Heterogeneity Stumps the Fed

Heterogeneity - the state of being heterogeneous; composition from dissimilar parts; disparetness.

Ceteris paribus (Latin for "with other things remaining the same") was one of the favorite terms used when I was studying economics and it appears that not only is the Federal Reserve reliant on this phrase but they are also using the other economic theory of all people acting rationally.  Neither of these ever works in the real world but economists love to try theories based not on real world examples but based on ceteris paribus in an effort to prove the impact of a change in one economic variable.  This is akin to data mining, digging for data that proves your point even though the two variables are often not even vaguely related, but it is becoming more and more apparent that something as simple as Heterogeneity is stumping the Federal Reserve for the simple reason that they seem to rely on ceteris paribus and rationalism.

Heterogeneity essentially says that people will act differently from one another given a set of economic variables.  The Federal Reserve does not seem to consider this when making their policy decisions as if they did then I would expect their decisions to be very different.  Without digging too deep into the subject let's take a look at their current policies of low interest rate and money stimulus.  The idea was that if you hold interest rates low and pump trillions into the economy through the reserve banking system that individuals would not hold onto cash but would load up on debt and invest the proceeds creating businesses and jobs.  All you had to do was dump enough money into the top of the funnel and it would eventually trickle down to the man on the street.  Voila, simple as that and hey presto all is well.  (Sorry I could not resist the kitsch phrases as to me they highlight the lunacy of the decision making process.  Who knows maybe they use these words behind closed doors as how else can they hatch such a poor plan?)

Years later and trillions of dollars they are still scratching their heads as to why this ridiculous plan has not worked but it is as simple as heterogeneity.  People do not act in one massive unified body and, changing one variable, interest rates, does not make another variable, high debt levels, magically vanish. The results of this massive stimulus project has been to create what is turning into another stock market bubble and one of the largest wealth divides in history with such feeble economic footing that the economy cannot even handle 1/4 of 1 percent increase in rates..  

As I pointed out a few weeks ago the velocity of money is at an all time low for the simple reason that people are not spending money.  As the vast majority of individuals are earning less today (in inflation adjusted numbers) than they were a decade ago and as the labor participation rate is at a 38 year low, it is no wonder that there is little to no economic benefits coming from more Fed stimulus.  People act within their own personal constraints and the lower end of the labor market has not seen any economic recovery and is still struggling to recover from the last economic meltdown.  Until they feel the benefit of an economic recovery throwing more stimulus at an overvalued stock market will not get the job done and raising rates will kill the supposed golden goose.

Had the Federal Reserve and the government spent their time and money looking at how to get the labor participation rate up rather than making fat Wall Street bankers fatter I would argue that the economy would be on solid footing.  Simple examples to get money into the hands of the low earners would be to stimulate small business growth with tax incentives and lower reporting requirements, provide students with no interest on their student loans while sending a rebate check to those that just fell outside of this benefit and spend money on roads and infrastructure projects to name a few.  Doing this would mean more jobs, resulting in more money in the hands of those that would spend the extra income, improving consumer confidence and an economy not reliant on zero interest rates.  For now though their focus is on more stimulus and while their numbers seem to show success the global economy and company earnings are pointing in the opposite direction which is why my money stands on the sideline watching and waiting.