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The Pulse of Capitalism

Issue Number 05-2, July 2005

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International Comparisons
Business Activity Indicators
Financial Indicators - United States
Selected International Transactions - United States

Where Did All the Money Come From?

The New York Times (March 25, 2005) recently printed an article by Floyd Norris that began as follows:

"There is too much capital in the world. And that means that those who own the capital - investors - are in for some unhappy times.....Those with capital find they must pay high prices for investments that are likely to produce only a little income."
These comments bring out one of the great dilemmas of the current economy. There is a huge supply of investment funds, but there are few promising opportunities to employ them. Net equities issued by non financial corporations have been negative for years, thanks to mergers and stock buy-back programs. Bank interest rates are negative after inflation. The dividend-price ratio on S&P common stocks has been below 2 percent since 1996, while stock prices have been flat since 2001. Only real estate, in certain locations, has offered generous returns.

Various terms are used in discussing this situation such as "liquidity", "leverage", "asset inflation", as well as "excess capital". In this discussion we will use the terms "money" and "investment money". Investment money is that part of income that is not spent on current consumption but put into some form, such as a bank account, stock, bond, that is expected to yield a return greater than the amount originally deposed.

Money Creation

We have already cited some of the evidence of excess money such as negative real interest rates and low stock returns, but the extent of money growth is best realized in the accompanying graph comparing M-2 money supply growth with real GDP growth from 1980 to 2004.

Money today is primarily bank deposits - 89% of M-2 in 2004. To understand how bank deposits multiply, we have to refer to the "money multiplier" explained in economic text books. When a bank has reserves (funds) in excess of those required by F.R.B. regulations, it can lend those reserves to a borrower. If the borrower then spends those funds and they are deposited in another bank, this second bank will then have excess reserves and will be able to make a second loan, and so on.

The amount of money the second bank and subsequent banks can lend depends on the percent of their own deposits they must hold in reserve, either in vault cash or on deposit with their Federal Reserve Bank. If the required reserve is 20%, then an initial excess of $100 can grow to a maximum of $500 in deposits - the reciprocal of the reserve requirement.

Through the past three decades, the Fed has progressively (in response to various problems) reduced reserve requirements so that today required reserves as a percent of total bank deposits are less than one percent. This means that a newly created reserve can grow to a maximum of $10,000 in deposits. Thus we have a fiat money system that can grow to huge multiples. Economists like to call the Fed's power to create reserves "high powered money". Today it has more power than ever.

The multiplier explains why we have so much money, but why does so much of it flow into investment money; why doesn't more money turn into more consumption? The answer to this question is found in our income distribution. In 2003, 49.8 percent of disposable family income was received by the upper fifth of families and 73.2 percent by the upper two-fifths of families. (Britannica Year Book) Families in these brackets need only part of their income to satisfy their needs and wants, and the rest of it becomes investment money. This investment money financed the great expansion of information technology in the nineties, but some of the expansion proved unsound, resulting in the bankruptcy of scores of companies in this sector. As a result, investors are now more risk averse. More importantly, there is now no new technology on the scene that could duplicate the impact that I.T. has had on the economy. I.T. itself will continue to grow but at a much slower pace. Thus, a void has been left in regard to new investment money.

One consequence of this lack of traditional opportunity to invest in new and highly promising technologies has been the emergence of loan securitization. These innovations create a pool of consumer loans or mortgages and issue bonds secured by the pool of assets. This transfers ownership of the underlying assets to bond investors from banks and retailers. The growth of these arrangements has been astounding. In 1990, asset-backed and mortgage-backed securities constituted 12.3 percent of credit market debt outstanding, but by 2004 it had grown to 23.6 percent. In dollars, this securitized debt rose from $1,660.8 billion to $8,698.7 billion. In this case, we have investment money not going into "capital" investment but rather into mortgage and consumer debt financing. Capital investment offers the hope of future wealth increase, but debt financing offers no such hope.

Federal Reserve Operations

The Fed has two means of conducting monetary operations. We have already alluded to the first one - setting required reserve levels for bank deposits. These requirements have been reduced to such a low level that they are virtually meaningless. This situation is not likely to change since raising requirements in today's environment would devastate the money markets.

The Fed's second means is the buying and selling of government securities in the open market. Buying securities results in crediting the reserve account of one or more commercial banks, an increase in total bank reserves available to make loans. Selling securities results in a charge that reduces bank reserves. In actual operations, in recent years there has been only one year (2000) when reserves were reduced, and that was to offset part of a huge increase the year before to prepare for a perceived "YTK" problem when computers might malfunction due to the millennial date change. Other than this aberration, the Fed has consistently increased reserves through the years. In 2004, these government securities held by the Fed totaled $717.8 billion.

The open market operations of the Fed are designed to achieve a federal funds interest rate set by the Open Market Committee. A low (or lower) rate is achieved by buying more securities while a higher rate is achieved by reducing the volume of purchases or actual sales. Over the past four low-interest years, yearly purchases have averaged $40.8 billion.

The combination of open market purchases of government securities, which create bank reserves, along with the money multiplier are the foundation for the expansion of the money supply shown earlier.

Interest Rate Movements

Explaining interest rate behavior is about as difficult as explaining stock market behavior. The federal funds rate and the 3 month Treasury rate track each other very closely. When plotted together, it is difficult to determine which rate leads the other, or whether there is a consistent relationship.

Since recent federal funds rates have been the lowest in history, one would expect the Fed's open market purchases to be the largest in history, and this turns out to be the case but perhaps not to the extent one might expect, as shown in the following:

Average Fed funds rate Average open market purchases
1991-94 4.11 $29.7 bn
2001-04 2.01 $40.8 "

Apparently the underlying demand for money was weaker in the 2001-04 period than in the 1991-04 period so that lower additional reserves were needed to move rates down.

The recent behavior of interest rates has confounded everyone including Alan Greenspan. The reason for this is apparent in the following data:

2003 5/24/2005 Change
Federal funds rate 1.13 2.99 1.86
10 year Treasury rate 4.01 4.04 .03
Corporate Aaa bond yields 5.67 5.04 -.63
New home mortgage yields 5.80 5.82 (3/05) .02

When the Fed began raising the federal funds rate in July 2004, almost all observers assumed that interest rates across the board would rise with it. But that has not happened. Two of the rates shown above - high grade corporates and new home mortgages - are now lower than in July 2004. A two percent rise in federal funds has no effect on the general market. One interpretation of this is that investors do not expect any rise in inflation and therefore want to lock in a moderate return while they can. This implies a slow-growing economy with no great demand for investment funds. But it also underscores the abundant supply of money available to meet such demands.

If we think about the financial underpinnings of two of our biggest markets - new cars and new homes - we get an insight into the condition of the current economy. New car buyers are offered no-downpayment terms, extended repayment periods, low interest rates, and even cash pay-back incentives. New home buyers are offered no-down-payments, interest-only mortgages, and record low 15-year and 30-year mortgage rates. These incentives not only keep the buying binge going, they are required to keep it going. Buyers simply cannot meet the minimum standards for down-payments and stable income that traditionally have been demanded. This new way of operating is fine as long as we have a rapidly expanding economy and job market, but it will lead to much anguish if that does not prove to be the case.

In any case, it is fairly clear where all the money came from; it is much less clear what all the consequences of that money creation will be.

International Comparisons
Canada Germany Japan United Kingdom United States
Real GDP (% chg. on year ago)
    2003 (Q4)
1.6 0.2 3.4 2.8 4.3
    2004 (Q4)
3.0 1.5 0.8 2.9 3.9
    2005 (Q1)
3.3 1.1 1.3 2.1 3.7
Industrial Production (1997=100)
117.0 110.3 94.5 99.8 110.9
121.1 113.4 99.6 100.1 115.5
    FQ 2005
na na na na 118.2
Retail Sales (volume - % chg. on year ago)
    2003 (Dec)
0.8 -2.5 0.4 4.0 7.4
    2004 (Dec)
4.8 -5.9 -1.0 3.2 5.9
    FQ 2005 - Mar
4.0 nil 0.7 2.7 3.0
Consumer prices (1982-84=100)
177.7 148.3 118.7 213.0 184.0
181.0 150.8 118.7 219.4 188.9
    FQ 2005
182.9 152.2 118.0 222.8 191.9
Unemployment Rates
    2003 (Dec)
7.4 10.4 4.9 4.9 5.7
    2004 (Nov)
7.3 10.8 4.5 4.6 5.4
    FQ 2005 - Mar
6.9 12.0 4.5 4.7 5.2
Interest Rates (3 months)
    2003 (Dec)
2.59 2.15 * --- 3.86 0.90
    2004 (Nov)
2.56 2.22 * --- 4.99 2.07
    FQ 2005 - Mar 30
2.56 2.15 * 0.2 4.95 2.90
Stock Indices (ending)
8,220.89 3,965.16 10,676.64 4,476.90 10,453.92
9,246.70 4,256.08 11,488.76 4,814.30 10,783.01
    FQ 2005 (3/30)
9,484.30 4,347.50 11,565.90 4,900.70 10,540.90
Current Acc't Bal's ($bn) latest 12 months
18.5 56.3 136.0 -30.8 -530.7
    2004 3Qs
23.4 96.0 171.8 -49.0 -665.9
    FQ 2005
20.2 109.0 170.1 -717.0
Foreign Exchange Rates
1.40 1.13* 115.94 1.63 119.08
    2004 3Qs
1.30 1.24 * 108.15 1.83 113.55
    FQ 2005
1.23 1.31 * 104.51 1.89 109.29
Currency units per U.S. $
UK pound in U.S. $s
U.S. dollar: index of dollar against major trading partners, January 1997=100
* Euro area: euro in U.S. dollars
Sources: Economist, Economic Indicators,
F.R. Bulletin, Survey of Current Business

The GDP data indicate quarterly change from one year ago. Canada and Japan show small upturns in the first quarter of 2005 in comparison with the first quarter of 2004. Germany, the U.K. and the U.S. show decreases. Industrial production weakened in the U.K., eased a bit in Germany and Japan, and remained strong in Canada and the U.S. The retail sales data for Germany and Japan show no growth over the past three years. The data for Britain and the U.S. indicate a declining trend while the Canadian data show an increase for December 2004 and a smaller increase for March 2005. Consumer prices continued their consistent trend upward except in Japan where they have actually fallen over the past three years.

The unemployment rate rose in the first quarter in Germany and Britain while declining in Canada and the U.S.; Japan's rate was unchanged.

Short term interest rates have been low for the past three years, but they started to rise in Britain and the U.S. in 2004 and the first quarter of 2005. The latest economic data indicate weakening trends rather than strengthening ones, casting doubt on whether there will be a sustained uptrend. Long term rates in general are lower than a year ago, indicating weak demand for funds. Stock indices reflect a cautious optimism, although the U.S. index was slightly lower in the first quarter.

The major trends in current account balances continued. Canada, Germany, and Japan maintained substantial surpluses while Britain and the U.S. again incurred substantial deficits. The U.S. deficit equaled 5.9 percent of GDP. The U.S. dollar declined against all the currencies shown in the first quarter.

Business Activity Indicators - United States
2003 2004 FQ 2005
Industrial Production (1992=100) 110.9 # 115.5 # 118.2 #
    Capacity Utilization Rate (% total industry)
75.5 # 78.1 # 79.3 #
Manufacturers' New Orders (billions of $s) 329.2 # 365.8 # 379.3 #
New Construction Expenditures (billions of $s) 915.7 # 999.6 # 1,052.7 #
Real Gross Priv. Dom. Invest. (chained[1996]$s) 1,628.8 1,843.5 1,958.8 *
Business Sales - Mfg. & Trade (billions of $s) 851.8 # 940.8 # 983.4 #
Business Inventories (ending) (billions of $s) 1,180.2 1,270.7 1,288.9
Retail Sales (billions of $s) 273.0 # 293.5 # 305.6 #
Retail Inventories (ending - * Nov) (billions of $s) 435.0 459.7 462.4
Per Cap. Personal Consump. Expend.'s (chained 2000 $s) 25,270 25,965 26,432
Nonagricultural Employment (millions) 130.0 # 131.5 # 132.8 #
    Goods Prod. (millions)
21.8 # 21.9 # 22.1 #
    Services Prod. (millions)
108.2 # 109.6 # 110.8 #
* Annual Rate
# Monthly average
Source: Economic Indicators

Real GDP rose 3.8 percent in the first quarter of 2005, the same rate as in the fourth quarter of 2004 but below the 4.4 percent average for 2004. Manufacturers' new orders continued to increase, but durable goods did not contribute to the increase.

Industrial production rose through 2004 and continued at a slower pace in the first quarter. Durable goods and mining were the strongest sectors. The capacity utilization rate was the highest since 2000.

The new construction boom continued unabated through April, with substantial gains in new housing and lesser gains in non residential and government construction. Houses for sale also continued to rise moderately while the vacancy rate for rental housing remained steady at 10.1 percent. Real gross investment continued to rise sharply thanks to residential spending, equipment and software investment, and inventory accumulation.

Business sales growth slowed a bit in the first quarter, but retail sales growth remained strong. Business and retail inventory growth continued at about the same pace as in 2004. These activities were spurred in 2004 by strong growth in per capita personal consumption expenditures, and these expenditures also rose strongly in the first quarter.

Non agricultural employment grew a strong 1.3 million jobs in the first quarter. The strongest grouping was business and professional services at .3 million, but most major groupings showed increases.

Financial Indicators - United States
2003 2004 FQ 2005
National Income (billions of $s) 9,679.8 10,339.6 10,887.0
    Percent change
4.9 6.8 5.3
Per Cap. Disp. Personal Income (chained [2000]$s) 26,570 27,281 27,706
Avg. Real Gross Wkly Earnings (1982=100) 278.72 277.61 276.94
Gross Saving " 1,487.9 1,639.0 1,781.8 *
Consumption of Fixed Capital " 1,354.0 1,407.3 1,408.1 *
    Net Saving "
133.9 231.7 373.7 *
      Private "
501.6 583.6 620.3 *
    Government (all) "
-367.7 -351.9 -246.6 *
Commodity Price Index (1995=100) 74.7 89.0 (135.6) @
Producer Price Index (1982=100) 143.3 148.5 152.7
Corp. Profits (with i.v.a.&c.c.a.) (billions of $s) 1,021.1 1,181.6 1,326.3 *
Interest Rates - 10 year Treas. 4.01 4.27 4.30
Money Supply - M3 (ending) " 8,889.2 9,453.4 9,522.7
    Percent change
3.7 6.3 .7
Commercial Bank Credit (ending) " 6,249.9 6,769.8 7,038.1
Consumer Credit (ending) " 2,013.5 2,104.5 2,129.2
Credit Market Debt (ending) " 33,864.9 36,674.8 37,310.7
    Nonfinancial Sector "
22,887.0 24,880.5 25,395.1
    Financial Sector "
10,977.9 11,794.3 11,915.6
    Household Sector "
9,231.7 10,276.2 10,515.3
Total bankruptcy filings (thousands) 1,660 1,597 401
* Annual rate
@ New series
Sources: Economist, Economic Indicators, F.R. Bulletin, F.R. Flow of Funds, Administrative Office of the U.S. Courts

National income rose $547.4 billion (a.r.) in the first quarter of which $316.0 billion was compensation of employees and $144.7 billion was corporate profits. Real per capita income rose $425 (a.r.) from the 2004 average, but real average weekly earnings fell by $.67; real weekly earnings have been falling since 2002.

Net saving rose $142.0 billion (a.r.) in the first quarter of 2005. Most of this increase was due to a decline of $90.8 billion in the federal deficit; undistributed profits rose $71.7 billion while personal saving fell $34.9 billion.

The commodity price index base has been revised to 2000=100 from 1995=100. The new data show a 35.6 percent increase in the U.S. dollar index from 2000 through the first quarter of 2005 but only a 9.7 percent increase in the sterling index, a 2.9 percent decline in the euro index, and a 35.3 percent increase in the yen index.

The rise in raw materials has contributed to a continuing strong uptrend in producer prices; since 2002 this index has risen 13.8 points.

Corporate profits increased $144.7 billion (a.r.) in the first quarter despite a sharp drop in the capital consumption adjustment. Corporate profits are about 50 percent higher than in the late 1990s, but stock indices remain well below the peaks reached at that time.

The 10 year Treasury rate by June remained at 3.95 percent despite an increase in the Federal funds rate (a one day rate) to 3.0 percent. This conundrum seems to reflect low demand for capital in the private sector, prompting strong flows into the safety of Treasuries. M-3 money supply growth slowed considerably in the first quarter to the slowest pace in a decade. The Federal deficit declined as receipts rose more than expenditures.

Commercial bank credit grew briskly, primarily for securities other than Treasuries, and loans and leases, both real estate and commercial/industrial. Consumer credit advanced at about the same pace as in the last two years.

Non financial debt grew 10 percent (a.r.) in the first quarter while financial debt grew 4.8 percent. Household sector debt increased 9.3 percent (mortgages 10.6 percent but consumer credit only 4.6 percent). Since 2000 disposable personal income (boosted by Federal tax cuts) has risen 24.5 percent while household debt has risen 50.0 percent. Federal debt during that period grew 34.3 percent. Pretty impressive changes for a five year period!

Selected International Transactions - United States
2003 2004 FQ 2005
Trade Balance on Goods & Services ($bns) -494.8 -617.6 -171.8
    Goods "
-547.3 -665.4 -186.3
    Services "
52.5 47.8 14.6
U.S. Owned Assets Abroad, net [inc/capital outflow(-)] " -328.4 -855.5 -60.7
Foreign Owned Assets in US, net [inc/capital inflow(+)] " 889.0 1,440.1 226.1
    Net change in US Int'l Inv. Pos'n "
560.6 584.6 165.4
Net change in Foreign Owned U.S Securities
    Treasury Securities & Cy Flows "
306.0 394.4 91.9
    Other U.S. Securities "
271.5 421.0 115.7
Source: Survey of Current Business

The negative balance on trade in goods and services continued to grow in the first quarter of 2005. Exports and imports of goods both rose in the first quarter compared with the fourth quarter of 2004, but the increase in imports exceeded that in exports. Services receipts, however, increased more than services payments in the first quarter.

Financial inflows for purchase of U.S. assets by foreigners slowed more than financial outflows for purchase of foreign assets by U.S. residents in the first quarter of 2005 compared with the fourth quarter of 2004, but the net difference, if maintained will still result in a new record (well over one-half $trillion).

Foreign official purchases of U.S. Treasury securities fell considerably in the first quarter, but private purchases picked up, resulting in only a small deceleration from the 2004 pace. Foreign purchases of U.S. securities other than Treasuries were down compared with the fourth quarter of 2004 but still large enough to exceed last year's record level.

Copyright © Andrew Caughey, 2005

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore,differ from one report to another.

Published August 2005

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