Well, another presidential debate is behind us! I reiterate what I mentioned in Kee Points following the first debate, which was that I was unaware of any compelling evidence showing that debate outcomes influence voters’ opinions. For example, I follow the PollyVote model to gauge probable election outcomes. Rather than relying on one specific forecasting methodology, like polling data or betting markets, PollyVote combines multiple models (expert and public opinion polls, prediction markets, econometric and “index” models, etc) in a scientifically rigorous way. Going into the first debate the PollyVote model had Clinton in the lead for the popular vote at 52.4% chance. A week later, after moving around at bit, it remained at 52.4%. I’ll report on this week’s developments following Sunday night’s debate next Monday.
As for the economy, third quarter GDP growth numbers for the US are due out on October 28th (advance estimate), and “Nowcasting” models are indicating growth (annualized) slightly above 2% (2.1% Atlanta fed, 2.2% New York fed). That is disappointing but better than the .8% first quarter and 1.4% second quarter numbers. Interestingly, the New York Federal Reserve Banks’s Nowcasting model also includes an estimate for the fourth quarter, which stands right now at 1.3%. That would indicate a deceleration going into year-end. That estimate will change as we get into the fourth quarter and more data become available, but it will be worth watching as the fourth quarter progresses.
I have talked about several possible reasons for such a slow growth rate during this expansion, and one of them is muted business investment spending. A recent research paper from the Federal Reserve Bank of San Francisco sheds some light on this. The paper starts by highlighting the fact that there are excess returns on capital in the US that aren’t being followed by an investment boom, which theory would predict. To unpack that a little bit, return on capital or investment (ROI) basically means how much money you are generating as a percentage of the money you have invested or sunk into a business. By the same token interest rates – a proxy for how much you have to pay to get that invested money – are extremely low. Normally, if the returns on investment or capital are high, and the cost of money or capital is low, then you would expect companies to keep plowing money back into these “positive spread” businesses and projects, i.e. a lot of capital spending. But that is not happening, and the question is, why not?
The answer given in the San Francisco fed paper is that credit recovery has been slow, the slowest of any recession since the early 1960s (even with low interest rates), and this has contributed to declines in investment and output (GDP). The banking system has two basic constraint or limitations on the amount of credit it can create: (1) excess reserves, and (2) capital requirements or “bank regulations.” Since excess reserves are at historically high levels because of fed quantitative easing (QE) programs, they can’t be the constraint, so the authors focus on regulatory restrictions to credit creation, such as the Dodd-Frank Act, which was passed in response to the financial crisis in 2010. Specifically, the Dodd-Frank legislation was over 850 pages when first passed in 2010 and has expanded to multiples of that. According to the Competitive Enterprise Institute, by 2013, over 15 million words of rules required by Dodd-Frank had been written, enough to fill 28 volumes the length of War and Peace. This led firms like JP Morgan in 2014 to add 3000 new compliance employees, on top of the 7000 it had added the year before, even though total employee count was expected to fall by 50000 (AEI). As for small banks, the president and CEO of Vision Bank in Ada, Oklahoma, told the House Oversight committee that “Every dollar spent on regulatory compliance means as many as 10 fewer dollars available for creditworthy borrowers...less credit in turn means businesses can’t grow and create new jobs. As a result, local economies suffer, and the national economy suffers along with them” (Washington Examiner). That’s a self-interested plea for sure, but consistent with what I’ve heard from many bankers over the past several years.
The legislation has many merits as well, but it has created uncertainty for the banking industry. The San Francisco fed authors argue that when uncertainty is high and credit is constrained, only those projects with the highest returns are funded. Economists call this credit rationing and it would help to explain why ROIs have remained high (ie. only the highest ROI projects are being funded). In addition, tighter credit means fewer projects are started, so fewer investment opportunities are available. That leads to declines in investment and output, and that means lower credit demand and thus lower interest rates (Federal Reserve Bank of San Francisco). All of this, the authors argue, is why there is such a big gap between the cost of investment funds and the return earned on those funds without having an investment spending boom at the same time. My thoughts are that the gap is real, and that this is a decent effort at explaining some of it. I would add, however, that the gap was developing even before the Great Recession and before Dodd Frank, so the San Francisco fed’s reasoning is only a partial explanation.
Banks borrow funds by paying interest to depositors and lenders (usually short-term), and loaning those funds out at a (hopefully) higher rate (usually longer-term), so the spread or difference between the rates banks pay for funds and the rate banks earn on those funds – approximated by the difference between short and long-term rates – is important. And that spread is about half of what it has averaged over the past 50 years. In addition (but not to get into the microeconomic weeds too much here) banks also have costs that don’t vary with the rates they have to pay for acquiring funds. These are costs like buildings and personnel, and the costs of the resources used to attract depositors (advertising, etc.) and to find borrowers (research, credit analysis). When spreads are low these costs have to be covered by fees in addition to spreads, like charges on various types of activities (ATMs, checking accounts, loan origination fees, various transaction fees, etc.). These too have been curtailed under Dodd-Frank legislation in the interests of consumer protection, and this has contributed to lower bank profitability and restricted lending. The point of all of this is that only by recognizing some of the reasons for slow growth can you then know what’s really important to watch for possible changes to growth in the future.
Posted on Wed, October 12, 2016
by Danny Aleman