30 Apr 2012

Wenzel vs. Murphy: You Decide

Economics, Federal Reserve, Financial Economics, Shameless Self-Promotion 10 Comments

[UPDATE below.]

Well, Bob Wenzel has already been knighted due to his remarks at the NY Fed, so in the interests of keeping Sir Bob humble, I want to recall something back from November.

Some of you may remember that Tom Landstreet and I had a piece run on Nov. 7 on Forbes, in which we said the following:

Many analysts have been surprised lately by the strength in certain economic indicators, such as the growth in business investment in the third-quarter GDP report, particularly in equipment & software. The hopes for a general rebound are misplaced, however, because temporary depreciation rules may be driving the apparent upswing. The generous bonus depreciation and small business deduction rules begin to drastically phase out in January 2012, which will likely cause a dramatic reversal in investment and other indicators.

Wenzel didn’t think too highly of our view. In a post titled, “Bob Murphy: It’s Not Austrian Business Cycle Theory That Counts, It’s Depreciation Rates,” Wenzel wrote:

Bob Murphy, along with Thomas F. Landstreet, have an odd column out at Forbes, which seems to diss Austrian Business Cycle Theory and promote depreciation rates as the key to the economy…

Say what? Depreciation is driving the upswing? I have been one of those forecasting a general (manipulated) rebound because of Fed money printing, based on ABCT. I don’t see anyway that depreciation is the major driver in this economy.

ABCT holds that central banks print money which generally first goes to the capital goods sector. This flow of funds results in a (manipulated) boom in the capital goods sector. Federal Reserve Chairman Bernanke is now printing money (M2) at a rate of 15% plus. That is a lot of money to be hitting the system. In fact, over the last 12 months, it is nearly a trillion dollars. M and L apparently want to ignore this trillion dollars and hang their hat on depreciation changes.

…In other words, businesses are going to be hit with a big new tax burden.What does this have to do with a general rebound? If you know that you are getting business because of a depreciation law that is about to expire, are you going to crank up your business for a demand that is not going to be there in a year? Of course, not. Do glove makers continue to crank up sales for the summer months? Should we send out an alarm saying, “Hey glove makers, coat makers and sweater makers are going to get smacked when summer hits. The economy is going to tank.” ? Of course not. Expected changes are planned for.

The depreciation change is not fooling anyone. … Do M and R think that the businessmen on the sell side of these transactions aren’t aware of this? Do they think the sellers are idiots?

Needless to say, Wenzel wasn’t convinced of the cogency of our analysis.

Back to our Forbes article, Landstreet and I looked at the last time such a drastic change in depreciation rules occurred:

Note that if the accelerated depreciation rules are temporary, then the long-term impact may be muted. As the expiration deadline for a particular benefit approaches, we might see businesses simply pull forward their routine replacement of equipment. Thus the surge in investment during the period of eligibility might be matched by a collapse in investment after the expiration.

For historical evidence, we can look at what happened when the bonus depreciation rate dropped from 50% in 2004 down to 0% in 2005. Even though investment in equipment and software jumped 21% over the two-year period, the growth was not spread uniformly.

Instead, there was strong growth through 2004 (with fourth-quarter 2004 equipment & software investment up 12.1% from the prior quarter), but then an abrupt slowdown going into first quarter 2005, when this investment category only rose 2.4%. Businesses likely pulled forward much of their planned equipment amd software purchases—which normally would have occurred in early 2005—into 2004, to take advantage of the expiring 50% bonus depreciation.

We face a similar situation today, except that the stakes are higher. To reiterate, the bonus depreciation rate drops from 100% to 50% in January, and at the same time the Section 179 maximum deduction drops from $500,000 to $125,000. Anecdotally, we know many businesses have been rushing to get their capital purchases “placed in service” before the 2011 deadline passes. This has given an artificial boost to business investment and other measures thus far, but investors should be ready for a sudden reversal come 2012.

Now in the actual paper that we put out for Landstreet’s investment clients, we were more specific, and focused on Nonresidential Fixed Investment, as well as Equipment & Software. (The latter is a component of the former.) We showed how, over the period from 2004-2005, average growth in both categories was strong, but that it was unevenly distributed. Specifically, quarterly growth was high in these categories in 3q2004 and then slowed into 4q2004, then fell sharply in 1q2005 before starting to recover in 2q2005. We specifically predicted that we would see a similar pattern, though more pronounced, this time around in both those categories, with reference to the 2011 and 2012 numbers.

Lo and behold, the advance estimates from the BEA released last week show the following (you have to click on the Tables to get these details):

Nonresidential Fixed Investment
3q 2011: +15.7%
4q 2011: +5.2%
1q 2012: -2.1%

Equipment & Software
3q 2011: +16.2%
4q 2011: +7.5%
1q 2012: +1.7%

So, Landstreet and I are declaring Miller Time on this one. Not only did we say that GDP growth was going to be lower from 4q –> 1q (which it was: 3.0% down to 2.2%), but we specifically called one of the components of the slowdown. This is from the BEA’s press release: “The deceleration in real GDP in the first quarter primarily reflected a deceleration in private inventory investment and a downturn in nonresidential fixed investment that were partly offset by accelerations in PCE and in exports.”

In contrast, Wenzel has been pushing a “Keynesians are idiots, they don’t see the boom caused by Bernanke’s mad money printing spree” story. Every time a decent economic indicator has popped up, Wenzel has reiterated this line. So if he wants to say Bernanke has slowed his money-printing from when Wenzel bit my head off back in November, OK, but then he can’t at the same time mock Keynesians for being so pessimistic about the “manipulated recovery.” Bernanke can’t be simultaneously spiking and slamming the economy.

If anything I think 1q 2012 showed the exact opposite of Wenzel’s take: Business investment decelerated (or actually declined, depending on the category), while consumer spending and foreigner spending were up. If you were doing a standard ABCT explanation, isn’t that backwards?

Don’t get me wrong, I am fully aware that people can get lucky when throwing out predictions. But Wenzel bit our heads off when our piece came up, so I think it’s not too cheeky for me to mention that at least as far as the crude BEA numbers go, we hit that out of the park. Landstreet’s clients are telling him on the phone, “Huh, you called that one, Tom.”


UPDATE on May 3, 2012: Wenzel has responded here. He makes some good points, especially about the fact that the stock market definitely didn’t move in accordance with the Landsburg/Murphy perspective (though technically we didn’t say, “Short the market!”).

On another matter, Richard Peach of the NY Fed has a different version of how things unfolded that fateful day.

10 Responses to “Wenzel vs. Murphy: You Decide”

  1. RGallatin says:

    Robert Wenzel’s lunch at the New York Fed was not a “speech” in the sense that he was holding forth in front of room full of Federal Reserve policy makers and analysts. I spoke with Richard Peach at the New York Fed: the “speech” was just Robert Wenzel having lunch in the dining room with two people — Richard Peach and one colleague — during which Wenzel read his speech to the two of them over lunch. This was not Netanyahu at the UN.

    • Robert Wenzel says:

      When I entered the Federal Reserve Building, I had no idea how many people I was going to be speaking to. As I wrote in my summary of the speech, at first Peach sent out a formal invitation, that was cancelled within in 15 minutes.

      Peach then emailed me that the speech would go on. Indeed, he had many more chairs reserved for my visit than attendees and only told me when I entered the building that he wasn’t sure how many would show up “because of a conflict with another seminar”. That said I did overhear him go up to the Fed Liberty Room host and say that he did not think the group would be as large as originally expected.

      As I have told many people, once I was in the Fed building, I was determined to give that speech to the bathroom mirror, if necessary. That some economists showed made a “bathroom speech’ unnecessary. And rest assured if Ben Bernanke or Bob Murphy showed up for the speech, I would not have changed a word.

      Judging from my web logs, although many Fed economists failed to attend my delivery of the speech, I did get their attention and they have since read the speech.

      • Robert Wenzel says:

        BTW, in my hard copy version of the speech,(watch for publication announcement at EPJ in the next couple of days) I go into much more detail about the backstory of the speech, how it did appear someone tried to kill it, copies of some of the email exchange with Peach, some of the economists, who were invited and failed to attend, who did attend, who appeared irritated, who appeared angry, etc.

  2. Ben says:

    Just an observation: I find it ironic that Wenzel is basically saying, “Look how wrong Murphy is on this one. He’s assuming that businessmen are stupid, but they clearly aren’t.” Doesn’t ABCT also make this same assumption (that businessmen are extremely shortsighted when it comes to making investment decisions based on artificially low interest rates)?

    So while we may not have to send out an alarm to the glove and sweater makers, Wenzel would probably say we should send an alarm to capital intensive industries in a period of monetary expansion because they are too stupid to realize that the low interest rates are not sustainable. That’s funny.

    • Bharat says:


      What I took from that ^ (someone can correct me if I misinterpreted it) was that ABCT was about malinvestments; not a general overinvestment, but overinvestment in certain areas and underinvestment in other areas.

      So with that being considered, I don’t think your logic is correct. It’s not that businessmen are stupid. It’s that they aren’t omniscient enough to know which investments are correct and which are not without the correct interest rate signal, which becomes more drastically difficult to deal with the longer it is price-fixed. The longer the rate is fixed, the longer entrepreneurs are attempting to play the game of “let me take advantage of this low interest rate.” Because if they don’t, they’ll lose out to their competition.

      Regardless, I think Professor Murphy is correct on this one. Anticipation in a situation like this doesn’t mean, as Dr. Wenzel tried to point out, that investment wouldn’t fluctuate because businessmen would have already accounted for the future. Because the rules are changing, anticipation should cause a surge in investment before the change and a fall afterward. Entrepreneurs will take advantage of the rules while they still can.

      It’s like if sales taxes are expected to go down in the future, individuals won’t increase consumption now because of the expected decrease in taxes. They will increase consumption later after the taxes are decreased. In other words, consumption will be lower now relative to the future. Speculation on regulation differs from speculation on prices. No one is going to buy extra apples now to sell later based on the expectation of higher future taxes because the revenue generated from the higher price doesn’t accrue to them.

      • Ben says:

        I think we’re on the same page. I didn’t mean to imply that ABCT says the problem is overinvestment in general. When I said “capital intensive industries,” I meant things like housing, where there clearly has been malinvestment. And I agree that businessmen can’t know which investments to make if the interest rates are manipulated, but if they project that interest rates will stay near zero for a very long time, they are being stupid.

  3. Gee says:

    Is it possible you just have different metrics for ‘general recovery’ ? So that you take it to meen increased GDP and capital investment while Wenzel takes it to meen lower unemployment and inflated stock market prices ? Oh screw it, fight fight fight !

  4. John G. says:

    Good call, Doc. You appear to be spot-on.

    You and Bob did a fine job keeping each other honest on this one. Good to see worthwhile collegiality.

    I value my daily subscription to Bob’s commentary and analysis, but we all make mistakes sometimes.

  5. George Soto says:

    AnonymousNov 8, 2011 05:25 PM

    Doesn’t a decrease in tax revenue increase the deficit, which is being monetized to keep short-term interest rates between 0 and 0.25%? Won’t the rate of monetization slow when the taxes are raised afterwards and the deficit closed (ceteris paribus), and therefore contribute to the down side of the business cycle?

    AnonymousMay 3, 2012 10:22 AM

    In theory yes, but in practical terms I think not. You assume increasing taxes will actually lead to closing the deficit but an unintended consequence of higher tax rates is slower business growth. It will backfire because now the government will collect less in revenue on lower returns for businesses. Is it better to collect revenue at a 35% tax rate with diminished investment income or to collect it at 25% with a higher volume of investment returns? My point is that higher tax rates will not necessarily reduce the deficit but actually increase it causing slower business growth and hence less income to tax. Regardless I believe the real problem in fiscal policy is spending and this administration will continue spending more while increasing taxes. A recipe for disaster. I believe Murphy and Wenzel agree on the general outlook and just disagree on the sequence of events. Murphy seems to believe we are headed for a downturn much sooner where as Wenzel believes we will be in the boom phase for a more extended period of time. Love the debate between these Scholars.
    What do you think about this conclusion Dr Murphy.

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