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Guest Post: The "W" Recovery?

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Submitted by Leo Kolivakis, publisher of Pension Pulse.


First things first, let me tell my mom that I love her dearly and wish all the moms out there a Happy Mother’s Day.

Now, I have put off writing this comment long enough. This is partly because analyzing this economy is not as easy I first thought. Having said this, let me explain to you why I think this will likely be a “W” recovery.

U.S. led us into this mess and it will (hopefully) lead us out

Back in August 2008, I wrote a comment, Galton’s Fallacy and the Myth of Decoupling, where I critically examined the myth that the U.S. economy no longer leads the global economy. Despite the prophetic doomsday predictions, the U.S. economy still dominates the global economy and I do not see this changing or many years.

So what exactly happened to the U.S. economy that eventually led to a severe and synchronized global downturn? President George W. Bush was right when he said “Wall Street got drunk”, but he neglected to mention the weak regulatory framework and cheap credit that allowed the big banks and their big hedge fund and private equity clients to reap huge gains.

Moreover, global pension funds in their myopic focus on alpha, shoveled billions in hedge funds, commodity funds, private equity funds and real estate funds, in what I have dubbed the pension Ponzi scheme.

[Note: Read Warren Buffett's 2005 Berkshire Hathaway annual letter, How to Minimize Investment Returns.]

They all fed this big machine that some rightly call Casino Capitalism, and they all share blame in their common denominator of failure. It is simply absurd for them to now band together and say “nobody could have predicted this once in a lifetime event.”

But now we are in a mess and we need to see if there is light at the end of the tunnel. The job of a good economist is not to be a perma bear or a perma bull but to analyze the current state and try to see where we are and more importantly where we are heading.

Importantly, economic and financial analysis should always be forward looking, not backward looking. This is something that escapes even the most sophisticated experts in finance who often place too much emphasis on recent history to extrapolate future trends.

So where are we now? If the U.S. leads us out of this global mess, are there signs of a recovery over there? Let’s begin with Friday’s job report where some believe a slowing of job cuts signals that the worst of the recession may be over:

Payrolls in the U.S. shrank in April by the least in six months as the worst recession in half a century started to ease and the federal government stepped up hiring for the country’s next census.

Payrolls fell by 539,000, fewer than economists forecast, after a 699,000 loss in March, Labor Department figures showed yesterday in Washington. Still, the unemployment rate jumped to 8.9 percent, the highest level since 1983.

The economy has lost 5.7 million jobs since payrolls started dropping in January of last year. At the same time, the jobless rate probably won’t start retreating until an economic recovery is secured, and the loss in wages will hold back consumer spending for months, analysts said.

“The most intense pace of reductions in the labor market appear to be behind us,” said Joseph Brusuelas, director at Moody’s Economy.com in West Chester, Pennsylvania. “The economy has taken several tentative steps on the road to stabilization.”

Stabilization? Perhaps but it is worth keeping mind mind that if you dig into the numbers, 66,000 people were hired by the federal government mostly for the 2010 census. In fact, the Census expects to hire a total of 1.4 million workers in 2009, but these are temporary jobs.

One encouraging sign on jobs front, however, was that a separate report, the household survey, showed that the U.S. economy actually added 120,000 jobs in April, which is considerable better than the payroll survey.

The discrepancy between these two surveys has some economists asking how bad are job loss reports?:

If I told you BLS estimates the job loss at both 5.7 million and 3.7 million, you would be puzzled if not skeptical. But it’s true.

With the exception of a few die-hard economists, not many people know about the lower number because it wasn’t reported in the media or in the monthly BLS press release on the employment situation, and it’s pretty hard to find on the Bureau’s Web site. To locate the information, you have to search the Bureau’s Web pages by plugging in the title of the following report: Employment from the BLS household and payroll surveys: summary of recent trends.

On the first page of the report is a table showing both the 3.7 million and the 5.7 million total nonfarm job loss since the business cycle peak in December 2007. The larger job loss number comes from the monthly survey of establishment payrolls. The smaller number comes from the government’s monthly household survey with employment adjusted to the definition of payroll jobs for comparability.

Household-measured civilian employment is adjusted to a jobs measure by subtracting out agricultural employment, the self-employed, unpaid family and private household workers, and workers absent from their jobs without pay, and adding in multiple jobholders. Population control revisions are also smoothed.

The April BLS report comparing the two employment series is 11 pages long, but nowhere will you find an explanation or a discussion of the sizeable discrepancy between the two job loss figures in the current recession.

The question has important policy implications and needs addressing. If the reason for governmental silence is that the BLS can’t explain the difference, it should say so and at least put forth some plausible hypotheses.

Even though the monthly sampling error of household survey employment is larger than the error for payroll employment – a good reason to prefer the payroll data in the evaluation of month-to-month changes in employment – this can’t be used to justify ignoring valid trends in the household series over several months or longer.

In 2006, BLS wrote: “Divergences in the two surveys’ employment measures may occur again. At such times, data users and analysts would be well served not to think of one survey as ‘right’ and the other ‘wrong.’ ”

In the 2001 recession, household employment after adjustment to a payroll definition also fell by less than payroll jobs measured by establishment survey, though, like now, the discrepancy received little attention. (For earlier recessions, BLS doesn’t have the necessary data to adjust household employment to a payroll concept.) In the subsequent employment recovery, though gradual, the household adjusted job count continued to ring a more positive note, rising by 2.1 million more than the traditional establishment-based series.

The sharpest drop in employer-reported payrolls during the current recession occurred in the past half year, a loss of 3.9 million jobs. By comparison, household-measured employment adjusted to a payroll definition fell in the same period by 3.1 million, or by 800,000 less. That difference averages out to more than 130,000 fewer jobs lost a month, not a small number. In the first 10 months of the recession an average of 180,000 payroll jobs were lost a month compared to 55,000 a month for the household adjusted series. In both these recession subperiods, the adjusted household job count did not fall as fast as employer-reported payroll jobs.

All in all, at this juncture there’s no good reason to reject the smaller 3.7 million recessionary decline in jobs estimated by BLS in favor of the 5.7 million number.

One possible explanation for the discrepancy: Some workers who lose their regular jobs go off-the-books in their next job, a tendency that’s likely to increase in a recession. These workers would not be counted in the payroll survey, but could be picked up in household interviews. The BLS in 2006 wrote that although off-the-books employment “obviously is not counted by the establishment survey, because the workers would not be shown on employer payrolls, the household survey will capture some or all of such activity.”

We are in a serious job recession, but it may not be as bad as we thought.

According to Stéfane Marion, Chief Economist at the National Bank of Canada, the pick-up in household survey employment augurs well for future employment gains because this survey tends to lead payroll survey at market bottoms.

[Note: Stéfane is a former colleague of mine and one of the best economists in the industry. He and his team, which includes Yanick Desnoyers a former senior economist at the Bank of Canada, have been mostly right in their macroeconomic forecasts. You can read their weekly economic letter and monthly outlook by clicking here.]

You might have noticed that I omitted talking about other leading economic indicators like the ISM manufacturing index, which is stabilizing but well below the 50 threshold which signals expansion.

For me, it’s all about jobs right now. If the U.S. job market does stabilize, this will be a significant boost to depressed confidence levels. I know that employment is a lagging indicator but given the unrelenting bad news on the job front, any sign of stabilization will boost confidence levels, albeit from depressed levels.

And I should add that boosting confidence is the key to making sure a recession does not spill over into a depression.

What about the wealth effect and higher savings rate?

There is no doubt that the carnage in the stock market and the housing market has dealt a serious blow to U.S. (and global) household wealth.

Apart from paying off debt, U.S. households are saving more to achieve their financial objectives, and we are witnessing a turnaround in the U.S. negative savings trend that began back in the early 1990s.

Longer-term this is good because it builds solid foundations for the next economic recovery but short-term, it could lead to the paradox of thrift where privately sensible decisions lead to publicly bad outcomes.

But the key here is in just how painful transition to higher savings rate will be:

  • Households will henceforth determine their level of savings and adjust their consumption according to income level. While the savings rate climbs towards its new balance point, consumption will need to grow at a slower pace than income. The transition from a low or almost nil savings rate to a higher one will not be painless. However, once this new rate stabilizes, it will be possible for consumption to grow more or less in lockstep with income.
  • Consequently, the faster the savings rate rises, the shorter the consumer recession will need to last.

I can’t overemphasize the last two points (you should read that economic letter to gain more insight on this important transition).

All the gloomy economists who are calling for a U.S. savings rate to soar to 15% do not understand macroeconomics. If you are calling for that, you are basically stating that a severe economic depression is the only outcome.

Moreover, you are forgetting about the other factors that affect savings: housing prices and the stock market. Global stock markets have rebounded strongly from their March 9th lows and according to Fed Chairman Bernanke, the U.S. housing market is stabilizing:

The housing market is beginning to stabilize, and the recession should end later this year, Federal Reserve Chairman Ben Bernanke told Congress this week. However, Bernanke said this will happen only if the financial system continues to gradually improve and doesn’t relapse into a credit squeeze.

The slight improvement with the housing market is the first to be seen in three years. Bernanke said that sales of resale homes are stable, and sales of new homes have recently increased, though both still remain at depressed levels. According to Bernanke, the affordability of homes is the most steadying factor.

Though the housing market is looking up and Bernanke hypothesizes that the recession’s end is in sight, he said that growth will remain slow and unemployment high for a year after the recession ends.

“We continue to expect economic activity to bottom out, then to turn up later this year,” Bernanke told the congressional Joint Economic Committee.

The Fed Chairman is right to forecast a jobless recovery, but is the U.S. housing market really stabilizing? Robert Shiller, the Yale University economist who helped create the home-price gauge, recently spoke with TIME’s Barbara Kiviat:

People are talking about the housing market bottoming out. Do you believe it?

The conspicuous fact with our [Case-Shiller] data is that prices are still falling, although at a somewhat lower rate. There is also some sign of pick-up in pending-home sales. But to me the dominant fact is that prices are still falling. We’ve never seen a real estate market turn on a dime. For the longer horizon, though, it’s possible that we are picking up. The other thing that is striking is that home prices have come down a lot, so they’re no longer very overpriced.

If houses are no longer overpriced, but prices are still falling, does that mean we’re overshooting?

That is the issue, whether we’ll overshoot and end up being below, in inflation-adjusted terms, where we were in 1997. We’re not quite down to where we were before, but we’re getting close. Overshooting is typical in the stock market, but in the housing market, I don’t know. We’ve never really had such a big, national bubble in the housing market before.

Are there structural changes we need to make so that we don’t have this sort of craziness again?

Yes. This crisis was substantially caused by a failure to manage real estate risk. Notably, we got individual homeowners into a leveraged position typically with their entire life savings in real estate in one city, in one house. That’s very risky. I have one proposal for continuous workout mortgages. Right now we think it’s a great thing if banks will give struggling homeowners a workout. Why do we only want to come in after the fact? My vision for our future is that it should be planned for and priced into the initial mortgage. We could update mortgages in a way they protect people from things beyond their control— like high national unemployment.

What else?

Home-equity insurance. We want to have homeowners’ insurance, which protects against things like fires, updated so that it protects against a loss of market value. Fires were a big problem hundreds of years ago. Houses were burning down all the time. Now we’ve developed a different problem—the residential housing market has gotten much more volatile.

The company you started, MacroMarkets, just got approval for tradable securities linked to the Case-Shiller house-price index. How does that factor in?

One reason we have bubbles in the housing market is because there’s been no way to short housing [that is, to make money when prices fall]. The ability to short is essential to an efficient market, otherwise there’s nothing to stop zealots from pricing things abnormally high. If you buy one of these long securities, called UMM, it’s like buying a house, except you don’t have to go through the real estate agent, take possession of a property, maintain it, rent it out. But we also have the DMM, which is short housing. Markets like this will also create an infrastructure for products. For example, insurers could issue home-equity insurance and then hedge themselves by taking a position in this market.

The Case-Shiller housing futures that trade on the Chicago Mercantile Exchange haven’t really taken off, though.

I know. It’s bizarre. People are fascinated by housing they want to read the home section of the newspaper and gossip about it. But they don’t seem to want to trade it. I think it’s all a matter of getting it right. And we continue to work on it. It’s like insurance. They invented life insurance in the 1600s, but it didn’t become common until the 20th century.

What are your thoughts about the economy more broadly are you seeing ‘green shoots?’

What we’re seeing now is some renewed optimism, and it could develop into something, but it’s still too early to know. In the Great Depression we had a recovery after ’33—it wasn’t a full recovery, but it was a recovery. So it’s entirely plausible that we could be there soon. But a full recovery didn’t come until 1947/1948. We really messed up our system for now, and it’s going to be hard to have a full recovery. But we could have further gains in the stock market and an end to the home-price declines.

To what extent do you think we’ll learn from everything that’s happened? How long before we start making mistakes again?

We do have memory that goes for generations. I was struck by an LA Times article that I saw from 1886, after the Los Angeles housing bubble. The writer said something like Californians have learned. Never again will we allow real estate speculation to go so far. And he was kind of right. I don’t think California had another massive real estate bubble until the 1970s. After a hundred years, we’re allowed to forget, right?

But we’ve had credit bubbles, and there were other asset bubbles, too like Internet stocks.

I don’t think there’s any perfect solution, because the essence of a free-market economy is that people are allowed to make mistakes. And some of these bubbles have a good side. The Internet bubble of the 1990s brought us Amazon and eBay. They’re still with us. Stabilizing the economy isn’t the final goal. Having a little bit of turmoil, as long as it doesn’t get out of hand, is part of creative destruction.

You have a history of highlighting parts of the economy that have gotten out of hand before other people are paying attention. What’s next?

I don’t know if I’m ready to make any big announcements. I’m worried about the tremendous expansion of the Fed’s balance sheet and unwinding that, but I suppose we’ll probably do that all right. I’m worried about the anger that’s developing. People have tolerated a lot of inequality, but in light of recent events, I could see social changes. But that’s not forecasting a bubble.

The great debate over inflation goes global

Professor Shiller isn’t the only one worried about the tremendous expansion of the Fed’s balance sheet. Hossein Askari and Noureddine Krichene wrote an op-ed for the Asia Times, The mirage of recovery, where they state:

Neither G-20 policymakers nor the US seem to recognize that the current recession was the product of overly expansionary fiscal and monetary policies during the past decade. Obviously, these policies yielded a temporary high demand-led economic growth during the 2002-2007 period accompanied by the highest commodity price inflation in recent memory; however, they also triggered a food and energy crisis, general bankruptcies in form of meltdown of sub-prime loans, an economic recession and trillion of dollars of bailouts in the US and Europe that socialized financial losses. These bailouts will weigh on economic growth for a long time in the future.

These same policies are now being replayed around the world. The supporters of these policies claim to be innovative as if for the first time in history they were implementing voluminous fiscal expansion and the free printing of money. Yet these policies were used time and again in the past with startling examples such as the German hyperinflation in 1920-23, Latin American hyperinflations in 1950-1985, and the more recent Mobutu and Mugabe hyperinflations.

In all cases where these policies were tried, there was devastating inflation, a substantial decline in real income and a considerable impoverishment and social malaise. Notwithstanding historical evidence against rapid monetary and fiscal expansionism, G-20 policymakers and the US now believe in success of super inflationary policies.

US policymakers diagnosed the current crisis as lack of demand for goods and services and large excess savings in the form of a piling up of food and energy goods in the US, and totally dismissed the large external deficits that reached about 6% of GDP in recent years and negative national savings. They believed in deflation when housing, food, and energy inflation was crippling the economy. The refusal to link the Bush administration’s war spending and excessively expansionary fiscal and monetary policies and the current financial crisis has been a main stratagem in the speeches of Fed officials.

For his part, Andy Kessler writes this in the Weekly Standard on putting the toothpaste back in the tube:

A shadow banking system–Lehman, Bear Stearns, Merrill Lynch–was borrowing short-term in money markets at, say 2 percent, and instead of the classic 10:1 leverage of banks, they were levering up 30:1, sometimes 50:1, creating money out of thin air well beyond the intention of the Federal Reserve. It didn’t show up in prices, mainly because of a huge and productive tech sector as well as the waves of cheap Chinese laborers who were providing cheap shoes and toys and furniture to Wal-Mart, “hiding” the over-creation of money. But it did create a shadow economy of home builders, linoleum layers, decorators, Home Depot Expo salesfolks, and on and on.

And that was shadow wealth. The only real wealth is wealth that is productively created. The rest is just paper. After the collapse of the banking system, sunny and shadow, hoarding became the order of the day. The world rushed into U.S. Treasuries. Short-term rates as a result are almost zero. The dollar has been a safe harbor, jumping versus the euro and the yen. No one wants to spend money, on houses, on cars, or even, gasp, on big screen TVs. So the velocity of money has shrunk. To what? Well, no one really knows.

So to make up for lower velocity, to keep the economy from shrinking like a raisin, the Fed has been increasing the monetary base to increase the amount of money in circulation. But it’s hard. Even with TARP funds, banks don’t want to lend, so their 10:1 increase of Fed money isn’t happening, let alone 50:1 Bear Stearns-style money creation. Bernanke has therefore been buying U.S. Treasuries, with cash, to increase the money supply. Which is pretty funny since he is also selling U.S. Treasuries out the back door to fund the $787 billion stimulus package and the $1.3 trillion Obama budget deficit.

The Fed can put all the cash it wants or thinks it needs into the economy, but someday, maybe soon, maybe in a year or two, the economy will start growing again. People will stop hoarding dollars. Their 2004 Taurus will be looking a little old. Baby needs a new pair of shoes. Banks will start lending again to businesses and maybe even to home buyers. As money starts getting spent, all that money’s velocity starts increasing. Oops, there goes the price level. With so much money floating around, chasing too few goods, inflation is a-comin’. The Fed will have to start pulling all that extra money off the street and back into its vaults. And in just the right amount.

But how? Doing the opposite of what it is doing now. By raising interest rates. By sopping up dollars by not only selling Treasuries, but also selling all those mortgage-backed securities and other toxic stuff bought from Bear Stearns, AIG, Fannie and Freddie, and everyone else. By removing all the backstops it put in for the commercial paper and other markets to keep them functioning.But won’t that have the effect of slowing the economy? Sure will. This is a tightrope act. Getting all that toothpaste back into the tube will require the skills of a surgeon and the moxie of a middle linebacker, and someone deaf, dumb, and blind to congressional meddling. And worse, this is something that has never been done before.

By the way, it isn’t just the Fed. Central banks around the world have slashed interest rates and engaged in some form of quantitative easing. The great inflation debate has gone global:

If central banks cannot mop up the huge liquidity when economic recovery comes through, asset bubbles and inflation may once again be triggered. Furthermore, inflation has become a global phenomenon in recent years, and a policy mistake at one major central bank could create inflation risks for the whole world.”

It may sound irrational to be worrying about inflation in the middle of a deflation crisis. These two curmudgeonly quotations come from China, signalling that solutions deemed obvious in one part of the world may look quite different from another with conflicting interests.

The first, from the People’s Bank of China this week, is a clear warning that savers there could become the victims of a western economic recovery tempted to inflate off the debts incurred in the current recession, including by currency devaluations. The second, from an article in the Financial Times by Andy Xie, a Shanghai-based economist, warns that US policy is pushing China towards developing an alternative financial system to protect itself from such an outcome.

Because of its reserve currency status the US can print money, in the spirit of its former treasury secretary John Connolly, who told his European counterparts in 1971 that “the dollar is our currency but your problem”. Ireland is currently suffering from a similar British attitude. Xei says Obama’s decision to redeem mainly those who caused the recession rather than its ordinary US household victims will reinforce the pressure for competitive devaluations. This makes a 1970s-style global stagflation the likely outcome. In that case China would be forced to float its currency and create a single, independent and market-based financial system. The dollar would then collapse.

The Chinese are not the only ones concerned about inflation. Combating it is the main mandate of the European Central Bank, inspired especially by German recollections of hyper-inflation in the 1920s. The European Central Bank’s decision on Thursday to issue €60 billion covered bank bonds designed to stimulate credit markets is a belated recognition that deflation demands a different approach. This represents 0.5 per cent of euro zone GDP, compared to the equivalent 2 per cent in the US – and a huge 8 per cent in the UK, which issued another £50 billion that day.

This deep recession shows how closely coupled the US and euro zone economies are, and also how bound up the financial sector is with the real economy in both regions. German banks are exposed to a surprisingly huge €816 billion toxicity, for example. And Irish mortgage holders were relieved by the ECB’s interest rate reduction to 1 per cent not least because an estimated 340,000 (one in five) Irish homes are worth less now than when they were bought and that the wider household indebtedness taken on in the boom is obscured by such low rates. None of this is yet factored into the cost of bank rescues here, should there be widespread defaults.

Increasingly there is a common debate on the danger that inflation could accompany and subvert economic recovery in the US and Europe. It has been sharpest in the US, largely because the Obama administration’s actions have been so radical and rapid.

During the 1990s the 1970s became known among economists as a period of great inflation and output stagnation summarised as “stagflation”. In contrast the phrase “great moderation” was coined to describe the subsequent two decades of relative stability, during which policymakers came to believe they had found the means to control inflation by judicious targeting of its causes and had flattened out the business cycle previously so integral to the history of capitalism.

Monetarists convinced that the quantity and velocity of money in circulation determines inflation influenced policymaking, while neoliberals drove home their view that self-regulating, efficient markets optimise socially beneficial outcomes. Economic theorists built mathematical models predicated on these narrow and questionable foundations which then profoundly influenced risk management policies over the last decade.

This recession has exploded these assumptions and exposed their ideological bases (for an accessible self-criticism by leading US economist Barry Eichengreen see his article, The Last Temptation of Risk). It has revived Keynesian macroeconomics, largely discredited in the 1970s and then disregarded in subsequent decades. It is more geared to tackle such large systemic questions in which there is a great overlap between economics, politics, history and society.

Both of these traditions are involved in the argument about inflation. The Keynesians see governments resorting massively – even if inadequately or insufficiently – to deficits, state indebtedness and stimulus programmes to arrest economic slump, rescue financial systems and revive activity. They approve of this, saying it is essential in the short term to tackle deflation and that the theory and policy to control inflation with higher interest rates and other measures during a recovery are adequately known and understood.

Monetarists disagree, worrying that the immense quantities of money printed and released by governments since September last will inevitably result in a higher inflation that could smother any recovery. To some extent this is a left-right issue, pitching social democrats against conservatives. From the German or Chinese points of view – different interests crosscut these ideological cleavages.


Deflation on the horizon?

So is it only a matter of time before the next great inflationary episode begins? Maybe but for now, deflation is here. Japan is back in deflation, British retail price inflation turned negative for the first time in nearly 50 years in March and according to Nouriel Roubini, we should get ready for three years of deflation:


“There is already excess capacity in the global economy because of the over-investment in capacity by China, Asia and other emerging markets,” Roubini told Bloomberg News in Singapore Wednesday. “Without an increase in global demand, we will have even more excess capacity,” and China “is not building domestic demand,” he said.

In the U.S., Roubini said housing, consumer goods and commodity prices will be held down by excess capacity and weak demand, and “this will lead to deflation in the next three years.” Roubini added that he expects both economic data and corporate earnings to disappoint.

Many economists expect the U.S. economy, which has been in a recession since December 2007, to enter a recovery phase by Q4. Even so, global trade is expected to contract 9 percent for the year — international trade’s largest decline since World War II, according the the World Trade Organization.

Further, Roubini predicted that 2010 U.S. GDP growth is going to be very low, totaling only 0.5 percent. “Prospects for recovery in Europe and Japan are even worse than in the U.S.,” Roubini said, Bloomberg News reported.

Deflation – - a protracted, systematic decline in prices and wages – - occurs in pronounced recessions and other conditions where demand is non-existent, and it robs companies of the ability to increase revenue and hurts the economy’s ability to grow. If it takes hold, that’s another hurdle policymakers will have to grapple with as they attempt to end the U.S. and global recessions.

Through fiscal and monetary policy, the United States has added a record $12.8 trillion in stimulus and liquidity to the economy and financial system, a policy that economic conservatives have argued will to lead to rising inflation.

Economist David H. Wang, an economic modeler, agreed with Roubini that those concerns are misguided — because we have a more serious problem to worry about. Although there are “inflationary forces acting on the economy,” Wang said, “the deflationary forces are stronger, currently.”

“Roubini is on the mark. In the U.S., the housing hangover is the biggest factor because it is a large component of the cost of living. Also, when houses are not bought in large numbers, neither are the goods that go in them, and that has led to downward price pressure on consumer goods,” Wang said. “Internationally, we can see a clear overproduction in autos, and this is rippling through other sectors, including commodities like steel, and electrical components. Nine of my ten international industrial variables have deflationary readings, so the bigger danger is deflation, at least through mid-2010.”

Wang said, ironically, a rising price of oil — historically the bane of the industrialized world — could be a savior here, by counteracting deflation pressures. However, although oil burst through $55 per barrel Wednesday on talk of a recession bottom, Wang expects the price to retreat to “well under $45, due to excess supply, taking more cost pressure off prices throughout the system.”

Once an obscure, little-regarded academic, Roubini rose to prominence in 2008 after he successfully predicted — two years in advance — the current global financial crisis and recession. Roubini was the first economist to predict massive mortgage and housing-related losses for U.S. banks, which he originally pegged at $1 trillion; Roubini’s most recent estimate now sees those losses totaling $3.6 trillion.

Economic Analysis: Inflationary pressures exist, but again, the deflationary pressures are stronger. That is not to say that government spending from the stimulus can’t cause “pocket” price surges – such as a rise in local food costs in an area that builds a new U.S. Navy submarine or major alternative energy facility, for example. But nationally the demand is not there, due to high unemployment, and, according to Roubini, international demand is still insufficient to eliminate the surplus of manufactured goods built up during the previous expansion. With both domestic and international demand so light, the contours are in place for a period of weak pressure on prices, which historically has led to low, or, worse yet, negative, inflation.


In the Accrued Interest blog, the author writes, Inflation: Not this ship, sister and notes the following:

The securitization market makes this all much more complicated. The supply of loanable funds isn’t just a function of cash in the banking system, but also cash invested in the shadow banking system. Right now net new issuance in ABS (meaning new issuance less principal being returned in old issues) is negative, meaning supply of funds from the shadow banking system is contracting.

This contraction of funds doesn’t show up anywhere in the Ms, at least not directly, but obviously it matters in terms of consumers ability to buy goods. And it isn’t just about availability of credit, which had everything to do with liquidity. Its about demand for credit also. Consumers want to save, they don’t want to borrow right now. The following chart of household liabilities shows consumers actually decreased their total liabilities in 2008, the first year-over-year outright decline since the Federal Reserve began keeping the data in 1952.

Consumers are like a Monopoly player who has mortgaged all his properties. Passing GO doesn’t cause him to buy more houses, it causes him to unmortgage his properties! That isn’t inflation!


Sorry, we’re still screwed

In his article, Sorry, we’re still screwed, Henry Blodget writes why Jeremy Grantham, a former bear, is now a short-term bull:


Basically, he thinks the fire-hose of stimulus will drive stocks (if not the economy) up another 10%-20% by the end of the year. But please note the emphasis on “short-term.”

After our current rocket rally plays itself out, Grantham thinks, the market will once again crash and then stay in the dumps for at least seven years.

Why?

Because of the massive declines in our net worth, our debt problem, and compression of price-earnings ratios. Specifically, we’ve lost our shirts and we feel poor–which isn’t conducive to profligate spending. We still need to get rid of $10-$12 trillion of debt. This debt-reduction process will pressure profit margins (lower leverage) and pressure spending–because we’ll have to save more instead of spending it. We’ll also need inflation to reduce the real burden of the debt.

Stocks, meanwhile, have actually climbed back to fair value (900 on the S&P). And after long periods of over-valuation (the last 15 years), we’re due for a long period of under-valuation.

Here’s Grantham (full quarterly letter embedded here):

For the biblical record, Joseph, consigliere to the Pharaoh, advised him that seven lean years were sure to follow the string of bountiful years that Egypt was then having. This shows an admirable belief in mean reversion, but unfortunately the weather does not work that way. It, unlike markets, really is random, so Joseph’s forecast was like predicting that after hitting seven reds on a roulette wheel, you are likely to get a run of blacks. This is absolutely how not to make predictions unless, like Joseph, you have divine assistance, which, frankly, in the prediction business is considered cheating. Now, however, and defi nitely without divine help but with masses of help from incompetent leadership, we probably do face a period that will look and feel painfully like seven lean years, and they will indeed be following about seven overstimulated very fat ones.

Probably the single biggest drag on the economy over the next several years will be the massive write-down in perceived wealth that I described briefly last quarter. In the U.S., the total market value of housing, commercial real estate, and stocks was about $50 trillion at the peak and fell below $30 trillion at the low. This loss of $20-$23 trillion of perceived wealth in the U.S. alone (although it is not a drop in real wealth, which is comprised of a stock of educated workers and modern plants, etc.) is still enough to deliver a life-changing shock for hundreds of millions of people.

No longer as rich as we thought – under-saved, under-pensioned, and realizing it – we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally. Collectively, we will save more, spend less, and waste less. It may not even be a less pleasant world when we get used to it, but for several years it will cause a lot of readjustment problems. Not the least of these will be downward pressure on profit margins that for 20 years had benefited from rising asset prices sneaking through into margins.

Closely related to the direct wealth effect is the stranded debt effect. The original $50 trillion of perceived wealth supported $25 trillion of debt. Now, with the reduced and more realistic perception of wealth at $30 trillion combined with more prudent banking, this debt should be cut in half.

This unwinding of $10-$12 trillion of debt is not, in my opinion, as important as the loss of the direct wealth effect on consumer behavior, but it is certainly more important to the financial community. Critically, we will almost certainly need several years of economic growth, which will be used to pay down debt. In addition, we will need several years of moderately increased inflation to erode the value of debt, plus $4-$6 trillion of eventual debt write-offs in order to limp back to even a normal 50% ratio of debt to collateral. Seven years just might do it.

Another factor contending for worst long-term impact is the severe imbalance between overconsuming countries, largely the U.S. and the U.K., and the overproducing countries, notably China, Germany, and Japan. The magnitudes of the imbalances and the degree to which they have become embedded over many years in their economies do not suggest an early or rapid cure. It will be hard enough to get Americans to save again; it will be harder still to convince the Chinese, and indeed the Germans and the Japanese too, that they really don’t have to save as much. In China in particular they must first be convinced that there are some social safety nets.

A lesser factor will be digesting the much shrunken financial and housing sectors. Their growth had artificially and temporarily fattened profit margins as had the general growth in total debt of all kinds, which rose from 1.25x GDP to 3.1x in 25 years. The world we are now entering will therefore tend to have lower (more realistic) profit margins and lower GDP growth. I expect that, at least for the seven lean years and perhaps longer, the developed world will have to settle for about 2% real GDP growth (perhaps 2.25%) down from the 3.5% to which we used to aspire in the last 30 years. Together with all the readjustment problems and quite possibly with some accompanying higher inflation, this is likely to lead to an extended period of below average P/Es.

Twin recessions?

Some economists also note that rallies in stock markets may be short-lived, and a ‘W’ patterned economic revival is more likely if the Fed fails to quell an expected inflation bout early, leading to twin recessions:

“I believe we are headed for a W-shaped recovery, with a down-up-down pattern,” Steve Hanke, professor of applied economics at the Johns Hopkins University Maryland, wrote in his column in Forbes magazine.

“We are approaching an up segment now, but my advice is to avoid being suckered into any stock market rallies.”

Hanke says a shrinking of the Fed balance sheet – bloated by acquisitions of dud assets and government debt on one side, and printed money on the other – is needed to avoid another bout of inflation.

This can cause another downturn.

Culprits

Hanke’s comments came as Fed chairman Ben Bernanke said in a congressional testimony on May 05, that he expected “economic activity to bottom out, then to turn up later this year.”

On May 07, US lawmakers voted to create a 9/11-style commission of experts to probe the causes of the financial crisis, but it is not clear yet whether the real culprits would be caught.

So far most analysts and the popular media have heaped blame on economic players who responded to Fed rate signals.

“There is a lot of finger pointing going on over who’s to blame for the financial crisis: bankers, derivatives traders and the regulators who failed to keep an eye on them,” says Hanke.

“Let me add two names that usually escape the dragnet: Fed chairman Ben S. Bernanke and his predecessor, Alan Greenspan.

“Rather than confess and repent, the folks in Washington are running the recovery plan with the same misguided prescriptions.”

There is however a historical precedent for paper money central bankers being caught and paying the ultimate price for their sins.

The French guillotined the ‘central bankers’ who created ‘assignat’ paper money and caused an economic collapse in revolutionary France.

The current financial crisis was sparked by Fed rate cuts to stave off ‘deflation’ in 2002.

“Instead of lowering interest rates seven years ago, the Fed should have raised them,” Hanke said.

“This would have blunted the credit boom that led to the bubble.”

Inflation Targeting

Modern ‘inflation targeting’ central banks generate positive levels of inflation, which are cumulative. In addition, missed targets (higher than expected inflation) are allowed to be bygones, adding to the problem.

The ‘by-gones’ effect is greater at the Fed, which does not have a strict legislative inflation target.

Bouts of deflation on the other hand are needed to bring the system back on balance and clear away excessive debt.

“What the Fed has failed to realize is that most deflations are good ones, not bad ones,” Hanke said.

“During the last two centuries there have been many deflations throughout the world. Almost all of them have been good ones precipitated by technological innovation, rising productivity, global capital flows and sustained economic growth.

“If farm mechanization cuts the price of wheat, you get a rising living standard. This is good.”

Hanke says tightening policy instead of loosening (printing less money instead of more) in 2002 and 2003 would have saved the U.S. dollar from the wild swings it has taken in the last seven years.

Electronic Printing Press

Bernanke boasted in 2002 that “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost,” to generate “positive inflation”.

“As the Fed fought deflation, the dollar tumbled,” Hanke pointed out. “From January 2002 until mid-July 2008 the greenback lost 44 percent of its value against the euro.

“This ignited the global commodities bull market that pushed crude to $145 a barrel and led to food riots in Egypt and Uzbekistan.

“Then, as financial markets seized up and the demand for dollar liquidity surged, the greenback abruptly reversed course.

“In a little over three months last summer and fall, the dollar appreciated by 28 percent against the euro. Commodity prices collapsed.”

From September 2007 most of the money printed by the Fed has gone back home to roost, with the Fed paying interest on reserves.

On May 06, the US monetary base was officially 1,704 billion dollars, up from 842 billion but 777 billion was back in the Fed as ‘excess reserves’.

“Investors watching the recent rally may think that the Fed has stabilized the markets and saved the day but its approach is fraught with danger,” says Hanke.

“As the self-regenerative powers of the market system kick in, the demand for money will fall and the velocity of money will correspondingly go up.

“Unless the Fed shrinks its balance sheet by selling bonds and mopping up excess dollars, inflation will roar back with a vengeance.”

Hanke fears the Fed will put off such decisions for at least two years, with congressional elections due and Bernanke’s term due to expire in 2010, but will “eventually have to bite the bullet and shrink its balance sheet to fight inflation.”

This could push up interest rates and cause a ‘W’ shaped recovery says Hanke.

“You should keep your eye on what is around the corner: some inflation, a shrinking of the Federal Reserve’s balance sheet and another spate of economic weakness.”

I realize this is a long comment but I hope I have given you lots of food for thought. While some think there is too much excess capacity out there due to weak global demand cementing deflation, others worry that the world is awash with liquidity that will re-ignite another devastating inflationary episode and a more serious global downturn.

The key in all of this is how central banks will remove excess liquidity without sending the global economy back into a severe recession. If they do not have a coordinated game plan for doing this, I believe that the ‘twin recessions’ outcome is the most likely scenario.

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11 comments

  1. don

    You second to last paragraph you mention overcapacity and weak global demand: thus global imbalances of over consumption in the West, overproduction in the East. The global attempt underway is to re-start the engines of this global imbalance.

    Keep in mind that over consumption in the West was fueled not by income but by debt, thus we have debt deflation. Re-starting consumption in the West will largely – should it succeed – be the result of re-starting credit production, thus increased debt, along with the lesser effects of the stimulus package to support income.

    China is attempting to expand export production. It too is falling back on the structural global imbalances. Success in re-starting international trade and getting the global imbalances back working again would lead to inflation. Failure would amount to debt deflationary forces being too great, reflecting the fact that over consumption (debt-based) in the West and overproduction in the East pose an insurmountable difficulty.

    So . . . in the end, it all amounts to whether one believes that the structural global imbalances can be re-started and sustained, which then brings on the threat of global inflation.

    So this is the real question at hand: can this structural imbalance be re-started and sustained, or are the contradictions inherent in this global imbalance so great that structural changes in global capitalism are inevitable? What those changes will amount to is another question entirely.

  2. Snoring Beagle

    Leo, nothing amiss here you do good work. My comment is the length and breadth of the blogs you submit. I may be wrong but it would seem better if you would breakdown your topic to something more akin to the fast pace of the web.

    The web is not known for holding the attention span of readers on one topic as deep as you would like to convey.

    For instance a word count using Open Office indicates 7524 words and 16 pages of type for the above post.

    Keep up the good work. Less is more.

  3. JP

    Leo,
    I agree with the sentiment in Snoring Beagle’s post above. Today I could read the entire post, because I had the time. Often I can’t read the full item because of time constraints.
    Can I suggest an upfront summary? For this post, I believe your summary is the almost contained by last two paragraphs (though I would beef up the conflict between in/deflation possibilities and present it as likely deflation first, then inflation.)

    Anyway, thanks for the post. It was indeed much food for thought.

  4. Brian Hayes

    JP’s suggestion of a summary may assist busy readers, but gee whiz, Leo is informed and productive and honest. I think he writes with an appropriate style that both asserts and supports those assertions. Oh but anyway, I’m just commenting to say Thank You and Keep Up The Good Work.

  5. Leo Kolivakis

    I truly do apologize for the lengthy post, but this is an important topic that deserves some elaboration. I didn’t just want to provide hyperlinks.

    I added a bit on securitization after reading this comment on the Accrued Interest blog:

    http://accruedint.blogspot.com/2009/05/inflation.html

    As far as I can tell, the securitization market is still very quiet, which tells me shadow banking is still quiet and credit is still dry out there.

    It is one thing to print money but money has to circulate in the system. If banks are not lending and securitization is dead, the economy will contract.

    Now, I did not get into the possibility of another round of goods deflation from China. If China’s economy slows more, the Chinese might just devalue their currency and flood the U.S. market with cheap goods.

    Another round of goods deflation will undoubtedly increase the risks of deflation and throw a wrench in the Fed’s attempt to reflate the economy.

    The best case scenario is mild inflation but if history has taught us anything, nothing is ever mild. We are going to overshoot on one side or the other.

    cheers,

    Leo

  6. Juan

    Leo, don’t definitional and sample size differences between the two employment surveys make them non-comparable, even w/adjustments?

    Gerald Minack just had a nice piece on ‘Green Shoots and Earnings’, including as well NIPA corporate profits; the dive does not appear quite over.

    But yes, it’s hard to see rates of contraction not stabilizing, still, stabilization can also be stagnation even if the latter becomes labeled ‘recovery’.

  7. Leo Kolivakis

    Juan,

    The employment reports are different but the discrepancy between them cannot be explained away that easily. My contacts tell me that at market bottoms, the household survey leads the way and the payrolls will follow and improve in the coming months. I have seen the chart and it is true that household survey data leads the way.

    On your second point, I agree that stabilization from depressed levels does not mean a full fledged economic recovery. The jobs will not come to the financial industry and they will not be created fast enough in other industries to absorb all those unemployed workers.

    The thing I am looking for is whether we will end up with stagflation (1970s) or debt deflation.

    Right now I am just not sure. I am still inclined to think that deflationary pressures are just too strong, at least for the next few years.

    Regards,

    Leo

  8. "DoctoRx"

    In the throes of the Great Depression, rates on Treasuries trended up despite deflation, due to fears of inflation.

    When I look at the wholesale trade #s from Census Dept out Friday, down 18% yoy, or the report (h/t Mish) from the California controller’s office of April sales tax receipts down an astounding 51% yoy (nominal, ignoring inflation!), I conclude that what is happening in home and auto sales is widespread: a Depression.

    Worldwide sustained zero or near-zero interest rates in the face of these amazing declines in a largely post-industrial economy suggest to me that we are more likely than not following the path of the 1930s.

  9. autodidact

    My eyeballs would fall out if I read this entire post — as good as all of it no doubt is. :)

    One comment: Midway through, it states that Bernanke says the housing market is stabilizing. Excuse me, but if Bernanke said the sun had come out this morning, I would wonder if it actually hadn’t. At any rate, I would look out the window to check.

  10. wintermute

    Good post Leo. Very interesting. Grantham makes a lot of sense – we are in worse trouble than most people realise.
    As there is no official definition of depression then a proxy is GDP shrinkage by 10% and unemployment of 25% (think U-6) These are big target numbers which are closing in fast.
    Stagflation looks the order of the day with weak wages and rising prices from commodities and effects of QE. The Fed is heading for a brick wall. It will one day need to raise interest rates to combat inflation – but there will be so much government debt that the interest payments will be unaffordable at high yields. What will clever Ben do then?

  11. Brick

    It is so hard to tell what is going on from the unemployment figures, that there must be a significant margin of error involved. Traditionally during April lots of jobs are created and the figures have been adjusted to reflect that. Why the amount of adjustment this year needed to be greater than last year is not explained. The only unadjusted number we have really is the payroll numbers which were actually up, but since farms take on lots of workers during the spring and summer that does not say a lot. If less people got jobs on farms this year as I suspect and the adjustment were not changed accordingly then this could have introduced error. My personal opinion is that there may be some stabilisation in manufacturing while other sectors of the economy are still in steep decline. I doubt whether the US economy can really stabilise for long while Japan and Germany are still on a decline.

    Despite sellers withdrawing from the housing market, there is still a glut of unsold new housing. For any sort of stabilisation of prices to occur that glut has to reduce and typically there is at least another nine months new housing stock to shift. This glut of housing is often concentrated into particular housing market sectors in a particular area, meaning that while some prices are decline others can be stabilising. We probably have reached the tipping point in some areas where housing is down 40 percent in value which causes sellers to withdraw from the market but the tipping point of 60 percent where it starts to become economically sensible for prime mortgage holders to default has not been reached. The other problem is that mortgage rates are creeping up as treasury yields go up, sending the economy on another downward trip.

    While a W shaped recovery is possible, nobody is considering the possibility that were are on a downward staircase, as the economy takes a number of steps downwards. Equity and commodity trading currently seems to have no bearing on fundamentals and regardless of demand we are starting to see financial gamblers pushing up prices. What happens when they push fuel prices all the way back up again. There have been a lot of claims that these markets are forward looking, yet firms that you could pick out as doing particularly well during any recovery are not seeing there share prices rise, while firms which may never recover even with a recovery are seeing shares rise meteorically. It has the classic look of a bubble and despite the warnings from those knowledgeable in the markets, I expect it to have the legs keep going.

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