Tim Duy Versus Hedge Fund Manager Scott on the Economy

Full disclosure: I have a great deal of respect for both Tim Duy and the hedge fund manager Scott who is also quoted in this post. As you will see, Duy wrote an interesting post addressing a question posed by Brad DeLong, in essence “Since we are in the midst of the worst financial crisis since the Great Depression, why isn’t the economy in worse shape?” Although the answer is more complicated and nuanced, a big piece of it is that we haven’t felt the impact of the crisis because our friendly foreign funding sources have stepped up to provide liquidity.

As readers no doubt know, I’m pretty bearish, but if Duy’s take is correct (and perhaps more important, continues to be what is driving the equation (although I harbor doubts that this forbearance can be sustained), perhaps the downside will not be as bad as it ought to be. I forwarded Duy’s post to Scott, who is even more bearish than I am, and I thought readers would be interested in this take.

Admittedly, the two analyses address different questions: Duy focuses more on why conditions are as they are now, while Scott is more forward-looking.

First from Tim Duy, via Mark Thoma (charts omitted):

I think economic activity has surpassed most peoples’ expectations….

1. The nature of the expansion defines the nature of the following contraction. The post-tech bubble expansion was anemic by most measures, and never gained much traction until the housing bubble arose….The tepid upside suggests a tepid downside….

2. The impact of the consumer slowdown is partially offshored….This shifts job destruction to an overseas producer. In fact, as spencer at Anger Bear shows, the recent improvement in the real trade balance has less to do with rising exports, which continue to follow recent trends, than the sharp slowdown in real import growth….

3. Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis. The accumulation of US assets is also forcing an expansion of foreign CB’s balance sheets, creating global monetary stimulus that allows the rest of the world to decouple from the US economy, supporting continued US export growth (see point 2 above).

Ideally, the slowdown remains moderate, allowing for a rebalancing as we expand export and import competing industries domestically, narrowing the current account deficit and eliminating the necessity of foreign official financing. This means accepting a period of time with suboptimal domestic demand growth and structural adjustment. Excessive fiscal stimulus risks testing the willingness of foreign CBs to continue to accumulate US assets. Moreover, I believe that excessive stimulus will eventually foster a more damaging inflationary dynamic, but such a process would likely build over a long period of time – the seeds for the 1970s were planted in the 1960s.

In short: External dynamics play a significant role in explaining the relatively mild US downturn. As long as foreign CBs are willing to accumulate US debt, the US government is willing to issue debt, the Federal Reserve is willing to accommodate the debt with low interest rates, we will avoid the most dire deflationary predictions.

Now to hedge fund manager Scott’s reading:

[A colleague] asked me this morning what I thought of something I’d sent him, in which the writer noted that financials aside, the rest of the S&P earnings so far have not been so bad. My response was to say that, first, the timeline for economic events to play out is remarkably languid, always taking longer than one expects. And given the fact that one views it unfolding in a sense through a series of discreet datapoints, some of which are manipulated, and all of which are subject to “noise” and some serendipity, it is both really hard and really important to focus on the underlying trends in order to maintain a clear view of the larger picture.

Along those lines, for example, one might note that MSFT, GOOG, CSCO, and ORCL–all big, important tech companies with something approaching monopoly-like market positions, but all most certainly exposed/leveraged to the larger economy, have disappointed or warned in the recent past. There’s a clear message there. The other big element to consider with regard to the quarter just past is the element that the rebate checks played. Note that even with them in play, consumer spending was pretty muted. In their absence, I expect the second half of the year to be pretty challenging.

I used to think that maybe employment could hold up, based on the thought that since it never really zoomed in the recovery, it might not really decline now. I no longer believe that, just think that it’s taking some time to play out…..

Tim gingerly tiptoes around the issue my friends and I always come back to at our “Austrian” lunches. And this is the thought that we’ve issued more paper than our economy can ever pay back–given the size of the economy, it just does not compute. How long foreign central banks will continue to play the game is a difficult question to answer, and the attempts at answering are pretty much pure speculation anyway. But again, trying to view the situation from 30,000 feet, the trend of moving away from the dollar is certainly apparent. Bulls, and what me worry types can certainly find enough datapoints to continue in a fool’s paradise, but at some point this becomes one of Herb Stein’s what can’t go on forever, stops, moments, and either interest rates go through the roof, or the dollar really collapses, or both.

There is very little to feel optimistic about right now, if you think carefully about the issues we face, as far as I can tell. The
developments of the last week were really sickeningly disheartening to me, frankly. In terms of your banana republicanism, what could be more so than Paulson basically playing investment banker, forcing Syron into the arms not simply of Morgan Stanley, but also of Goldman, to talk about raising capital. Nice rainmaking there! And that followed by Cox essentially engineering a short squeeze in all the financials? It really is heartbreaking, frankly, and not just in light of what it did to my pnl on Wednesday and Thursday. So all those stocks are up 35%, but the underlying economic situation hasn’t changed a bit, except to the extent that we have more clues about the cluelessness of the guys in charge. Yikes

And he provided this comment earlier in the day on a post that featured the quote, “Classic Buffettology advises us to get greedy when others are fearful”:

The issue with Buffett/Rothschild’s buy when people are fearful admonition and wondering why it’s not applicable here is that nobody seems even slightly fearful. Just as the January effect moved into December as people became aware of and started to anticipate it, and as the Dogs of the Dow lost potency when it too become well-publicized, old saws do the same. And everybody’s looking for that capitulatory moment, so they can catch the exact bottom, as a result of which we’re nowhere near to reaching it. A VIX above 30 being one of those magic indicators, the Vix hit 30 for perhaps 30 seconds (I exaggerate a bit) yesterday before every buy button on the Street started getting pushed insistently like a rat learning how to release cocaine.

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  1. Eurobear

    The point about everyone looking at the same indicators and acting in the same way is absolutely true, acting without fear they may be but its only as they think they have their own potfolio under control.

    Due to this perception that they all know what is going to happen it is just a delaying factor to the eventual outcome.

    This market is not so different to other bear markets, just look at the number of bank failures to this point, its no more than average for a normal period in time. To mis quote the Banking Establishment Cabal in Washington.

    We’re actually still deciding who will kick off in the first quarter.

    The reason the financials are getting so badly whacked is that again general knowledge of the situation is better than it ever was before, however long term the loss of money available to the consumer due to housing woes and the de facto impact on income(spending power) will kill the economy.

    Add in rampant inflation and you have a perfect storm.

  2. RK

    As the coalition of the “willing” dollar accumulating
    central banks and their SWF’s morphs into “reluctant”
    accumulators, the question of where they diversify dollar risk becomes an important one. One thought is
    that a new world currency might emerge. My candidate is not gold, the yen or yuan, but the humble BTU, or British Thermal Unit, and its’ half brother, the calorie. Brad Setser’s post in links below
    raises the prospect of more money going into natural resources as an early sign of corroboration.

  3. anon

    So this time the problem is the current account deficit and the ensuant export of paper. NOBODY has been right about predicting the timing of “the end” of this problem. Those who predicted impending disaster several years ago have actually been trumped by the opposite behavior – central banks upping their accumulations of dollars since those forecasts. And treasury yields remain less than half of what they were a decade ago. The fundamental problem with Stein’s law is that things can go on a lot longer than you think – long enough to make Stein’s law redundant because the problem when measured in relative terms eventually gets downsized through a variety of gradually corrosive factors – e.g. housing bust crimps consumer demand crimps imports; oil prices beget demand destruction beget lower oil prices beget lower oil deficit; etc. etc. etc.

  4. Richard Kline

    A few of my overlapping thoughts: Lags in effect are always underestimated at the macro scale. We are only a year into this, and it didn’t hit the banks on the chin until last November, so seven months for them. That is long enough to go broke if the public authorities do nothing—which they did for the first two months—but they have massively intervened at least four times since in different ways, in December, January, March, and now July.

    Job losses: Duy’s point is well taken that the employment hit for such demand destruction as we have seen has been substantially overseas. So far. The domestic airline and auto industries _will_ take a hit, but that isn’t even in the pipeline yet. Construction has sagged, but that is where those rebate checks come in, just enough demand juice to mask the downtrend for a few more months.

    More importantly, the US didn’t get into its bubble alone; the rest of the world climbed in there with us. And they can’t get out of their macrofinancial strategies quickly, emphasis on the modifier. China evidently _tried_ to rebalance itself a bit more toward Europe in the Spring, but they evidently got the stiffarm behind the curtain and stopped. they and the Gulfies, and most others may not WANT to keep funding us, but they will need time to come up with another play. So it’s more of (our) money after bad until they can catch a train outta here. They will not fund us _at current levels and terms_ indefinitely. Two more quarters, maybe; then, new deal. Unless we come up with a New New Deal first. Don’t count on it.

  5. dryfly

    Tim gingerly tiptoes around the issue my friends and I always come back to at our “Austrian” lunches. And this is the thought that we’ve issued more paper than our economy can ever pay back–given the size of the economy, it just does not compute.

    Whenever a self-avowed 'Austrian' says something like that I want to ask them for their credentials… "Your papers, pleeeze."

    Haven't they forgot about fiat? Its pretty much unlimited UNTIL it is no longer accepted. As long as Duy is 'right' about the FCBs & SWFs eating our paper Scott will be 'wrong' about his computations.

    So how long will the FCBs & SWFs continue to eat our paper? That's the gazillion dollar question. Probably as long as they are more worried about their populace eating them than they are about the real returns from that paper – and I'm quite serious about that.

    This is more about the politics of development & 'decoupling' than about our deficit & profligacy (symptoms & resultants – not causal factors IMHO). If 'they' ever get 'rich enough' to no longer worry about their street & our market access THEN Scott will be right & our paper will be exposed for what it is – empty promises. I don't think that is happening soon.

  6. Phil

    “Development: US Fails to Measure Up on ‘Human Index'”

    Interesting article on the human side of the equation.
    “Human development is concerned with what I take to be the basic development idea: namely, advancing the richness of human life, rather than the richness of the economy in which human beings live….” said the Nobel laureate economist Amartya Sen, who developed the HDI in 1990


  7. donna

    Given that my family personally has lost somewhere over 50K this year, I don’t think the economy is holding up so well. We’re lucky we can afford that, and even not really feel it since it’s in retirement accounts, but we are sure not happy about it.

    Economy holding up so well, bah. What idiocy.

  8. Jonathan Bernstein

    As a trader and security analyst who trained as an economist, I think I see one point that some mainstream economists are missing. The previous economic expansion consisted of what security analysts would term one-time gains.

    In examining corporate earnings, Wall Street analysts distinguish ongoing, “operating” profits, which spring from the usual efforts of the business, ie, continuing revenues, which stem from sales of the companies products or services, versus one-off gains which usually consist of gains on sales of assets.

    Outsourcing produced a one-time gain in the profits component of GDP. By moving production (and services such as call centers) off shore, companies got to produce at lower cost while selling the same product to US customers at retail, thus plumping up margins. We should note well, Corporate Germany and Corporate Japan have been loth to do this, and keep jobs in their respective home countries when they can. If you don’t have customers at home with good jobs, they can’t buy your products. Corporations got themselves a one-time gain, but consumers (aided by foreign purchases of US securities, which kept rates low) were able to keep buying goods for a longer time than expected because they raided the housing ATM. Unfortunately, as consumers are finding out, you can only gut the equity of your home once.

    As an aside, we have priced oil as cheaply as we could in this country, rather than taxing it and encouraging the development of renewable and sustainable sources of energy. Again, you can only burn a barrel of oil, once.

    As Richard Kline and others pointed out, the game goes on longer than we expect, but it does end. We are about to find out what our economy looks like, when we have burnt all our furniture.

  9. Jonathan Bernstein

    The final sentence of my previous post should have read, ” We are about to find out what our economy looks like when we have, metaphorically speaking, burnt all our furniture in order to heat our homes.”

  10. Anonymous

    The notion of a tipping point is very relevant here. I’ve traveled overseas every year, and there’s a steady increase in the number of people that distrust the dollar and US markets. It’s a fools game to guess when the tipping point will arrive, but can there be any doubt its inevitable.

    The US economics establishment is determined to find every way to debase the dollar. The tipping point cannot be far.

  11. Anonymous

    joebhed said

    It feels a bit Nero a-fiddling.

    We recognize the dampening effect of the global economy on our slide to what the optimist seems to describe as “the most dire deflationary predictions”.

    While the more pessimistic hedge-funder sees the fallacy of our financial system almost exclusively in terms of its “paper” nature.

    He correctly focuses on the truly amazing scale of our debts in the contrast to our economic system’s ability to ever repay those debts. Or, that paper, as he calls it.

    Our economy is incapable of ever paying back the debts we already have.
    But the FED bankers have one more feel-good plan.
    The vehicle for keeping the economy slip-sliding, rather than crashing, into oblivion is the highly-popular method called issuing more debt.
    Lots of it.
    Hello, taxpayer?

    Now, this is where we should be seeing the image of the cat chasing its tail.

    Given that every dollar in new debt (money) that is issued to grease the slide must be repaid about three times over by future dollars, and, given that each and every one of those additional future dollars are going to come into being as debt, that will have to paid back threefold to the holders of that debt, well, right there we come more to the point of the dog that caught the truck.

    But my point is not how, or where or when or how much.
    Its more about who and why.

    The Federal Reserve bankers were responsible for whatever happened in the banking system and the economy.
    This is all their doing.
    Their money-centric economic policies are now playing out.

    The expansion of the debt-money system in this country was used principally for the purpose of rewarding those who had the money.

    What else do capitalists do with money but use it to make more money?

    Are these the guys we want looking out for full employment or the environment?

    We have invested in, or should I say become debtors to, the money economy brought about by the Federal Reserve bankers.

    It has bankrupted the country and the economy.

    The time of their debt-money system has run its course, having trampled upon the well-being of the American worker and our natural resources.

    It is time for fundamental reformation of the monetary system in this country.

    Put the FED bankers out to pasture.
    Allow them to play with their own money, rather than that of the American taxpayer.

    And put the taxpayers and their government in charge of creating the nation’s money.

    And, paper or gold has nothing to do with it.

  12. Hank Roberts

    Yes we could come up with enough new value to cover the debts.

    Low hanging fruit of energy efficiency and conservation. Single easiest thing to do is insulate all the houses. Yes, the houses the landlords own, too. Insulation is like plumbing and electricity, now, it has to be in place and working. It’s the single most efficient economy we could be making right now, this summer, before winter comes.

    Look farther ahead.

    Resources two hundred miles or more away — straight up. Tag and release the next chunk of asteroid to come by. Continue that. Land steering motors on them (ion engines, solar powered) as soon as we can and start bringing them back to within reach in a measured way.

    Stop whining. WE’ll all be dead in decades. Life goes on, we owe it the best push forward we can give. Your kids, my inlaws’ kids, everyone else’s kids.


    Captain Renault: Oh, please, monsieur. It is a little game we play. They put it on the bill, I tear up the bill. It is very convenient.

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