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.