A Modest Proposal
A post by Annaly Capital Management
Some recent economic data (like today’s downwardly-revised “final” reading on 1Q 2010 GDP) have suggested that the economic recovery is waning. Not surprisingly, talk of additional stimulus has started to show up. A widely circulated column from today’s UK Telegraph titled “Ben Bernanke Needs Fresh Monetary Blitz as US Recovery Falters” theorizes that the Fed is debating further asset purchases. The rationale is that since there is reduced appetite for further fiscal stimulus, the Fed will pick up the baton and expand its balance sheet, possibly to $5 trillion.
Our modest proposal? Don’t.
The Fed should certainly do its part to facilitate the orderly functioning of financial markets, through the various lending facilities it has already set up (and in some cases shut down). But more asset purchases? What is the point? The 10-year Treasury is already approaching 3%, and corporate borrowing rates are more than reasonable on an absolute basis. 30-year fixed mortgage rates are already at brand new lows, and this is after the Fed concluded its Agency MBS purchase program.
There is an iron-clad law in economics called the law of diminishing marginal returns, which usually refers to labor. The more workers you continue to add, holding all other inputs constant, the less productive are those additional new workers. As we’ve already seen by looking at the money multiplier, the Fed’s balance sheet is also subject to diminishing marginal returns. The Fed’s expansion of the monetary base is having a smaller and smaller effect on the overall money supply. We believe further growth of the Fed’s balance sheet will have an even smaller effect than the first expansion, which seems to have only given us a ripping year-long rally in risk assets.
In the light of calls for new government stimulus, we should point out that the same law of diminishing marginal returns applies to total debt outstanding in the economy. As the total amount of debt to GDP has grown , the marginal return of an additional dollar of debt has shrunk dramatically. The chart below breaks out by decade the addition to GDP per each additional dollar of credit market debt outstanding.
To construct this chart, we looked at the nominal growth in GDP and divided it by the nominal growth in total credit market debt outstanding. As you can see, in the 1960s each additional dollar of debt created just over $0.65 of GDP. The 1980s saw this ratio cut in half to $0.34 dollars of marginal GDP per $1 of marginal debt, and we have since cut that in half again to $0.18 of GDP per $1 of debt created. We seem to be quickly approaching a level of total debt outstanding where additional indebtedness doesn’t add to economic growth at all. And the Fed has already reached a level in its Federal Funds Rate where it can’t cut any lower.
Attempts to stop a deleveraging economy with quantitative easing and government deficit spending have reached a point of no (marginal) return. Recessions, though painful, have the effect of purging the economy’s excesses and setting the stage for future growth. Preventing this process often causes more problems than it solves. Just ask the Japanese.