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The Asset-Rich, Income-Poor U.S. Economy: Some Similarities/Lessons for Pakistan

By

Inayat U. Mangla

Professor of Finance & C. Law

Western Michigan University

Kalamazoo, MI. 49008, U.S.A

Email: inayat.mangla@wmich.edu

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Background

The Asset-Rich, Income-Poor U.S. Economy : Some Similarities/Lessons for Pakistan

• History repeats itself and conventional wisdom, despite current global challenges, has continuous merit

• We are all familiar with Japan’s Econ. crash of 1990’s, and its subsequent two lost decades of economic malaise, recessions and stock market crash

• Nikkei 225 dropped from 40,000 to 8,000 (80% ↓). Today, around 20,000 - 1% Real growth (ẏ) despite lowest level of ST and LT rates in world history.

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U.S. Experience• K. Warsh (June 20, 2014, WSJ) calls Japan’s experience “Balance Sheet

Recession” (B.S.R.). This conclusion wasn’t forgotten by U.S. Fed during /after GFC.

• What was GFC?: Some facts: Fin. Markets, Fin. Institutions, ẏ, , u̇�(C.B. / Inv. B), ST-FFR and LT 10Y USGBY before and after.

• Policy response: Fed engineered an extraordinarily loose M.P., what can be described as “Balance Sheet Recovery”. The Policy started in 2008 in various forms and shapes – QE1, QE2, Operation Twist and QE3.

• Summary of all these developments can be seen in the Fed’s B.S., which stood at $5T in Jan. 2015, vs. normal average of $0.7T. – a nice happy birthday on Fed’s 100 years.

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Insert Fed B.S.

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Fed ‘B.S. Recovery’- An Evaluation • Fed officials have said several times that among other benefits, its QE

programs have helped boost U.S. equity prices.

• Critics of Fed’s B.S.R. argue that it hasn’t produced business investment, it has been an opportunity killer for the U.S. labor force.

• The Fed assures us- even with improved inflation dynamics, credit markets have priced for perfection, and stock prices are at a record level.

• DJIA @ 18,000, S&P500 @ 2100 and NASDAQ @ 5000 on April 8, and some similar consolation for Pak KSE @ 30,000 with P/E=25.8 with historic average 15

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Balance Sheet Recovery: Evaluation • The agg. wealth of the U.S., H.H., including stocks and real estate

holdings hit a new high of $82T-a whopping ↑ of $26 T in wealth since 2009. No wonder most analysts on Wall Street applaud the Fed’s unrelenting balance sheet recovery strategy.

• The Fed’s extraordinary tools (QEs) are far more potent in goosing balance sheet wealth than spurring real income growth. Bernanke has asserted that higher stock prices are an outcome of Fed purchases of U.S. Treasuries.

• However, another approach of research suggests a different perspective, e.g. PIMCO. Based on their analysis, QE has not been the driving force behind rising equity prices in recent years. They found that since 2009, corporate profits have had a more direct relationship to stock prices.

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• Coming back to the critics of Fed’s policy, it provides little comfort for middle-class families and small businesses that must rely on their income statements to pay the bills. About half of American households do not own any stocks and more than one-third don’t own a residence.

• The most recent March 2015 employment report reveals the troubling story for Main Street. Only 120,000 jobs were created in March, income for most Americans remains under stress, with only modest improvements in hours worked, and average hourly earnings.

• With the so-called improvement in the labor market, and the unemployment rate dropping to 5.5%, Fed faces two big policy questions:

• When to raise rates, and how to go about raising them.

• Federal funds futures, which price off Fed policy expectations, imply the target rate will be 1.0% by August 2015 vs. zero today.

• The Fed may end up lifting rates first and dealing with its $5T balance sheet later. Why? Conventional mechanism of excess reserves will not work.

• Yellen, Fed Chair, referred to a broader measure of ů called U-6, which includes part-timers looking for full time work and people who want a job but haven’t been looking. U-6 has fallen sharply but is still historically high 12.1%. It’s taken a full 84 months for the number of people working to get back to its previous peak, in 2007, a discomforting postwar record.

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U.S. Corporations• Meanwhile, U.S. corporate CEOs have used financial engineering – debt

financed share buybacks, M&A etc., instead of capital investment in property, plants and equipment. In 2014, U.S. corporations added more than $2T of new debt e.g.:

Apple, GOOG, CISCO,ATT, Pfizer etc., including even some banks.

• Some of these corporations paid a lower YTM on these bonds than 10 year U.S. Treasury yields.

• Institutional investors extend their risk parameters to beat their benchmarks.

• Retail investors belatedly participate in the rising asset-price environment, and are forced to take more risk.

• Simultaneously, U.S. corporations are loaded with cash of $3T, and globally more than $4.5T- a cash headache for organizations.

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• All of these above-mentioned strategies have lifted balance-sheet wealth, (B.S.W.) at least for a while.

• But real economic growth - averaging just a bit above 2% for the sixth year in a row - remains sorely lacking.

• Higher asset prices are not translating into meaningful increases in capital expenditures.

• The weak growth in business investment is proving to be an opportunity killer for U.S. workers.

• The result is those with jobs have some job security but they are less willing to run the risk of finding a better opportunity, or negotiating for higher wages.

• What matters is the quality of jobs!

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Jobs are not enough• The malaise in the labor markets, and muted business investment – help

explain why productivity measures are 1.5 percentage point below the historical norm. e.g. 1.5% VS 3% in 1990s.

• Higher productivity implies increased efficiency in output per worker- a hallmark of the U.S. economy for the 1980’s, 1990’s and early 2000’s.

• Productivity is growing more slowly, averaging a little over 1% since the recovery began, about half the average of 2.5% from 1947 to 2007. But productivity growth had begun to slow even before the recessions, since around 2005. John Fernald of the Fed (2014) attributes this to the waning of the IT revolution.

• I encourage graduate students to calculate productivity for Pak. economy from 1980’s until present and compare it with its peer economies of S.E. Asian countries. You will find similar rather more declining output per worker.

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• The Fed’s latest forecast is for the U.S. economy to grow at 2% during this decade; and the unemployment rate to fall to about 5.5% by the end of 2015.

• If Fed’s scenario finally comes to pass, interest rates are likely to move meaningfully higher across the yield curve. The money pouring into the financial markets may be redistributed in part to the real economy.

• Therefore, stocks, leveraged loans and real estate are likely to be re-priced in a higher interest rate regime.

• If rates move quickly or unexpectedly, the glorified balance-sheet recovery could suffer a blow.

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F.M. Shock

• What if there is an unexpected financial shock that causes the economy to derail in the next two years?

• This could happen due to geo-political factors, too quick risk ↑ in interest rates and inflationary expectations.

• The Fed would surely be called upon to bolster asset prices and stimulate the real economy.

• It is an open ended question, but would a return by the Fed be effective?

• The common view is that neither Wall Street nor Main Street would be comforted by a return to Quantitative-Easing.

• My own view is that such a shock has a higher probability b/c. . . .

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Balance Sheet Wealth• Balance Sheet wealth is sustainable only when it comes from

earned income, and not from Financial Engineering and government fiat.

• Wealth creation comes from strong sustainable growth that turns a proper mix of labor, capital and technology into productivity, productivity into labor income, income into savings, saving into capital, capital into investment, and investment into asset appreciation.

• This is good old macro– and microeconomics. Concepts of Production Function and Slow Steady State growth models.

• Unfortunately, this too has not been the path of Pakistan’s economic growth.

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U.S. and Pakistan economies

• Hence, the U.S. needs an exit strategy from 2% or less growth trap of the last seven years.

• The Pak. economy needs to get out of a slow growth rate of 3.8%. (Mangla 2011) as there are No short-cuts through Fed/SBP or MOF-engineered Balance Sheet wealth creation.

• The sooner the Fed exits its extraordinary monetary accommodation, the sooner businesses can get back to business and labor can get back to work.

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Some Comparisons

• What is the difference between 2% economic growth and 3% growth in the U.S. economy? Or 3.8% VS. 7-8% growth in peer economies of Pakistan?

• The real difference is one between a balance-sheet recovery that helps the well-to-do and an income-statement recovery that advances the interests of all citizens.

• The question is: What have we done to improve macroeconomic policy to achieve these target growth rates?

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Monetary vs Fiscal Policy

• Despite all the merits of M.P. and F.P. which Keynes (1936) and Post Keynesian told us, there are limits to what M.P. alone can achieve.

• The fact is that M.P. is not limitless. The first Nobel L. Tinbergen (1968) alluded to this by requiring the equality of # of instruments needed to achieve # of goals.

• Effectively any Central Bank has one tool ( Mˢ or R-rate). • Thus, it can achieve only one target-perhaps price stability.• It is also imperative to know how economic policy affects the

real econ. activity – an issue politicians and central bankers grapple with any financial crisis, or B.S. crisis of Pakistan which have occurred regularly within 7-8 year cycles.

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Monetary vs Fiscal Policy• Two famous economists, and Nobel winners, Sargent and Simms (SS)

presented their empirical research on cause and effect of macro-economic policy. Messers SS developed models that C.B. and policy makers use to analyze effects from tax increases to interest rate cuts.

• The core message of SS research is: that the world of economics is more interconnected than traditional models recognize, and that economic policy must reflect these interconnections. Central banks cannot resolve economic crises alone; their policy must be supported by fiscal policy, which is controlled by legislators.

• To expect more from M.P. without proper support from F.P. is illusionary and political stunt by policy makers and politicians (Political Economy) .

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Global Liquidity Trap

• Despite the huge budget deficits in the U.S. and other G.7 economies, there is NO “crowding out” because of global supply of liquidity, but perhaps not in the case of Pakistan.

• Even in EM/economies, this holds true to a certain…

• Any meaningful recoveries in global economies need more prudent role of F.P. and tax reforms, structural reforms in labor market and political will of making tough choices, which is lacking.

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U.S. Economy• The US economy is weak for a number of simple

reasons and does not need multivariate regressions to see them.

• First, a great deal of business activity that used to be conducted in the U.S. has left the U.S. for China, Mexico and large parts of Asia because of high corporate taxes, higher U.S. wages and excessive regulations which discourage investment.

• Second, a relatively declining educational system, incapable of providing qualified workers for industry.

• Third, an oversized government, leading to a redistributionist psychology which badly allocates K.

• Fourth, anti business growth regulation.

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• Ignoring the U.S. political involvements and its related ‘costs’, some examples of these redistributions include: Massive public and private sector debt (currently 348% of GDP, not including U.S. unfunded liabilities of Medicare, Social Security, prescription.)

• In the 21st century, we have seen dramatic monetary-based expansions, an overleveraged and almost out-of-credit consumer, devastating annual budget deficits and perennial current account deficits that are financed by the dollar serving as a world reserve currency.

• This cannot go on forever.

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Stock Markets/Asset Prices• Having described this “pessimistic” future outlook for the U.S. economy in

this decade, what can we say about asset prices?• My simple answer: As corporate earnings/profits are the milk and mother of

stock prices, it does not take a Ph.D. to predict that asset prices are going to fall.

• Financial pundits are also predicting a “Great Crash of 2016, the third $10T loss this century.”

• This is called “Greenspan’s black box syndrome,” when he testified before the U.S. Congress in 2008: His famous eight words: “I really didn’t get it until very late.”

• ‘This stock bubble is beyond 1929 and 2007,’ says John Hussman.• If this is not enough for a steep decline in stock markets, please have a look

at this anecdotal empirical evidence. Call it a statistical fluke, but at times flukes hold true!

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Back to Pakistan

• What is the relevance of the U.S. experience and economic challenges for Pakistan?

• There are a number of similarities of economic challenges faced by Pak. Economy.

• However, a fundamental difference between the two economies is that while there is an ongoing continuous debate and analysis about macro-econ. policy in the U.S. and its evaluation; unfortunately, there is little discussion about coherent and consistent policy making in Pak.

• Might is right approach.

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The message for Pakistan

• B.S. maneuvering and Financial Engineering will not work.

• The country needs to establish law and order situation first as a necessary condition.

• We have been living on borrowed time and money, and ad-hoc decision making in macro economic management since early-1980’s

• Some examples of my assertions are:

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Pakistan’s Policy Issues: Examples

• Exchange rate policy and Balance of Payments/Trade deficit

• Budget deficit• Energy Deficit• Circular Debt, Privatization Issues, etc.• Low economic growth rates• High inflation rates• I can go on, but will only focus on Exchange Rate

policy and B.O.P issues for illustrative purposes.

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B.O.P and Exchange Rate Policy• Pak. has faced these B.O.P issues at least four-five times since

1980’s (e.g. 1981, 1991, 1997-98, 2002-03, 2013).• Have dealt with these issues only by a ‘piecemeal approach’

such as “Political and Financial Engineering”, “Rent Seeking Behavior”, and capitalizing on geo-political events of the last three decades.

• The result: Continuous and repetitive occurrence of these problems within a cycle of 6-7 years.

• Let us look at the most recent B.O.P crisis of 2013 and a sharp drop in Pak. Currency (Rupee).

• Thanks to a series of recent external transactions – a $2B Eurobond sale; secondary offerings of UBL and PPL; ‘Friendly Money’ program disbursements of $1.5B from the World Bank and ADB; IMF new $6.8B fin. facility; and partial inflows from the 3G, 4G/LTE telecom auctions led to the boost in capital account and helped offset the weaknesses in the current account.

27Business Recorder; July 22, 2014

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• Most of these recent temporary fixes in the capital account are what I have called before as “Financial Engineering”. Just as Fed has loaded its B.S.; M.O.F and SBP have increased its B.S. to stabilize external account and control the exchange rate depreciation of Rs.

• More reliance on foreign debt is not the permanent solution. • Even heavy reliance on domestic debt is a sign of poor health

of the economy.• SBP reports (July 2014) an increase of 44% in domestic debt,

as interest cost of domestic debt increased to $961 B. • More alarming is debt stock to GDP ratio, which has increased

from 29% in 2009 to 42.2% in 2014.

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Thank you!