10.30.2013 0

Dow hits new high, but is this just a paper boom?

Money_BombBy Robert Romano

On Oct. 29, the Dow Jones Industrial average reached an all-time high. So, what has investors cheering? A manufacturing boom? More jobs? Lower taxes?

None of the above.

It was “expectations that the Federal Reserve will keep its economic stimulus program in place,” reports the Associated Press.

But, that supposedly “temporary” central bank program of $85 billion a month in U.S. treasuries and mortgage-backed securities purchases is predicated on a very weak financial outlook, high unemployment, and depressed credit markets.

Five years after the financial crisis was supposed to be over, its continuation cannot be good news.

Perhaps the reason is because that calamity still has not ended.

In the first two quarters of 2013, the amount of credit outstanding nationwide — that is, all debts public and private — has expanded by $658.6 billion, according to data compiled by the U.S. Federal Reserve.

If it continues at that pace, it will grow a total of $1.3 trillion by year’s end to about $58.2 trillion, a 2.3 percent increase.

That may sound like a lot, but it’s actually not. Last year it grew $1.88 trillion at 3.34 percent annual rate. The slower expansion this year could indicate that credit once again slowing down, along with the economy, usually a bad sign.

In contrast, since 1945, credit outstanding nationwide has expanded an average of 7.9 percent a year. The meager growth in new debt today indicates that consumers, business, and banks are borrowing less, and therefore not spending as much. Another not so good sign.

That is because, sadly, there is a direct correlation between credit expansion and economic growth, which in turn has consequences for unemployment, inflation, and other indicators.

When credit contracts or even slows down its expansion, as it has in recent years, the economy tends to follow suit.


This was true in 1946, 1949, 1954, 1974, 1975, 1980, 1982, 1991, 2008, and 2009. In all of those years, real Gross Domestic Product (GDP) contracted. And in each of those years, credit outstanding nationwide had either contracted or registered slower growth from the year prior.

In two years, 1947 and 1958, this was not true. The economy contracted but overall credit grew. Although to be fair, in both years financial sector credit slowed down significantly.


In 10 out of the 12 years in question, or 83.3 percent of the time, recessions were directly linked to an overall credit slowdown or outright contraction.  And in the two other years, they were linked to a financial sector credit slowdown.

This has direct implications for economic growth, which has been lackluster since the financial crisis began. Namely, if you, I, and everyone else are not going deeper into debt, future growth is questionable. Call it a design flaw.

Since 2010, real growth has only averaged 2.36 percent. So far in 2013, it’s only at 2.7 percent, still below the at least 3 percent needed to help unemployment reduce substantially called for in Okun’s Law.

A significant indicator has been financial sector debt, which decreased from $17 trillion in 2008 to just $13.9 trillion today. This $3 trillion of deleveraging in the financial sector has been offset by about as much Federal Reserve quantitative easing, without which credit would have certainly continued contracting, perhaps to a market bottom.

But rather than facilitate a recovery, this has merely resulted in a $2.3 trillion explosion of excess reserves held by financial institutions.

In other words, the monetary “stimulus” from the Fed continues to sit idle, not being used to drive credit creation and get the economy moving again. But why? Is the financial sector to big to grow?

The trouble is despite the credit slowdown, consumers, businesses, and banks remain highly leveraged, and have little extra room for borrowing. In the meantime, young people are not entering the labor force and housing markets at the same rate as in the past.

In short, demand for new credit is much lower than it was throughout the postwar period, calling into question the utility of an economic model that has been driven by credit creation for more than a generation. In lieu of a real private sector recovery, all the Fed can do is throw more paper at the problem.

This is the end result of the central planning of the pricing of money and the allocation of capital. The problem is exacerbated by a high demand for dollars — the world’s reserve currency — all over the world, which has necessitated the credit expansion. After all, the new dollars had to come from somewhere, why not debt?

But once it hit a ceiling, like any consumer who maxes out on his credit, the model broke down. If credit cannot grow, then how will the economy? The real dilemma may be that if the U.S. economy, and the dollar, can no longer reliably produce global growth and prosperity via debt creation, it may not be long before the rest of the world seeks alternatives.

Then, investors will have nothing to cheer about.

Robert Romano is the senior editor of Americans for Limited Government.

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