The fundamental question for the U.S. macroeconomic forecast is if the pandemic recovery can continue or if the economy is heading into a recession. This outcome will be determined largely by Federal Reserve actions during the quarters ahead. Given how long the Fed waited to fight the current bought of inflation, it is not likely they can return inflation to its target rate without monetary policy changes which would also induce a recession.

It is an open question if the Fed has the fortitude to follow-through fighting inflation. The forecast then, is either for recession, or anemic growth accompanied by continued inflation.

CERF’s baseline forecast embodies the assumption that the Fed will cease substantive hikes by December 31^st of 2022 and that the economy will not be pushed into recession. We do have one 25 basis point hike in early 2023, but no other hikes. This is a low confidence forecast, since it necessarily involves predicting the behavior of a body of political actors at the Fed.

This forecast for the Fed’s policy rate has implications for inflation. Inflation, with substantial momentum at the current time of writing, will not be much reined in by this forecast of Fed policy.

How strong is the Fed’s policy stance on inflation? The real ten-year Treasury yield was -3.1 percent using September yields with the core PCE deflator. As conventional wisdom has always argued, a negative interest rate of that magnitude indicates policy that is massively stimulative.

The presumed level of short term interest rates under this forecast scenario is that they reach 4.625 percent (based on the midpoint of the Fed’s target range) by mid-2023. By the Fed’s own analysis the rate needs to be above 6 percent in order to adequately combat inflation.

Inflation will subside, but it will not subside quickly, and the real 10-year Treasury yield will remain in negative territory for all of 2023, indicating that instead of being restrictive, the Fed’s policy will remain stimulative, for about a year.

We forecast that the Core PCE deflator will still be 4.8 percent at the end of 2022, and that it will still be 4.3 percent at the end of 2023. This is higher than the consensus forecast of 3.2 percent, but our forecast is lower than inflation expectations, such as the University of Michigan’s survey value of 4.8 percent.

This forecast is one where rates are not really that high. The chart below shows the third quarter real 10-year Treasury is still quite negative, and it shows real rates during the Volcker policy era in the early 1980s that did succeed in fighting inflation, and also pushed the economy into recession.

Because rates are not really that high, inflation will remain persistent, and, growth will be weak but positive. We do not forecast a recession in this scenario, in part because rates are not actually that high. They will not get high enough to halt inflation, and they will not be high enough to cause a recession.

CERF has argued that monetary and fiscal policy has been much too stimulative. While it is possible to justify stimulating the economy in the time of crises, policies have been a ratchet, ramping up support through payments and credit in times of crises and not subsiding thereafter. This occurred after the 2007-08 financial crises and again during the Pandemic in 2020.

Overly-stimulative policies help us understand the macroeconomic environment we are in today. Some forecasters are saying that the Fed’s impotence against inflation, with 300 basis points of hikes in seven months having failed to slow inflation momentum, has surprised almost everyone. This does not surprise CERF. The economy is overstimulated. According to CoBank estimates the U.S. household sector still has $2 Trillion in excess savings. And, we point to the most recent University of Michigan survey data, which as of October showed consumer’s expect inflation will still be 4.8 percent a year from now.

There are risks to this forecast. One alternate scenario is that the Fed does continue raising rates aggressively during 2023, sending the short term policy target well-over 6 percent. In this scenario, the real 10-year Treasury yield would surge into positive territory more rapidly, inflation would subside more quickly during 2023, and the economy would experience a recession.

Why is our baseline case that the Fed does not get in front of inflation? They have shown before that they are sensitive to markets, especially, the stock market. In October of 2018, they announced a balance sheet normalization policy that sent the S&P 500 into a 24 percent decline in just 3 months. On January 4, 2019, Fed chair Jerome Powell signaled a reversal of policy normalization, and in March of that year, stated that a multi-trillion dollar balance sheet might go on indefinitely. This of course, gave rise to the notion of QE-infinity, the idea that the Fed would never normalize policy.

The effect of significantly higher rates will have an important follow-on effect of raising the debt service costs for the U.S. This is more of an issue now, where the debt to GDP ratio is 120 percent, a historically high level for the U.S. This will be another source of pressure against further Fed rate hikes to levels above 5 percent.

CERF’s economic forecast for the next eight quarters is for growth substantially below potential. Many forecasters, including the Fed, point to demographic factors and make post-industrialized economy arguments to rationalize below potential growth. CERF disagrees. Most of the sub-par growth is driven by poor policies, policies that throw a blanket on what would be a much more healthy and robust economy.

Monetary and fiscal policies should follow policy rules, or a logic that is guided by economic theory and analysis. Policies since 2008, especially monetary policy, have been ad hoc. They depress economic activity through the specific disincentivizing impacts they impart on investing for the future, but in addition, they depress the economy through policy uncertainty. This uncertainty doesn’t just add difficulty to forecasting, but it also reduces the ability of households, establishments, and governments to make decisions for their, and the our nation’s, future.

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The BLS April Employment Situation is now available for all to see.  After economic forecast houses across the globe ran their models beginning in mid-March and re-ran them again and again until as recently as last night, we now have bona fide economic data on the historical and life changing event that we are living through.

Before even jumping in to the details of the report, we want to use this space to urge Governors to implement careful but sensible plans for re-opening their economies immediately. Just as importantly, we urge them to communicate the timeline for re-opening, even if plans are tentative. Simply stating that, “We will be guided by science.” is not a plan. And, waiting for cover from public health officials will significantly lengthen the country’s economic crisis and the overwhelming social costs that result.

CERF’s forecast for April was for employment losses of 19.7 million and an essentially flat labor force. The data shows employment losses of 22.4 million and an almost 6.5 million drop in labor force. While the employment loss was reasonably close to our forecast, the labor force contraction was not. In retrospect, we underestimated the massive disincentive to working (or even looking for work) that the CARES Act brought to the labor market. The April unemployment rate is 14.7 percent, lower than our forecasted rate of 16.5 percent. Our forecast error in this case is driven almost entirely by our miss on the contraction of labor force. If labor force had held at February’s level, the April unemployment rate would have been 18.9 percent.

The jobs breakdown by sector shows that the hardest hit of the major sectors were Leisure & Hospitality, Education & Healthcare Services, Professional & Business Services, and Retail Services. With job losses of 7.7, 2.5, 2.1, and 2.1, respectively, all experienced losses numbering in millions of people. Across the spectrum of industries, as well as across sub-segments within these industries, lower-paid workers were hit hardest. These workers and the households they reside in will suffer, as they are the least able to weather an adverse economic shock such as this.

The report has a number of black linings, not silver linings as some analysts have reported. First, the employment losses reported today almost completely wipe out all of the gains accumulated since the Great Recession. The labor force contractions are especially worrisome. Labor force contractions reduce the productive capacity of our nation. They put people on the couch, which leads to many kinds of well-documented social costs, including increased rates of domestic violence, divorce, and even suicide. What’s more, while 88 percent of survey respondents indicated that their job loss was temporary, this is not likely to prove true. We are persuaded by a University of Chicago study that suggests half of these self-proclaimed temporary losses will become permanent.

This morning’s report also provides evidence that the shutdown is eroding the core of the U.S. economy. Consider the position of American Latinos. As we document in the 2019 LDC U.S. Latino GDP Report, Latinos are a tremendous source of economic growth for the nation. In fact, despite being only 17 percent of the population, Latinos are responsible for more than 80 percent of the growth of the labor force from the Financial Crisis up to the start of the pandemic. The April report indicates that Latino employment dropped by about 6 million persons, a nearly 24 percent share of the nation’s job losses. Because Latinos were more likely to be working, they were also be more likely to be furloughed or laid off during the downturn. The problem for the nation is that the labor force’s strongest growth cohort is being disproportionately harmed. The core of the American economy is eroding, and this diminishes the long-term growth outlook for the nation.

The dramatic concentration of impacts in a few job sectors and among specific demographic groups indicates that the shutdown is also increasing inequality across every state in the nation.  Consider the contrast between a technology professional who shops at Nordstrom’s and an employee of the store. The government-mandated closure of a Nordstrom’s store has minimal impact on the technology professional, who will simply move her shopping online as she conducts her own employment responsibilities from home. The tech professional’s inconvenience will largely end with the closure order. In contrast, the Nordstrom’s employee will experience both lost income and lost work experience. The effects will be enduring. The Nordstrom’s employee confronts a much-changed economic reality.

The policy responses to the spread of the coronavirus have already initiated a historic economic contraction. These economic convulsions necessitate an immediate response. Lifting shelter-in place orders for all but the most vulnerable groups is essential. Research from the NBER indicates that narrowly targeted lockdowns along with continued social distancing practices and robust testing can minimize both loss of life and the extraordinary economic losses detailed in this morning’s report.

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First, we dismiss the unemployment rate altogether. The unemployment rate is simply not an accurate measure of labor market health. The Financial Crisis and Great Recession drove millions of Americans out of the labor force. The overwhelming majority have remained sidelined from productive economic activity.

What we watch carefully is labor force participation, and the latest jobs report has modestly good news. Labor force participation ticked up, as increasing wages drew more than 300 thousand people back in to the labor force.

Prior to Friday’s report, labor force participation stood at a low not seen since August 1978. With the latest increases, you only have to go back to May 1979 to find participation this weak.

Despite modest gains detailed in this report, the labor market is still weak from a historic perspective. If the labor force participation rate were the same as it was prior the Great Recession, today’s unemployment rate would be over 7 percent, nearly double the current rate.

In the latest report, construction jobs continue to be a sign of good news. Over the twelve months of 2019, construction jobs grew at a rate more than double that of all jobs. The January number was strong even compared to the past twelve months.

The post The January Jobs Report appeared first on Center for Economic Research and Forecasting.

Readers of CERF blogs and forecast publications know that CERF economists are critical of the Fed’s monetary policy, and have been for seven years now.  The Fed’s policies starting in December of 2008 were extraordinary, unprecedented, not recommended by economic theory, and have contributed to anemic growth and wealth generation for the past decade.

Prior to December of 2008, the Fed mainly relied on one policy tool, the Federal Funds Target rate (FFRT).  During the dark days of the financial crisis, they added two more policy tools, quantitative easing (QE) and interest on reserves (IOR).  CERF is most critical of IOR.

There are a few things that economists agree on, and one of them is that financial intermediation is good for the economy.  This is the process by which banks use savings deposits as a pool of funds to extend credit to businesses and households.  The IOR reduces the quantity of loanable funds available for intermediation by taking them out of the banking system and locking them up as reserves at the Fed.  Lending falls, investment expenditures fall, growth slows, and capital accumulation and future wealth fall.  These are unmistakably bad economic outcomes compared with having those funds available and extended to households and businesses who are growing.

What’s more, it is not clear how the Fed would respond if there were a severe recession tomorrow.  If they raised IOR, this would further restrict credit.  They could reduce IOR, but in a severe recession, weak loan demand would make this less effective.

It is clear that the Fed wants to maintain a massive balance sheet, and they have documented various technical benefits.  However, it is fearful of rapidly unwinding it, and this is the real reason for the glacial reduction pace.  A consequence of the Fed’s massive balance sheet is that it destroys the Fed’s ability to control short term interest rates.  IOR, a rate that the Fed sets directly, provides the short term interest control they desire.  The interest rate on reserves may actually be the most impactful policy that the Fed is employing, but that is only because unwinding the balance sheet would wreak unknown but horrible damage to the economy.

CERF economists have also criticized the fact that the Fed’s policy statements highlight the FFRT and QE, but IOR information is no longer provided in the Fed’s main press release.  Since December of 2015, changes to IOR have been deliberately buried in a technical note separate from the press release.

At the panel, Chair Powell and former chair Bernanke stressed the Fed’s goal of being transparent.  They repeated their desire to clearly and frequently communicate their policy intentions to the world.  However, not one word was uttered about IOR at any point during the one-hour long discussion on Monetary Policy.  It was clear this was done on purpose.  Neither the press nor the economics profession have properly brought the IOR policy and the resulting economic detriment to light until recently.  In particular, the January 1^st Wall Street Journal article, The Fed’s Obama-era Hangover by Phil Gramm and Thomas Saving, highlights the powerful impact of IOR on credit.  The article also explains that the Fed is now an interest rate follower.  It is no longer setting or leading short term rates.

It is clear that the Fed’s stated transparency goal is contradicted by the reality of the Fed’s actions.

I have a theory to explain this contradiction.  As forecasters, CERF economists routinely promulgate their economic analysis and their forecasts to the press and the community.  This is a challenge.  Economics is a complicated undertaking.  There are subtleties and complexities.  It happens that we’ll interview with the Media and then read their article and wonder what went wrong because the written article miss-represents our views and/or our analysis.  This appears to be a reality of the interface between economists and non-economists.

We have tools to deal with this issue.  We tell stories as much as possible.  We try to pull back from talking about many relevant factors to focus on one key factor.  But these strategies do not always work.

It may be that the Fed does not talk about IOR because it is difficult to explain.  There is more to IOR than the financial intermediation impact, as the Gramm and Saving article reveals.  The complexities include IOR interaction with other policy tools and various aspects of the economy.  It is difficult to explain to the public, in fact, even to economists who do not follow monetary policy closely.  Perhaps more important, the Fed does not want to publicly admit they are deeply fearful of the impact of rapidly unwinding the balance sheet.  Chair Powell would loathe to discuss either the difficulties with unwinding the balance sheet, or the IOR’s impact on the economy in public.

The Fed needs to come clean.  The Gramm-Saving article is likely to generate greater commentary, more articles, and additional questions directed to the Fed about its IOR policy and its assessment of the impact of IOR on the economy.  I expect that the pressure will become large enough that the Fed will be forced to directly address its IOR policy to the public.

With greater Fed transparency in IOR, academic researchers should then contribute.  They can build theoretical models of monetary policy that postulate and analyze formulae linking IOR to reserve flows, lending, investment, economic growth, and capital formation.  Empirical papers should then be written that test and use these new theories, and in particular, they should measure the detriment that IOR has on financial intermediation, economic growth, and wealth formation.

As we await greater scrutiny of Fed policy, it is becoming increasingly clear to the CERF team that the Fed doesn’t know how to undo the mess it created during the financial crisis.  The need to maintain its massive balance sheet necessitates ever higher IOR.  It places the Fed in the position of following market interest rates rather than driving them, as highlighted by Gramm and Saving.  It jeopardizes the Fed’s activist mandate and renders it impotent if a severe recession were to occur tomorrow.  This is such a mess that we should assume the next economic contraction could be at least as bad as the last one that the Fed seeded.

Gramm P. and T. Saving, The Fed’s Obama-Era Hangover, The Wall Street Journal, Jan. 1, 2019 https://www.wsj.com/articles/the-feds-obama-era-hangover-11546374393?mod=mhp

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It’s time for another presidential election.  Each candidate is promising new initiatives that will bring prosperity to Americans.  So, we’re forecasting vigorous economic growth?  No.

Our forecast is pretty much the same as it’s been for years, anemic economic growth as far as we can see.

Either Trump or Clinton will be president, but which one is president doesn’t matter for our forecast, because neither has a program that will generate the promised growth.

Trump’s economic plan is as brash, contradictory, and dishonest as he is.  He begins by assuming that countries compete economically.  This is a long-standing and popular misconception.  While not fans of Paul Krugman, we refer readers to his book Pop Internationalism for a readable, but sarcastic and arrogant, discussion of why this is not true.

Trump does offer tax, energy, and regulatory reform, which would increase our economy’s growth rate.  Those gains would be offset by his trade policies and his intention to export immigrants.  Decreasing trade and exporting workers, regardless of how the workers got here, are extraordinarily contractionary policies.  The plan is dishonest because he presents it as a unified pro-growth plan when he has advisors who have surely told him of the contradictions.

Clinton’s plan is as old, tired, and dishonest as she is.  It’s tax.  It’s spend.  It’s free stuff.  It’s more government.  It’s the same thing we’ve seen out of the Washington establishment for decades.  We all know, and she must know, it won’t bring the growth she promises.

We believe that presidents can have an impact on economic growth.  However, the president must be extraordinary and have congressional support, either because of party loyalty or political pressure.

President’s Kennedy, Reagan, and Clinton each initiated strong recoveries, recoveries that lasted for many years and saw several years of 4.0 percent or greater economic growth:

There were similarities between each of these presidents’ dominant economic policies.  Each relied on incentives and generally free-market solutions.  Kennedy cut taxes.  Reagan cut taxes and the regulatory burden.  Clinton expanded trade and changed welfare’s incentive structure.

We could have a similarly vigorous economy today, but the challenges are daunting.  It would require eliminating the negative incentives in three major pieces of legislation: Sarbanes-Oxley, The Affordable Healthcare Act, and Dodd-Frank.  It would also require rolling back the bureaucratic albatross that has built itself, increment by increment, into a formidable obstacle to economic growth.

Taxes should be reformed.  Eliminating taxes on repatriation of foreign earnings and on dividend income would be expansionary.

Monetary policy may be the biggest challenge to any president’s plan for a sustained vigorous economy.  It’s hard to see how the distortions built up by years of near-zero interest rates can be corrected without a dramatic decline in asset prices, a decline that would likely precipitate at least a short recession.  In a sense, the Fed has painted itself into a corner.

Whatever the Fed’s challenges, they are supposed to be independent of the other branches of government.  Presumably, the President’s only input is the nomination of the Chair and other board members.  We don’t believe the Fed is as independent of the political pressure as is advertised.  That said, it would take a very special Fed Chair to correct the current distortions.

Volker famously conquered inflation through a bold and controversial monetary policy, at the cost of what was until then our deepest recession.  The president would need to nominate and have confirmed another Volker.  We have no idea who that might be.

The four percent economic growth that Trump promises is possible, but it would require an extraordinary president to achieve it.  Unfortunately, our nomination process appears incapable of nominating extraordinary people.

The post United States Forecast appeared first on Center for Economic Research and Forecasting.

A decade of slow or declining economic and job growth has been accompanied by fundamental changes in America’s job composition.  Those changes have caused profound disruptions in the lives of millions of workers, primarily low-educational-attainment workers, and their families.

The situation is not improving.

Economic growth (GDP) appears to have slowed, even from its previously anemic pace.  Job growth has been weak too, but it’s a little better than economic growth.  Weaker economic growth than job growth implies declining or very weak productivity growth, and we’ve recently seen quarters with each.

Declining productivity doesn’t necessarily mean that individual workers productivity has declined.  It could.  If demand fell and businesses were slow to lay off workers, perhaps because of the cost of firing and hiring, individuals’ productivity would fall.

That’s not what we’re seeing now.  Instead, we’re seeing the impacts of changing job composition.  We’ve lost, and continue to lose, high-productivity jobs.  Our job growth has been in low-productivity sectors.  Naturally, high productivity jobs pay more than low-productivity jobs.

Combined, Mining, Construction, Manufacturing, and Wholesale Trade are still down over 2.5 million jobs since their pre-recession highs.  Other sectors have seen strong growth over the same period.  The generally very low paying Leisure and Hospitality sector has grown by over two million jobs.  The surprisingly low paying, on average, Education and Health sector has been our fastest growing sector.  It’s up 3.9 million jobs, almost all of which are in health care.

Technological change, increased trade, poorly incentivized safety net programs, regulation, and slow economic growth are all claimed to contribute to the change in job composition.

Technological change is an appealing explanation, but the past decade has been characterized by low business investment and slow productivity growth.  This is not what we’d expect if we were going through a generalized technological revolution.  As it is, the most visible gains from advancing technology have been in oil and gas exploration and production.  Oil prices are consequently down, but many governments, organizations, and people are doing all they can to limit or erase the gains from these technologies.

People have worried about technological change’s impact on employment since the dawn of the industrial revolution.  Time and again, those worries have proved unfounded.  I do believe, though, that the spread of electricity throughout the economy and the adoption of tractors in agriculture contributed to the persistent unemployment of the Great Depression.

The Great Depression and the Great Recession share some similarities.  So, we can’t reject the possibility that technological change is contributing to persistent unemployment, low investment and productivity growth notwithstanding.  If so, its impact is relatively minor.

Increased trade, combined with an ineffective safety net, has contributed to persistent unemployment.  This is a bit sacrilege for an economist.  If there is anything approaching a consensus among economists, it is that trade is good.  The proofs are elegant and convincing.  I have no doubt that countries that voluntarily trade are better off.  But, this ignores distributional issues, and distributional issues can be important.

As a free-trade enthusiast, I’ve argued, and deeply believe, that the benefits of free trade are sufficient to allow us to protect the workers, and the families of workers, displaced by the increased trade.  But, we don’t.  Maybe we shouldn’t expand trade until we do?

Our safety net is so bad that it actually contributes to persistent unemployment.  Means-tested welfare programs create cliffs, where small amounts of new income cause the loss of thousands of dollars in benefits.  So, why work?  Extended unemployment benefits encourage workers to be idle long enough that their skills atrophy.

Our regulatory environment is increasingly onerous, and contributes to persistent unemployment.  Perhaps the worst example is coal.  Our government has declared war on our coal industry, with the avowed goal of eliminating the industry, and by extension the livelihoods of the industry’s workers and their families.

Other regulations may be well meaning, but they are laced with pernicious consequences.  These include minimum wages, licensing requirements, and mandated benefits.

Recently, we’ve adopted more reckless ways to increase our economy’s regulatory burden.  Sarbanes-Oxley, Dodd-Frank, and the Affordable Healthcare Act are examples of massive regulations that were written in a short time in response to a perceived crisis and passed with insufficient consideration and debate.  Unemployed workers and their families pay a disproportionate share of costs of the poorly-considered regulations.

These regulations have performed one service.  For those willing to see, it’s clear that micromanaging markets by politicians and their bureaucratic lackeys is a terrible idea.

Slow economic growth contributes to persistent unemployment.  Unfortunately, it’s becoming increasingly fashionable to accept slow economic growth, or even argue that slow economic growth is good.  This is terrible thinking.  Our low and declining labor force participation rate, is one result of slow economic growth.  The fact remains that the best opportunity for a low-productivity worker exists with higher-productivity workers are employed.

How do we know when the higher productivity workers are employed?  The unemployment rate won’t help.

Unemployment numbers are distorted by labor force participation rates.  If a worker becomes discouraged and stops looking for a job, the unemployment rate falls.  The media, who engage in only the shallowest analysis, report this as if it were good news!  They say the world is better, when what really happened was that a person gave up looking for a job.  The once proud and self-sufficient worker surrendered to the soul-crushing life of a ward of the state.

The correct measures of economic vigor are labor force participation rates, new jobs as a percentage of the population, and per-capita GDP growth.  By those measures we aren’t doing very well.

What to do?

Lots of economists would say increase trade and public capital investment.  I disagree with both.  My arguments against public capital investment are here.

My reluctance to increase trade are not because I doubt the gains from trade.  Trade will increase the wealth of both trading partners.  Instead, it’s based on our inability to protect those displaced by increased trade.

Over the past year, I’ve had the opportunity to meet many men who lost their jobs because a factory moved to Mexico.  Yes, everyone was a man, and every factory moved to Mexico.

In every case, the impacts were devastating and long lasting.  Sure, some have bounced back and are now doing relatively well, but they bear the scars of divorce, destroyed families, extended unemployment, and reduced living standards.  More aren’t doing well, having slipped into a mind-numbing life of drug abuse and round-the-clock television.

We’re back to what to do?

One thing we need to do is completely revamp our safety net, in a way that always provides an incentive to work, to keep at least some of that next dollar earned.  Replacing our existing system with a negative income tax would do the trick, and save billions in administrative costs.  It would improve economic growth.  It would save families and lives.

We need to completely revamp our regulatory regime, reducing the compliance burden on businesses, embracing market-oriented solutions, and subjecting new regulation to rigorous cost-benefit analysis.

Just these two things need to be done.  Revamping our safety net and our regulatory environment would release Americans to do what they have always done: work hard, create wealth, and create opportunity.  We would see a sustainable boom, one like we haven’t seen in decades.

The post The United States Economy appeared first on Center for Economic Research and Forecasting.

In popular culture, there are “good” industries and “evil” industries.

Oil has held the most hated position of the evil list for generations and is likely to hold it until there is no more oil. Farming, once solidly on the good list, is moving to the evil list because its critics claim it uses too much water and its use of pesticides and herbicides hurt the environment.

Banking holds a special place on the bad list, having resided there for more than 2,000 years. Indeed, Dante had usurers condemned to the seventh of his nine circles of Hell.

Banks still exist because they serve a valuable purpose. They are intermediaries between huge numbers of savers and huge numbers of borrowers. As such, they dramatically increase the return to savers and, just as dramatically, reduce the cost to borrowers. We need banks. We need a well-functioning banking system.

Since the Lehman Brothers collapse, banks have become even more unpopular. They are blamed for the 2008 financial crisis and the terrible recession that accompanied the crisis. Much of that blame is undeserved.

Criminal bankers didn’t cause the Great Recession. Every industry has its criminals. Surely, there were criminal acts by bankers that went unpunished but they were small players on a big stage.

Banks are among America’s most heavily regulated industries. Beginning in the mid-1990s, the federal government, with bi-partisan agreement, set about to increase the percentage of the population that owned their own home. Their methods included incentivizing banks to loan to people who traditionally could not borrow. The incentives included rewards for cooperation and punishments for failure to cooperate. Banks had little choice.

Traditional lending standards existed for a reason. Many who borrowed under the new, more relaxed, standards eventually defaulted, contributing to declining real estate values and the Great Recession.

Consolidation of bank assets in ever fewer banks is the other culprit in the financial crash. For decades now, regulations on bank mergers have been incrementally relaxed, while bank operations have been increasingly regulated. Consolidation was not a stated purpose of the regulatory changes, but they have resulted in fewer banks.

The number of United States banks has collapsed from 14,400 in 1984’s first quarter to only 5,309 in 2015’s third quarter.

The decline in the number of banks has been accompanied by an increasing concentration of bank assets. Today, only five banks control almost half of all American Bank assets.

Bank failures have consequences. Big bank failures have big consequences. The government has decided that some banks are so large, and the consequences of their failure so onerous, that they cannot be allowed to fail. Those banks deemed too big to fail are bailed out. This results in terrible incentives.

When banks merge, they claim that they are diversifying and gaining economies of scale. Research is mixed on these topics. There is evidence that our largest banks are far above the cost-minimizing scale. There is also evidence that economies of scale persist throughout the size distribution. Similarly, there is evidence that banks merge with similar banks, achieving little diversification, and evidence that diversification persists through the size distribution.

The lack of consensus suggests that banks merge for other reasons. Market power and the too-big-to-fail option are prime suspects. The typical consumer and taxpayer does not benefit from these mergers. Market power allows banks to make excessive profits. Being too big to fail encourages banks to take excessive risks.

Banks did take excessive risks and we all paid a share of the costs.

Banks, being heavily regulated, have a huge incentive to try to influence their regulatory environment. Banks hire former regulators, providing an incentive for regulators to go easy on their potential future employers.

Our largest banks are heavy contributors to political campaigns and, as we’ve learned in the current presidential contests, they have found ways to directly support powerful politicians. So, we see lots of empty verbal abuse thrown at banks but little more.

What’s to be done?

• Higher capital requirements would reduce bank runs and stabilize our banking sector. Some economists recommend requiring reserves amounting to as much as 100 percent.
• A 100 percent tax on all assets over whatever is determined to be too big to fail would eliminate too-big-to-fail banks. This, in turn, would reduce banks’ incentives to take excessive risks.
• Private deposit insurance would reduce the influence of politicians and regulators, reducing the return to banks’ political spending. Banks would cut political spending.
• Limits on market share would slow the decline in bank numbers and reduce market power.
• Differential bank regulations based on asset size would further reduce the incentive for banks to merge. Small community banks have been critical contributors to local economies. We need more of them, not fewer.

A weak banking sector has contributed to the anemic recovery. A vigorous recovery needs a vigorous banking system, focused on economic growth rather than regulation. To achieve a vigorous banking system, we need to change bankers’ incentives. We need to move past demonizing to real reform.

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First, some presenters documented empirically that real interest rates since 1860 has had episodes, some of which lasted many decades, of very different behavior.  Not only has the level changed significantly in both directions, but the volatility has changed over time.  Of relevance for the current economy, it has recently been very low, oftentimes negative.

Some researchers discussed a variety of reasons why the real interest rate is so low, including the rate of time preference, fed policy, and other factors, but they did not mention the incremental productivity of equipment and structures.  This is probably because it is not intuitive that the incremental productivity of a computer, forklift, or a warehouse has fallen dramatically over time.

In Macroeconomic theory we relate real interest rates to the incremental productivity of equipment and structures via a formula.  However, when we go to the data, the latter is not observable.  To obtain a measure of the real interest rate, we must go to financial markets data and subtract inflation from a bond rate.  In thinking about a productive economy, a reasonable bond rate to deflate is the corporate bond rate.

Some researchers postulated the idea that the low real interest rate is the reason for the low performance of the US Economy.  I prefer the idea, promulgated by John Taylor, John Williams, and others, that the low real interest rate has been caused by other factors, in particular, fiscal policy uncertainty and costly regulations.  I worry that there is a wedge, partly policy driven, that has inserted itself between the after tax incremental productivity of equipment and structures, and the deflated corporate bond yield.  Another way of saying this is that while equipment and structures are themselves roughly as productive as before, but the productivity net of these recently higher costs is lower because the costs have risen substantially.

With this idea, we see that there are other factors, fiscal policy uncertainty and regulations, that have caused both slow economic growth as well as historically low real interest rates.  It is at least a possible that long-term trends in the regulatory environment have partly contributed to the long-term evolution of the real interest rates since the 1860s.

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One of the Big Five banks is BofA, and I am one of their customers. It is convenient for me to walk up to a BofA ATM machine in Michigan, Florida, Oklahoma, or anywhere in the U.S. and withdraw cash without paying fees.

It is also convenient for regulators at the Fed, the FDIC, and the Treasury to maintain surveillance over just 50 banks rather than say, 500.

The justification for the consolidation in late 2008 went something like this: size helps offset the bad assets on the books and we (the Federal government) will watch over these institutions very carefully now.

I strongly object to current U.S. banking policy. This is despite the convenience to me and despite the convenience to the regulators, although these are trivial. Policy should not be justified by convenience.

Size matters. The risks that $7 trillion in assets pose to a $17 trillion dollar economy are massive. A loss of “just” $1 trillion in 2015 would be six percent of 2014 GDP. One trillion dollars is double the contraction in GDP from 2008 Q3 to 2009 Q2.

Further, the trend is in the wrong direction. This, interestingly, is despite one of the intentions of the Dodd-Frank legislation. The top five’s share of total U.S. banking system assets has grown impressively, growing in every year but one since 1990. In 1990, they held less than ten percent of total assets, and by 2014, they held 44 percent. Soon, the top five banks will be fifty percent of GDP.

Returning to the carefulness of the regulation, just because the government is more involved with managing these large banks does not necessarily mean that the economy is safer. There is often a revolving door between regulatory agencies and those they regulate. This creates the wrong incentives for protecting the economy, and these incentives worsen as the large banks get larger.

We should change policy to begin the process of breaking up these banks. It will not be easy, and it will take time, so we should get started sooner rather than later.

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Liftoff has market watchers glued to their monitors for a number of important economic reasons. Because the rate is related to other longer-term interest rates through the Term Structure, and the longer-term rates are used to discount cash flows, this affects net present value (NPV) calculations, making more investment projects appear profitable. Aside from new projects, lower corporate bond rates bring down a firm’s borrowing costs, raising their net income.

The argument for low rates in late 2008/early 2009 was a good one. We had faced a serious financial crises and were in the middle of a serious recession, one that appeared at the time to be the second greatest economic contraction since 1929. Many financial entities faced a liquidity crunch, where short-term credit had vanished. Firms shelved positive NPV projects. Households were upside down on their homes. Because the housing market was so decimated the lower mortgage rates were thought to be needed to help resurrect home sales activity and promote refinancing which in some cases could help a household remain as a homeowner.

The Fed’s dual mandate of price stability and economic growth, argue in a conventional way against raising rates at this time. Historically, rates were raised as a way to cool down an economy with rising inflation or dropped as a way to spur economic growth. However, inflation and economic growth continue remain low compared with postwar U.S. history.

Despite this, I think the Fed should immediately begin the process of raising rates toward historically normal levels. The abnormally low interest rates were probably justified by the double feature of a financial crises and a large economic contraction back in late 2008/early 2009, but they do not have that justification now. The canonical Taylor rule formula as published by FRED at the St. Louis District Federal Reserve bank calls for a Federal Funds Target rate of 2.44 percent.

It is safe to say that financial markets, consumption activity, and savings and investment decisions are being distorted by the low interest rates. As one example, household balance sheet rebuilding was and still is important for the long-term economic health of the U.S. A higher return to savings would aid and incentivize this activity.

The economy should be able to grow with interest rates at normal levels. If it cannot, then it needs to relearn this ability. If this process ends up taking some time, we should begin it sooner rather than later. An imminent financial crisis does not seem to be a high probability event at this time. However, if one did happen now, being at the zero lower bound would be an inconvenient reality indeed.

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