiscal policy has been ugly. As I said earlier, tax hikes combined with government spending cuts is a quick formula for negative growth. And the Federal Reserve standing pat won’t get the job done either.

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