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One swallow does not make a spring

by on 13/06/2020

To those who think all our economic problems are behind us, as President Donald Trump expressed itself, i would say, “One swallow does not make a spring”.

To those who think the stock exchange correction is a sign for the beginning  of the end of the economic crisis caused by coronavirus, I would say, it is a frenzied reaction to trillions of dollars poured to the financial system, by the Federal Reserve in a few months, since March 2020. 

The money poured into the system by the Fed. will land in bank accounts, and has to be channelled to some kind of consumption or assets. High unemployment and uncertainty of income for most of the people prevents increase of consumption as an option. When people don’t feel, their bank deposits are safe, the option of bank deposits, bringing zero interest, is a very bad choice.

Real estate is not a short term investment option that could react to such a dramatic influx of liquidity within few months. All that is left is investment into the stock exchange market. 

Sudden rise in employment that happened in May is probably a correction of very low level business activity, that in the US, (with a culture of very low solidarity between employees and employed compared to Europe),  immediately caused 15% unemployment, jump from less than 5% unemployment rate before the pandemic. Not surprisingly, people after 2-3 month without shopping, want to compensate themselves, and refill their stocks of “necessities”, at home. Just to remind you, in the US the household consumption is about 70% of the aggregate demand. Its increase has an immediate impact on the GDP and the employment, when the production capacity is there, in a dormant state. 

The fundamental imbalance of the US economy that existed before the outbreak of the pandemic is caused by low saving rates and rising debt, to cover the high consumption level of private households and public spending. No administrative regulation, or custom tax policy can change this reality, but fundamental change in US economic realities, and change in the position of the US dollar as major reserve currency. The strong position of the US dollar is not anymore based on economic performances of the US economy, but by weakness of alternative European political institutions that caused weakness of the Euro . The latest performance of US political representation, can disturb the faith in US constitutions, and with it the faith in its icon, the US dollar. 

As to the Chinese option, it failed until now to present an alternative to the US dollar, in a form of Chinese currency, supported by the largest production economy in the world, due to undemocratic institutions, causing necessary mistrust in its financial institutions. 

I wonder, for how long is sustainable US policy of borrowing from China on one hand, and attacking Chinese unfair practices in international trade on the other hand. I would guess, China is not dormant any more, just waiting for the right time to fight back. It can come in some form of international digital currency, supported by Chinese economic production capacity, or any other unexpected form. 

US National debt

At May 2020 federal debt held by the public was $20 trillion and intragovernmental holdings were $6 trillion, that makes the total national debt of $26 trillion. The intergovernmental holdings are reserves to cover future pensions and social security payments, and are stable and not speculative.  Out of the 20 trillion,

$4 trillion were held by U.S. households, companies, and governments, 

$3 trillion by asset managers, 

$4 trillion by the Federal Reserve, increased from 2 trillion since march 2020.

$2 trillion by banks and insurance companies. 

$7 trillion, overseas, mostly by foreign central banks.

The foreign holders of U.S. Treasury securities share  have fallen from 43% of the US GDP at the end of FY 2013 to 36% at the end of FY 2018 (7% decrease, that represents about 1.4 trillion dollars in 2020 prices). Most of this decrease was done by China; its U.S. treasury securities holdings fell to 18% from 22% from December 2013 to December 2018, and Japan it’s share fell to 17% from 20%.

It seems, shift in the Chinese economic policy, of being the sole major foreign borrower of the US can be observed since 2010.

Curent Deficit level

In 2019 the US trade deficit ended with 600 miliard US dollars, while the federal budget ended with a deficit of about 1 trillion US  dollars, that is about 5% of the GDP. These are figures before the outbreak of the pandemic. The public deficit had to be covered in some way, either by increased investments of foreign countries, or increased savings of private holdings or corporate and non corporate businesses. 

US Trade summary in 2019

 (Milliard US dollars)

Economic regionUS ExportUS Importdeficit
South Korea56.980.023
Europe Excluding Germany, UK22030080
Total US Goods 1,5772,381804
Total US Services 923719-204

The trade deficit of US its not only generating debt, but it represents lack of efficient production capacity  in the US to supply enough goods for prices available today. Any kind of administrative restriction on import, will cause an immediate price increase in products produced by China in the short term.

Private households

It seems, according to the below data, private savings didn’t change significantly since the 2008 economic crisis, and remained between 6-8% of disponible income until the outbreak of the pandemics, when the personal savings has jumped from steady 7% to an unprecedented 35% from the disponible income. This happened despite the expected decrease in personal income.

The net worth of the private households has increased in the last 10 years from 70 trillion to 120 trillion US dollars. Most of this increase was result of stock exchange price increase. 

Balance Sheet of Households and Nonprofit Organizations

Out of the net worth at 2018, 41% were financial assets, that include stocks and bonds.

Nonfinancial corporate

As to the nonfinancial corporate savings, it has continued its trend since 2010. It increased in 2019 by 1.5 trillion dollars, and since 2010 by about 8 trillion dollars.

Relatively very little of the savings of US non financial corporate businesses, are holdings in form of US treasuries.

On the other hand the debt of the nonfinancial corporation grew from about 8 trillion to 14 trillion between 2010 to 2020 and from 40% of the GDP to 47%. Usually in corporations is expected, that most of the debt is invested into production capacity or yield generating assets, but it seems, part of this increase in debt was used for buyback of shares, and other non productive investments.

The repurchase agreements, seem to be in correlation of with the Federal reserves Quantitative easing policy.

Federal Reserve Bank

The Federal Reserve bank itself, increased its treasury securities holdings by about 2 trillion dollars between 2008- 2018,  by its quantitative easing policy, that between 2015-2019 ceased as seen in the following chart.

With the outbreak of the pandemics the Federal reserve increased its US treasury holdings by additional 2 trillion dollars by mid May, within 2 month. All this means, additional 2 trillion dollars in the monetary system deposited in the banks, while the banks have very limited options to increase loans and credit, as an immediate response to the increased liquidity. The result is increased excess reserves in the Federal reserve bank from 1.3 trillion to 3.2 trillion dollars.

In the short run the additional 2 trillion dollars are deposited back in the Federal reserve vaults. 

Public deficit and its consequences

The question remains, what does public deficit of trillions of dollars mean? Does public debt matter at all? Or what matters in the economy is inflation and unemployment and not the financial structure of the monetary base?

In the following chart we can see again more than 2 trillion US dollars increase in the system, in form of M2, (M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money. Investopedia.)

M2 is cash money or bank deposits, and is the other side of the public debt. What does it do to the whole economic system, based on prices as a major tool to balance between the demand and the supply? 

Since M2 is the most liquid form of money, ready for immediate use, the 18 trillion US dollars stand against the 20 trillion dollars of annual GDP. 

Here comes into the picture the velocity of money. 

The velocity of money is a measurement of the rate at which money is exchanged in economy. It is the number of times that money moves from one entity to another. … The velocity of money is usually measured as a ratio of gross domestic product (GDP) to a country’s M2 money supply.

As immediate response to the additional liquidity in the monetary system is sharp decrease of the money velocity. It seems, the velocity of money is in correlation with M2, that increased since 1990 from about 3 trillion dollars, six fold to 18 trillion dollars in june 2020. At the same time the urban consumers price index doubled itself.

As seen from the chart above, the rite of price increase is steady in the last 20 years. Even if the rate of price change will not change significantly, after all the pandemic did not damage the potential production capacity of the economy, still remains the question, who will benefit from this policy of excess liquidity, and who will pay for it?

The money’s value, just as of any other commodity, represented by its price, is dependent on its scarcity. Money price is the interest rate paid for either borrowing or lending it. In market economy, the demand volume for any commodity, goods and services (CGS), is regulated by its price, fluctuating according to preferences of those demanding and supplying the CGS. 

But what happens, when the commodity price is zero? Theoretically the demand for this item should be infinite. But in the real world the capacity to absorb CGS is limited, unless the CGS can be stored without cost. The result is limited demand for most of the CGSs in the real world. 

Does this apply for Money as well? It seems, there is no storing cost for money, (unless negative interest rate is introduced on deposits), so there can be infinite demand for money in case of zero interest rate.

But infinite doesn’t exists in the real world, limited by the size of the globe. This is why many, historically free of charge commodities, such as water, air, environmental balance, etc. at certain level of usage, started to have a price. The expected price for money, as to the money holders, has to come in form of negative or very low interest rate, or inflation, or both. On the other hand the lender sees as price of money real term interest rate, (inflation rate substracted from nominal interest rate).

Excess liquidity

The expected result of excess liquidity is inflation. It didn’t happen after the 2008 crisis that ended with the policy of quantitative easing, because of the global economy was with excess production capacity. The same doesn’t have to happen in 2020. The disruptions in international trade caused prior to the outbreak of the pandemic by the US, may cause price increase.

Inflation creates new redistribution of wealth and income. Usually the sectors in the economy, with higher level of flexibility gain more from an unsteady economy, while those with less flexibility and income from wages and pensions are on the side of losers. 

As to the question of employment and real economic activity, how does this dramatic increase of liquidity in the monetary system express itself? This question has to be divided into different time horizons. 

The short term, until the time when an effective vaccine is developed, estimated time is until midd 2021.

The middle term, time of restructuring of the economy. 2-3 years from vaccine development.

The long term. New economic reality. 

The table bellow presents the different sectors of the economy and their share in the GDP and employment, and the expected effect of the pandemics on them in the short term. It seems the economy can be divided into 3 equal sectors, with positive, neutral and negative impact of the pandemics on them. To my opinion the only sectores positively influenced by the pandemics are financial services due to expected monetary developments, professional advisers in finance, information, and legal issues, activities directly dependent on federal government decisions, such as education, social services and investments in infrastructure (subject to expected increased investment of the public sector into the economy), and information. The sectors with negative impact are real estate, manufacturing, arts entertainment and trade. Needed to mention, while the negative impact on the economy was immediate with introduction of quarantine, the positive impulse will be gradual. 

Industry sector % of GDPNumber of employees in millionsEffect of Covid-19(assumption}
Real Estate, Renting, and Leasing 132negative
Finance and Insurance85positive
Professional and business services1319positive
State And Local Government 1219neutral
Educational services, health care, and social assistance922positive
Durable Manufacturing68negative
Nondurable Manufacturing54negative
Retail Trade515negative
Wholesale Trade56negative
Arts, entertainment, recreation, accommodation, and food services 49negative
Transportation and warehousing35neutral
Other services, except government25neutral
Agriculture, forestry, fishing, hunting11neutral
Total 100151

The middle term development is expected to envolve after the pandemics has diminished. 

The new post pandemic people will adopt probably different behaviours and preferences, compared to the pre pandemic times, and all this will have influence on the economy as well, but i have no professional capacity to explore these fields. The major economic factor in the post pandemic world will be in a new monetary reality, with much more liquid money in the system, concentrated in the hands of certain sectors, and lacking in the hands of others. 

As to the business sector, producing the supply side of the economy, most of the money will be probably under the control of the commercial banking system, deposited as excess reserves in the federal reserve, waiting to be gradually released as loans to new ventures. Other gainers will be businesses that survived the crisis and are ready to act for the revival of the economy. Many of them prepared during the pandemic plans for new business ventures, that may be relevant or not in the new economic realities.

The private households, creating the demand side of the economy will be those, who kept their jobs, and those that have not. Most probably the additional unemployment rate will be about 10% of the workforce. Even if partly, the trillions of US dollars of quantitative easing will be channeled to these people, they represent about 10 to 15 percent of the workforce, to add to them about 45 million pensioners, and those dependent on their income, and it makes probably half of the US population. Those in the lower side of the income level, will probably have significantly less income, than before the pandemics, it means additional increase in the inequality of the income.

The following chart represents the increase in inequality since the seventies. Number 1 represents absolute inequality, while 0 represents absolute equality.

The expectation is that the inequality will further rise due to the policy of quantitative easing. The wealth will be concentrated in the hands of few even more than before the pandemic. 

All these expected developments are pointing towards one direction, less wealth, more inequality, more unemployment. 

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