Marshall Auerback is a Denver, Colorado-based global portfolio strategist for RAB Capital plc and a Fellow with the Economists for Peace and Security (http://www.epsusa.org/). He is a frequent contributor to the blog, Credit Writedowns, and the Japan Policy Research Institute (www.jpri.org) and a new contributor to The Big Picture.
Are Ben Bernanke’s “green shoots” metamorphosing into a fully fledged garden of economic recovery? Judging from the recent euphoria of the market, it certainly appears that way.
Whilst we have not been in the camp that has tended to see every green shoot as an overflowing weed, we certainly thought the market was increasingly pricing in economic oblivion in February, a Great Depression II, if you will. As we have studied the Great Depression, however, we have been increasingly struck by the differences between now and then. Whilst this is the most severe recession of the post W.W. II period, bear in mind that there has never been as vigorous monetary and fiscal policy response than what is now occurring. By way of illustration, let me point out that the amount of crude in the government Strategic Petroleum Reserve = 700 million barrels @ $50 =$35 billion.
The Treasury gold position is worth $235 billion. This week alone the treasury will sell over $100 billion of paper of which at least $70billion will be in notes.
So one can make a fairly compelling case that we have seen major lows, at least as far as the commodity complex goes. And there is increasing evidence of stabilisation in the housing market, notably in areas such as California. Additionally, we have seen a major inventory liquidation, which always happens in a slump, where production falls more rapidly than consumption does. Eventually you have to reorder.
Another point is to bear in mind is that at $1.17 trillion, the budget deficit really has got to a very big number. Even if one makes allowances for TARP expenditures (which in reality are actually Federal Reserve style purchases of financial assets, which should not be incorporated into Treasury functions), the number is sufficiently large to ensure that the government is helping the private economy restore its savings and its purchasing power.
The “Obamaboom”, then, now underway due to the ‘automatic stabilisers’ described above, and the additional fiscal adjustments are now kicking in as well. Unfortunately we got here that ugly way, via rising unemployment and falling taxable incomes-a real and tragic cost that is, sadly, water under the bridge.
Consequently, there is a case to be made for saying that we’ve at least found a floor.
On this basis, can we proclaim the end of the “Great Recession”?
That strikes me as premature for a number of reasons. The first one is that households are still trying to get their debts paid down and to stay in cash as much as possible, deferring purchases of new cars and homes. Absolute debt levels remain high. Also, the falling asset values are such that people don’t have collateral to support new loans if they wanted to take them. We don’t know how quickly the household sector can turn around its expenditures. We do need ongoing fiscal stimulus to offset the inevitable continuation of private sector deleveraging.
This ongoing high level of private sector debt delinquencies and defaults suggest that private debt burdens got too high relative to private income flows. Liquidating or restructuring existing private debt then makes more sense than getting banks to loan more money to the private sector. Private debt liquidation, which is the Austrian solution, can take the whole system down if enough people try to do it at the same time, or if a large enough institution does it in a disorderly fashion. As Irving Fisher noted, attempts to pay down debt can lead to higher real debt burdens as forced asset and product sales drive prices into the ground. We had a taste of that with the Lehman bankruptcy. Debt liquidation might form some part of the solution when seeking to eliminate private sector indebtedness, but it cannot be the main course.
If not, then the private sector needs to be in a position to net save and pay down debt. That cannot happen unless some other sector is willing and able to deficit spend. Some of this can be achieved through increased exports, although if every country sought to depreciate their currency in the manner of sterling, the result would likely be a further collapse in trade, since “beggar thy neighbour” devaluations mark protectionism by another name: two potential candidates, the government sector or the foreign sector.
Given the contraction in foreign demand and rapidly diminishing trade flows, that leaves government to deficit spend if the private sector is going to net save. This is not high Keynesian theory – it is double entry book keeping, which we have been doing for 5 or 6 centuries now. Think T accounts, 2, sides to every transaction, rather than micro household behavior, and you will avoid the more obvious fallacies of composition. At the lowest level of manufacturing capacity utilization in post WWII history, and a rapidly rising employment rate of almost 9% in the US (and rising), the crowding out perspective is not terribly relevant, is it?
The second problem is that in a recession, your domestic capital tends to get destroyed. This is particularly true in the auto sector. Any subsequent return will see more outsourcing and more imports, so a lot of the recovery will leak overseas, which will take away from the turnaround here in the US. And the increasing price of crude and food does cut into purchasing power in a big way. I always thought that if there was not a credible plan in place to immediately cut US domestic crude oil consumption, this would cause problems as soon as we started to grow again.
And, unfortunately, our crude consumption has dropped only modestly and is already increasing as GDP stabilizes, even at current levels of unemployment. As a consequence, crude prices are headed north again, and will support headline and eventually core CPI through the cost structure, as cost push ‘inflation’ resumes after pausing for the inventory liquidation. While off of last year’s highs, food prices are now rising from levels that are substantially higher than those of a few years ago and crude prices nearly doubled since last December. Rising bond yields are likely to curb mortgage refi activity, an important means of stabilising a still fragile housing market. The US fiscal expansion is also likely to drive imports, with rising crude prices increasing the US import bill as well. This keeps a lid on domestic employment as unemployment remains high and real wages stagnate, meaning increases in real consumption and wealth due to productivity increases and (some) employment gains necessarily flow to the ‘top.’
It also means US dollars will be ‘easier to get’ overseas which puts downward pressure on the $. The Fed and Administration is prone to look at this as a ‘good thing’ as they view increased ‘competitiveness’ that drive increased exports ‘necessary’ to ‘balance the trade account.’ It does add to GDP, but for the real economy, rising prices of imports while nominal wages are contained decreases real standards of living as workers use up their take home pay on food and energy and export a greater share of their output rather than consume it. The Fed will soon be looking at sub trend GDP, unacceptably high unemployment, a falling dollar, rising headline CPI and rising inflation expectations.
Recent history says they will keep rates low as long as they perceive a continuing output gap. The administration will see the same data and be hesitant to blame the Fed for inflation, for fear of triggering higher interest rates.
Overseas, bad things can still happen, especially in the financial sector where the Europeans have not come anywhere close to us in coming to terms with the new environment (and we haven’t gone far enough, so that’s saying something). Add to that the inability of the EU to do fiscal policy on a supranational basis and you get ongoing economic stagnation. The situation in Europe’s financial sector is quite frightening and on the verge of spinning out of control.
In the meantime, the markets have gone from discounting economic oblivion to anticipating a 4th quarter economic recovery (if not sooner). In our view, given the extent of leverage in the system, the ongoing refusal to lance the boil of toxic assets in the banking system, and a persistent reluctance to address the underlying causes of what got us into this mess (in spite of recent calls for Speaker of the House Pelosi for a Pecora Commission II, which we fear will be a whitewash), likely ensures years of Japanese style stagnation. Or if the economy does finally prove responsive to the monetary and fiscal gas that has been poured out, then an unpleasant inflation down the road awaits us. Neither of these scenarios is anywhere close to being reflected in the market at this time. The old adage of selling in May and going away never seemed more appropriate.