The Age of Oversupply: Overcoming the Greatest Challenge to the Global Economy - Softcover

Alpert; Daniel

Softcover

ISBN 10: 0241003792 ISBN 13: 9780241003794

Publisher: Penguin Books Ltd, 2013

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About this title

About the Author:

Daniel Alpert is founding managing partner of investment bank Westwood Capital, LLC. He is widely quoted in the business media and is a fellow in economics of the Century Foundation, the country’s oldest policy think tank. He lives in New York.

Excerpt. © Reprinted by permission. All rights reserved.:

PREFACE

In September 2012, the U.S. Federal Reserve Bank announced and—shortly thereafter—implemented its third, and by far largest, installment of “quantitative” monetary easing. “QE3,” as the initiative is known, has resulted in the Fed acquiring over $1.35 trillion in U.S. government securities through January 2014,1 and it is expected to generate aggregate purchases of over $1.5 trillion through the anticipated end of the program in mid-2014.

QE3 went well beyond the Fed’s two earlier rounds of quantitative easing—QE1, from November 2008 to June 2010, and QE2, from November 2010 to June 2011—and will, when ended, have gone on for longer than even the Fed’s initial round of easing during the heart of the global financial crisis and the Great Recession. The rationale behind QE3 can best be described as “shock and awe,” an effort to shock the U.S. economy into reflation and growth by flooding it with awe-inspiring amounts of cash while attempting to bring long-term interest rates back near historic lows seen in mid-2012 and perhaps forcing down the value of the dollar to make U.S. exports more competitive and imports less attractive.

However, by those measures, QE3 was less than successful. Inflation in the United States continued to fall during the implementation of the policy, reaching lows unseen since the Great Recession itself. Per capita real disposable income barely budged, falling well off its trajectory from 2010 through the commencement of QE3. Long-term interest rates, while falling back a bit initially, ultimately rose well past their 2012 lows, sending bond markets tumbling even before the announcement of the Fed’s tapering back its purchases—which sent long-term interest rates well above levels before QE3 began. Needless to say, for a variety of reasons I address in the book, the dollar did not tank.

What was “successful” about QE3, in the eyes of some, was what happened in the financial economy (as opposed to the real “main street” economy). As I wrote in chapter 6 of this book, in a section entitled “The Limits of the Fed,” hyper-easy money policy set off a rush of speculation in risk assets. As is the intent with any extraordinary monetary-easing measures, the Fed’s interventions over three rounds of QE flooded the economy with liquidity to avoid lock-up of the financial economy, made it very inexpensive to borrow, and, ultimately, made so-called “risk-free” assets—such as high-quality government debt—very unattractive to own by virtue of the parsimonious returns thereon. Commodities—especially gold, having seriously burned speculators in a spectacular collapse after its run up resulting from QE1 and QE2, and non-monetary metals and oil, having been overvalued by speculators during those prior rounds, relative to end demand—were no longer seen as safe.

So liquidity finally flocked to public equities, especially those easily leveraged with cheap money, which ran up to valuations by the end of 2013 that by some measures (such as the CAPE ratio popularized by 2013 Nobel laureate Robert Shiller) made them more expensive than anytime other than during the market bubbles of 2008, 2000, and 1929. From the announcement of QE3 through the end of 2013, the S&P 500 Index appreciated by over 31 percent.2

U.S. housing, which did not reach its post-bubble statistical low valuation until early 2012 (a fact that seems forgotten two years later),3took off as well—rising gradually at the start of the historically low bond yields that were reached between QE2 and QE3 and then accelerating greatly during QE3. By the end of 2013, U.S. housing prices had, on average, retraced nearly half the value lost since their bubble-era peak. Prices rose, fueled by the same low interest rates that fueled the stock markets, but were driven higher still by the post-crises anomaly of tight inventories of for-sale housing amid rates of household formation (and thus incremental demand) that continued at levels lower than at any time since the Great Depression (no, that isn’t a typo—and that’s in nominal, nonpopulation-adjusted terms).

Looking back at the recovery in home prices that occurred simultaneously with QE3, we saw a continuation of the phenomena described in chapter 11 hereof—inventories constrained by homeowners remaining underwater relative to their bubble-era mortgage and thus unable, or unwilling, to sell their homes—combined with those with very low levels of home equity, insufficient to afford a down payment on a new home and therefore de facto non-sellers. We also experienced a large number of investor purchasers of homes able to access low-cost capital to acquire the limited inventory that was available and to pay up for it when necessary. Writing about the third quarter of 2013, Zillow, the real estate database firm, noted:

. . . One in five American homeowners with a mortgage remains underwater, a stubbornly high rate that is contributing to inventory shortages and holding back a full market recovery. The “effective” negative equity rate, which includes those homeowners with a mortgage with 20 percent or less equity in their homes, was 39.2 percent in the third quarter. Listing a home for sale and buying a new one generally requires equity of 20 percent or more to comfortably meet related expenses.4

One cannot find a more classic example of a market unable to find a true “clearing” price level because of nonmarket influences (i.e., government policy initiatives).

But in elevating price levels for U.S. housing and sending public equity markets to new historic highs, the Fed’s impact on the real economy—demand for goods, services, labor, and new capacity (plants and equipment)—was far less than anyone could have possibly expected from such a massive intervention. Ultimately, the rapid appreciation of financial assets (and both here and throughout the book I, as is generally the practice in economics, include real estate as a financial asset) in 2013 created a “wealth effect” recovery in which the small percentage of Americans owning stocks—and a far more substantial number owning homes—were, and felt, richer and supported a modest recovery in consumption. This, for a while at least, spilled over into the economies of other developed and developing exporting economies, which benefitted from the increased consumption—which some economists refer to as “leakage” of the U.S. monetary stimulus. But as events seem to be demonstrating at this writing, such wealth effect–created demand is proving unsustainable in the age of oversupply.

One of the most obvious reasons why wealth effect–reliant demand is unsustainable is that the price of equities influences the consumption patterns of only a small, but very wealthy, number of consumers. A more disturbing reason is that in an age in which wages are not growing (and are unlikely to, as discussed throughout the book, but particularly in chapter 8), the wealth effect has been transmitting to consumers who were made exuberant by rising home prices, chiefly by means of rising consumer debt, which hit new post-bubble highs in 2013,5 resulting in the exacerbation of the declining U.S. household savings rate. The ability of households to continue to consume by taking on more debt has rather unpleasant limits, as we saw in 2007. Lastly, in a world of inadequate global demand for labor, production, and capital relative to the supply thereof, there is a tendency for businesses, consumers, and investors to materially misread improvements in one nation’s economic results when other competitive nations are showing downwardly trending performance.

In a nearly fully globalized economy for goods, and even some services, strength in the United States that comes with concomitant weakness in China and other emerging producers (or in Germany that comes at the expense of the European periphery and emerging producers), as we saw in the second half of 2013, can only be sustained for a very limited time, until the price levels offered by those deprived of demand for their output are lowered to recapture such demand. This would not be the case in an environment in which supply and demand were more evenly matched, but in the age of oversupply what we get instead is the tossing around of the “hot potato” of inadequate demand among nations and regions, yielding disinflationary tendencies around the world.

Thus, financial asset price appreciation, the resulting wealth effect, and short-term rises in business activity fail to result in the advanced economies reaching “escape velocity” where increased consumption produces a virtuous demand for additional domestic capacity and labor, which in turn sets wages and prices on a reflationary path. As 2014 dawned and the reality of the Fed’s exiting the policy that sustained financial asset appreciation set in (which it is doing precisely because the Fed came to see little sustainable benefit to the real economy from quantitative easing—and potentially problematic distortions therefrom), global stock markets—first in the emerging nations and then in advanced nations—initially reacted with dread.

The failure of QE3 to ignite price and wage reflation was writ large in 2013, during which U.S. goods prices actually deflated from twelve months earlier.6 While services rose in price, the principal contributor to price inflation in services was, unsurprisingly given the above discussion, inflation in the cost of housing. Housing costs comprise some 41 percent of the U.S. Consumer Price Index, and shelter alone is over 52.5 percent of the services component of the CPI.7 The peculiar confluence of easy money and structural anomalies in the U.S. housing market resulted not only in price appreciation of owner-occupied homes but also restricted inventories. These factors, together with an enormous rise in the number of households that—since the Great Recession—no longer qualified for mortgages, saw many more families thrust into the conventional rental housing market, causing U.S. rents to rise by 2.9 percent over the course of 2013.8

Add inflation in medical services during 2013 (which has since been staunched, for a variety of underlying reasons) and you have the vast majority of 2013’s anemic 1.6 percent core U.S. inflation. As further housing price inflation is unlikely to prove sustainable in the absence of wage growth, with healthcare service pricing already declining and with prices of imports (and exports) falling with global oversupply, where is price inflation to come from in 2014? In fact, there are few sectors to look to, and the bias going forward is far more likely to be deflationary.

During the course of 2013, especially after the Fed announced its intention to taper its asset purchases, the conventional bond market wisdom was that interest rates on U.S. treasury securities would rise as a result of the planned change in policy. The benchmark ten-year yield increased by over 1.25 percent from their 2013 low to their high at the end of the year.9 At year end, expectations were that they would rise further still. But as I wrote in Q2 2013, in chapter 13 of this book, and have reiterated publically numerous times since, with the confluence of ultra-low inflation (tending toward deflation in the absence of the factors previously discussed), a global “oversupply” of demand for high-quality, hard-currency sovereign debt, and with both domestic and global growth data continuing to be unimpressive, there simply is nothing underpinning a more precipitous rise in U.S. sovereign debt yields.

What there was, at year-end 2013, was a collective fear of what financial market participants call a “falling knife.”10 The perception that the Fed’s buying of U.S. obligations had been materially influencing the prices at which those bonds were trading (and, perhaps just as importantly, the perception that all market participants shared that notion) overwhelmed the aforementioned underlying economic fundamentals. Sure enough, as the Fed reasserted that it would proceed with QE despite soft economic data at the beginning of 2014, instead of rising, interest rates fell to a point at which the trading range of the U.S. ten-year treasury note fell by over 50 basis points from its level at the end of 2013. Quantitative easing had proven so disruptive of market pricing mechanisms that even the normally staid and sensible bond market didn’t know which end was up.

· · ·

I have spoken and written recently about 2014 being the year of economic “cyclicalists”—those believing that the Great Recession and its aftermath have just been the result of a very severe decline in the business cycle—versus the “secularists”—who believe that what we continue to experience is the outcome of profound shifts in the way the domestic and global economy is working, relative to its behavior in the past, as is argued in The Age of Oversupply. Secularists, myself included, believe that cyclical upswings—while still of course present—are now both muted in amplitude and of very short duration. I expect this will continue to be the case for some time, until the global secular issues of oversupply of labor, productive capacity, and capital are either addressed directly as recommended in this book, or until the imbalances discussed herein—gradually and likely painfully—resolve themselves over a protracted period of time.

The failure of monetary policy alone to revive robust growth in the United States and the European Union (which admittedly has limited monetary tools available to it because of the Euro regime) has become evident to their central bankers. The euphoria that greeted the Bank of Japan’s massive QE program—part of its government’s forceful effort to reverse deflationary pressures, known colloquially as “Abenomics”—has subsided as endogenous inflation has come almost entirely from the currency market’s devaluation of the yen and the resulting rise in import prices (almost entirely energy related), as opposed to wages or prices for domestically produced goods. Such a condition is unsustainable, and, as I predicted in chapter 7, Abenomics will ultimately join previous Japanese reflationary efforts in failing to reverse the disinflationary trend that, since the Great Recession, has seen the rest of the developed world join Japan’s fate.

In early 2014, the U.S. economy saw a continuation of weak wage growth and ultra-low core inflation. Furthering limits on wage growth at the high end of wage sectors and the failure of the U.S. congress to extend long-term unemployment insurance benefits will pose ongoing challenges. I am particularly concerned that more folks coming off long-term benefits and being forced into taking jobs at whatever they can find will exert further downward pressure on U.S. wages. Of some alarm at the time of this writing has been recent data demonstrating falling unit labor costs with a contemporaneous rise in productivity. As I discussed in chapter 2, rising productivity that comes from weakness in wages and exploitation of excess capacity is a far cry from the version of productivity that comes from technological advancement at optimal levels of employment. The declining labor force participation rate in the United States—notwithstanding the decline in the headline unemployment rate—is particularly ominous in this regard (only a portion of this decline is attributabl...

About this edition

• Publisher: Penguin Books Ltd
• Publication date: 2013
• ISBN 10: 0241003792
• ISBN 13: 9780241003794
• Binding: Paperback
• Number of pages: 288