Q1 GDP Confirms That Future Quarters Will Decline at Slower Rate. (posted 4/29/09)

April 30, 2009

In yesterday’s posting I wrote about how consumer spending had been supported in the first quarter by lower gasoline prices and a significantly lower tax take. In the current quarter, the comparisons won’t be as easy; most of the drop of gasoline prices has had its run and tax refunds will be much lower, although the Obama tax cut will have some positive effect.

Today I want to discuss the stimulus that GDP received from a sharp decline in our trade deficit.  We don’t have the actual trade statistics for March yet, but the GDP report signifies that the trend to a lower trade deficit is continuing. Consider these figures: (in billions of  constant $)

                                                 3Q’08      4Q’08       1Q’09

          Exports                      1,556.1  1,454.9  1,331.2          

          Imports                     1909.1  1,819.4    1,639.5            

         NET EXPORTS          -353.1    -364.5     -308.4

         EFFECT ON GDP                         -11.4         +56.1

Okay, so the effect of  imports declining more than exports was to add $56.1 billion to GDP, compared with a $11.4 billion negative effect in the 4Q 2008, making a total swing of $67.5 billion.  That was the single largest positive for GDP in the first quarter.  Interestingly, because the prices of our imports fell more than the prices of our exports (think oil), the effect on nominal GDP growth was even greater, making a positive contribution of $208 billion.

Which reminds of of some comments I made about two years ago, that as we entered a recessionary period, the considerable outsourcing of U.S. production to foreign factories would serve to make imports an unemployment shock absorber.  That’s exactly what has happened.

Meanwhile, certain parts of the economy that have been weak continued to be weak, notably residential construction, and nonresidential investment in structures and equipment which together knocked $183 billion off GDP and were the biggest negatives.

Residential construction has been so bad over the past year (down 23%) and has reached such a low level (now only 2.6% of GDP) that even if it doesn’t recover soon it will almost certainly stop being a drag.

The second biggest drag on 1Q GDP was a liquidation of non-farm inventories to the extent of $112 billion. This ranked as the second largest negative, and was sufficiently large that it’s unlikely to repeat at anywhere near that magnitude.

Perhaps not “green shoots” as the popular press call them, but a moderation of inventory liquidation, the end of the drop in residential construction, and continued but slower improvement in our trade balance are the best hopes for the next couple of quarters.  All in all, the 1Q numbers confirm my opinion that the steepest part of the contraction is behind us.  They say nothing, however, about how soon the decline will end, what will propel a recovery, or how much vigor it may or may not have.


How Consumers Managed to Spend More in 1Q 2009

April 29, 2009

By now you have read about the GDP decline in the first quarter of 2009.  It was the second quarter in a row of a more than 6% decline at an annual rate.  Of course, when we speak of such numbers we are usually referring to inflation-adjusted or real GDP. And that can hide some interesting anomalies.


For example, the real numbers show that Personal Consumption Expenditures rose by about $44 billion vs. $28 billion in current dollars.  That indicates that the prices paid by consumers went down, as indeed they did.  But a look at where prices went down the most shows what really happened during the quarter, which was that substantially lower gasoline and fuel oil prices effectively financed higher consumption in other areas.


Expenditures in Current Dollars

1Q 2009 vs. 4Q2008


            Personal Consumption Expenditures………………+$27.8 billion

               Motor Vehicles and Parts…………………..+14.8

               Furniture and Household Equipment……….   +0.6


               Clothing and Shoes………………………….+6.6


               Medical Care………………………………+18.9

               Other Services……………………………  +19.7

                                                   Subtotal                    +77.8               

               Gasoline and Energy………………………   -50.0

                                                    Total……………. $27.8                          


There it is: A $50 billion “tax cut” in the form of lower gasoline and fuel oil prices enabled about two-thirds of the increases in other consumption spending of $77.8 billion!  Because gasoline prices were even higher in the second and third quarters of 2008 the same dynamic was present in the fourth quarter of last year in an even greater magnitude.  Gasoline and fuel oil expenditures in the fourth quarter were a whopping $145 billion less than in the third quarter, a huge cushion to spending at a crucial time.


But…..now….the gasoline tax cut has dissipated, and coming to the rescue are the Obama Administration’s tax cuts.  In fact, the cuts began to be felt in the first quarter.  Personal income declined modestly in the first quarter, by $60 billion or 2% annual rate. But personal taxes were down by $193.5 billion, some part of which was the result of the tax cuts, so that disposable income rose at a 5% annual rate.  Putting taxes and lower gasoline prices together gave consumers $243.5 billion more to spend or save than they would otherwise have had, which accounted for the rather amazing performance of consumption in the face of immense job losses.


I’ll write about other aspects of the quarter’s GDP tomorrow.



Bear Market Rally or New Bull Market? Or Neither? Too early for Green Shoots. An Economy in Transition

April 18, 2009

When I am asked whether I think this is a rally in a bear market or a new bull market, my answer is “neither”. In my opinion, investors have reacted with relief to the growing sense that we are not headed for a depression. We think we can now plumb the bottom of the economic decline. The result is a modestly higher level of valuation (up 26% from the March 9 low) that is no longer anticipating a trough of unknown dimensions. You can think of it as a higher but still depressed plateau, around which stocks may fluctuate in a fairly wide range for some time ahead.

But, let’s get something straight. The U.S. and global economies are still contracting at an uncomfortably rapid rate. Just not as rapidly as they were. The rate of decline of the rate of decline has declined! My friend and economist Larry Chimerine suggests that whereas we have been experiencing a GDP contraction per month of about 0.5 to 0.6% since last September, the rate of decline may now be “only” 0.2-0.3% per month. The fever gas gone down a bit but the patient is still quite sick.

Importantly, credit market conditions have improved, and Wall Street, obsessed as it is with its own activities and problems, has reacted quite positively. For this, give full credit to the Federal Reserve in helping to satisfy high levels of liquidity preference on the part of market participants. As I have said before, imagine how bad it would have been if investors and business executives had tried to satisfy their preference for liquidity within a static stock of money. Our worst deflationary fears would have been a reality. (Speaking of deflation, see footnote on deflation in China)

But make no mistake. There is plenty of ugly news ahead. The quality of bank assets continues to deteriorate, even as the banks, enjoying extremely low cost funds, are making decent operating profits. The labor market still stinks. April is on course for another 700,000 job loss. And at this rate of job loss don’t try to convince me that labor statistics are a lagging indicator. The negative coincident effects on demand will be palpable.

Housing activity, adjusted for foreclosure sales at very low prices, is bumping along a very deep bottom, and housing prices are still declining at a rapid rate (an annual rate of over 26% for the latest three months). In fact, real estate of all kinds is falling in price pretty much continuously since early 2008. Moody’s Real Commercial Property Price Index (effectively an index of transaction prices, for all commercial properties, declined about 19% during 2008, and was down 5.5% in December (the latest number). Things have almost certainly gotten worse since then. (For more on commercial real estate price changes go to http://web.mit.edu/cre/research/credl/rca.html )

Household net worth continues to fall, and is now down over 30% from late 2007. It seems almost impossible to me that consumer optimism and spending will be anything but anemic and weak for months to come. To be sure, tax refunds are up substantially, and mortgage refinancings have climbed, adding to consumer spending power and softening the decline of retail sales. But a significant and lasting change for the better in consumer spending is simply not in the cards for many months.

Yes, fiscal stimulation will be a plus, particularly as we enter 2010, but a significant piece of federal spending will be offset by an ongoing contraction of state and local government spending. And the time that any sizeable stimulus spending actually begins is probably a year away.

Having been raised as a monetarist, I continue to put as much if not more weight on monetary expansion, which is being relentlessly and aggressively pursued by the Fed. Because of the Fed’s actions, I think we have avoided an even more extended and deeper economic contraction. True, so far the growth of the money supply has been sterilized by declining velocity, a reflection of high liquidity preference. But that will ultimately change, as it always has before, but with a lag.

I think there is a glimmer of light at the end of the tunnel. Policy actions will begin to give the economy some positive traction before the end of the year. But don’t expect much after a nice initial bounce that will come from some inventory building, some recovery in housing based on a large leap in affordability, and an eventual leveling of unemployment.

I have written before and repeat here that this is more than a recession. It is the beginning of a transition to an economy that will be characterized by an extended period of higher private savings rates and lower public savings rates. In other words, higher savings by consumers and businesses and higher dissaving by government. We will see lower consumption and private investment as a share of total domestic demand and a rising share of government consumption and investment. Compared to the years leading up to the current economic illness there will be more reliance on domestic private saving to finance government dissaving, and much less reliance on foreign savings to fill the gap. (see footnote on Savings and Investment)

Incidentally, in the past, periods of declining private savings have coincided with high returns from stocks, and periods of increasing savings rates have been accompanied by low returns.

Just how long this pattern of total demand will stay with us, nobody can say. We also are unable to judge at this point whether or not private savings will be sufficient, so that the Federal Reserve need not resort to monetizing a significant share of the increase of government debt and/or that we once again become uncomfortably dependent on foreign savings.

For those of you who are concerned about ultimate inflation, I refer you to a discussion of that subject in my April Musings.

Footnote on deflation in China: The Wall Street Journal reported China’s growth rate last quarter at 6.1%.  But what wasn’t said is that 2.4 percentage points of that growth came from deflation.  That’s right. Nominal growth was 3.7%.  Just as inflation is a subtraction from nominal growth when calculating real growth, deflation is an addition. Interestingly I’ve seen very little comment on this. I am no expert on China, so I will not speculate on what this means.

Footnote on Saving and Investment: A reminder to those who might have forgotten their college economics: in National Income accounting, saving and investment are an identity, i.e., are equal by definition. Thus, as government dissaving (borrowing) rises, either private saving must rise, and/or private investment must fall, and/or savings must be “imported” from a nation or nations with a savings surplus. Over the past few years we have been big importers of savings to finance an extraordinary climb of domestic consumption to record levels as a share of GDP coincident with a high Federal deficit. China, as a major exporter to satisfy our domestic demand, has been our largest source of foreign savings inflows, resulting in that nation owning a huge piece of our Federal debt.

Plumbing the Bottom of a Transitional Economy,……. The Worst May be Behind Us……and….. Is Inflation the Inevitable Result of Economic Stimulus?

April 5, 2009


There is an abundance of subjects to write about this month, so let me start with a summary of points I’d like to make:


<!–[endif]–>Th                 The stock market has been rallying, even in the face of continuing bad news, particularly on jobs, because investors evidently concluded that they could discard their worst fears of a depression and could finally plumb the bottom of the economic decline. (note that I continue to refrain from using the word recession because I think it’s the beginning of a potent structural shift in the character of the U.S. and global economies and not the recessionary phase of a typical business cycle.)

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As                   As a corollary statement, I believe that the economy has now seen its maximum rate of contraction. However, the decline will continue for at least two more quarters as job losses and lower corporate cash flow continue to negatively affect aggregate private demand and the quality of bank assets. By sometime in the third or fourth quarter, the huge monetary expansion and the first effects of the stimulus legislation will begin to give the economy some traction.<!–[endif]–>

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We                 We are in transition from a low savings economy, dependent upon foreign savings to finance a high level of consumption and private investment in residential real estate, to a rising and higher private savings rate that may still be insufficient to finance large government deficits. Any insufficiency might have to be satisfied by monetization of part of the deficits, an action that could raise inflationary expectations.<!–[endif]–>

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Th                 There should be an initial sharp upward bounce off bottom, probably in the 4th quarter or early in 2010, caused by an end of the housing decline, a recovery of auto sales from the current depressed rate, some inventory building, the effect of tax cuts on consumer spending, and the spending part of the stimulus package.  This is likely to be followed by an extended period of unsatisfactory growth.

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Be                   Because of the current expansionary policies, there will come a time, perhaps in late 2010 or in 2011, when inflation will become a worry; not an actuality, but a worry. There is a good possibility at that point that the economy will still be experiencing an unsatisfactory employment level. What does the Federal Reserve do then? To tighten would draw fierce political fire. Not tightening would feed the inflationary expectations which can all too self-fulfilling. A dilemma to say the least.<!–[endif]–>


Okay, let’s deal with these thoughts in no particular order. First, what suddenly gave investors some sense of sudden relief on March 10 that a depression was not in the cards? At the rally’s beginning it appeared to be piecemeal, better than expected news about retail sales, durable goods orders, bank holding company operating profits, rising mortgage refinancing, and sharp increases in housing affordability. But layered upon that was the Fed’s statement of March 19 that reinforced a perception that the Fed would continue quantitative easing to whatever degree necessary to halt the economic slide (see my posting of 3/20/09 and my Musings of December 2008).

The sharpness of the rally (best four weeks since 1933) was importantly a product of what was a very oversold market that was reflecting a cascade of bad and worse than expected economic news. As we should have known, stocks often “climb a wall of fear”. It has often happened during periods of economic distress. At this writing we are back to the level of early February after having been down as much as 26% for the calendar year.

I have no firm idea whether March 9 was the bottom of the stock market. I put the chances of that at about 60-40. It’s true that most conditions necessary for a bottom were there. Investor psychology was certainly very negative, as it usually is at market troughs. Valuations, compared with the recent decades were certainly depressed. They still are. We were probably experiencing the fastest rate of economic contraction at the time, which would about right for a market bottom.

What makes me so hesitant to say it was the bottom? Two things. First, labor market conditions are simply terrible and will not improve for many months. Those who are good at forecasting employment and jobs are in fair agreement that job losses will be continuing at 600,000-700,000 per month for at least several more months. I know that jobs data are lagging indicators. But job losses at these rates are very fast and will be shocking to consumer attitudes. Therefore, this time they could turn out to be leading indicators.

Second, the quality of bank assets is still worsening. Commercial real estate loans are being impacted by declining real estate values. Corporate profits are being crunched, thus increasing the odds of more defaulted business loans, and credit card defaults continue to rise. Loans made during 2006 and 2007 to finance leveraged buyouts are in big trouble, and mortgage defaults, even on restructured mortgages, continue to grow. Credit markets, while improved, are exhibiting low interest rates only for the U.S. Treasury and new mortgage borrowers. Spreads are quite high for other borrowers.

So, where are the lights at the end of the tunnel?

For a more complete analysis than I can give you, click here for Northern Trust’s Paul Kasriel and his team’s analysis. But in summary, even though jobs numbers are dismal, we have been seeing relatively good numbers on consumer real disposable income, thanks to unemployment benefits, tax refunds, and low inflation. So retail sales, while well below a year ago, have not been tanking. And beginning this month, the tax cuts in the stimulus package will bolster disposable income.

Importantly, we are seeing signs that lower house prices are beginning to have an effect on sales. Now, before we get too enthusiastic about this, recognize that foreclosure sales and seasonal adjustment factors are mucking up the numbers, but it increasingly looks as if we are bumping along the bottom even as prices continue to decline. Housing affordability has improved very substantially. The median sales price of existing one-family homes as a multiple of per capita disposable income is down about one-third from its peak and is below where it was during the 1990’s. And, of course, mortgage interest rates are down substantially (Bankrate.com is showing a 15-year fixed mortgage at 4.63%, and a 30-year fixed at 5.06%).

Most important, in my judgment, in sharp contrast to the early 1930’s when the money supply contracted sharply, the Fed has been expanding the monetary base and the money supply rapidly. With the current high preference for liquidity, this money is currently tending to have very low velocity, but think for a moment what a pickle we would be in if participants had attempted to satisfy their rising preference for liquidity from a level or declining supply of money. Eventually the velocity will pick up, perhaps slowly at first, and then as economic activity levels out it will rise more rapidly more rapidly. That will happen. Indeed, it may already be happening, but I expect by the third and fourth quarters that the effects will be palpable.

One possible problem needs mentioning. As I’m sure you know, the high consumption-low savings economy of the past few years was heavily financed with foreign savings, especially dollar balances earned by China as a result of large trade surpluses with the U.S. With global trade now contracting, and our trade deficit shrinking, we are “exporting” dollars at a slower pace. Thus, foreign dollar holdings are not growing by the same large amounts to help finance our rising deficits. This has worried some analysts into thinking that a large portion of our deficit may have to be monetized, i.e., financed by Federal Reserve purchases of treasury securities because of the reduced ability of foreign buyers. If this were to be the case, the ultimate inflationary effects would be worrisome, and inflationary expectations could soar at the same time the economy is recovering, creating conditions that could make the expectations self-fulfilling.

In order for this not to happen, our private savings rate would have to rise substantially from the level of recent years. But a higher savings rate is the flip side of lower aggregate demand, in this case lower private demand, because government dissaving is a given. (Total savings, in GDP accounting, consist of undistributed corporate profits, consumer disposable income minus personal consumption spending, plus or minus any government surplus or deficit of both federal and state and local governments). So, we are caught in the “paradox of thrift”, which is that if we all try to increase our savings, nobody will be able to do so because incomes will shrink.


The way out of this is, of course, is an increase in incomes and corporate cash flow as a result of a stronger economy, which in turn would importantly be the product of monetary expansion and government spending. This is the only scenario that might allow both savings and income to rise sufficiently to finance the future deficits domestically, at least for the next few years. That is the hoped for scenario, but it’s no shoo-in.

Is inflation the most likely aftermath of the huge monetary and fiscal stimuli, as many people insist? It’s tempting to draw sweeping generalizations about the inevitability of inflation, the burdens we are putting on future generations, and the declining role of the dollar.

To be sure, as Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” In many ways, Friedman was an extremist. An extreme monetarist and free market advocate. It is difficult to find instances in which Friedman even acknowledged the possibility that markets could go wrong, or that government intervention could serve a useful purpose. But his statement on inflation is close to being a truism.


I believe I am correct in saying that never in the modern history of the world has there been a hyper inflation where there has been an independent central bank. Bursts of high inflation perhaps, but not of the Weimar Republic variety that destroys economies.


We have an independent central bank, and of all the political developments we want to prevent, the impairment the independence of the Federal Reserve is numero uno.


The recent announcement by the Fed that they would buy up to $300 billion of treasury bonds, was of particular note in feeding inflationary fears. Monetization of the Federal debt, it is said, is the road to inflationary ruin. The beginning of the end of Fed independence……and so on.


Let’s get a couple of things straight. First, is that it makes no difference what assets the Fed buys, from furniture to mortgages. Any net purchases of anything by the Fed add to reserves of the banking system. So the purchase of longer dated treasuries is no different in its quantitative effects on money supply than purchases of treasury bills in the normal course of open market operations. The only difference is in the effect on the yield curve. Buying longer-term bonds brings down longer-term interest rates, something the Fed wants to happen so that borrowers, particularly mortgage borrowers, will be given a present.


Second, just as the Fed can create high powered money, it can take it away by the sale of assets on the open market. Here, the key questions are importantly political. Historically, when the Fed “takes away the punchbowl just as the party is getting started” (as former fed Chairman Bill Martin once said), there have been howls from congress, and occasionally from the president himself. The Chairman of the Fed finds himself spending more time before congressional committees than tending to policy. So if policy is too heavy handed, the Fed’s independence can be jeopardized to a non-trivial degree.


It seems very unlikely to me that a cost-push inflation, such as we had in the 1970’s, could become a problem today, given huge excess capacity in terms of both labor and physical facilities. Also, the structural changes that have taken place have inserted a disconnect in a wage-price spiral, i.e., the absence of cost-of-living clauses in labor contracts. So if inflation is to be a problem it will be monetary inflation.


I’m sure some of you are thinking of the looming large federal deficit spending programs as being inflationary. That is not necessarily so. The way spending is financed is not the relevant factor here. Federal spending can, of course, be inflationary when and if it competes with private demand for scarce resources. But such scarce resources are quite far from the actuality today and for several years to come.


My conclusion is that inflation, while it may be an ultimate problem, is not on the horizon for at least three years and perhaps longer.


Longer-term, our problems stemming from promising too much in the way of retirement benefits, health care and other entitlements are indeed very serious. There is no financing in place for these programs, and informed estimates put the present value of these unfinanced, future entitlements at about $65 trillion. Mind boggling, to be sure, and the problem is not just at the federal level. Municipalities, states, and private companies have over promised (think of General Motors). This means that there is the prospect of a growing burden of taxation and other spending diversion that will be placed on the coming generation.


I’ll close this already too wordy piece with a brief comment about why this is not simply a recession. I’ve said before in several previous Musings that it’s a transition from an economy characterized by overconsumption and overinvestment in residential real estate, financed importantly by foreign savings, and exploited by highly leveraged financial institutions, to a higher savings economy, much less dependent on consumption as the main driver, and more dependent on domestic savings to finance investment in new production facilities, technologies, and public infrastructure.


I believe we have a good chance of a successful transition, but it may be agonizngly slow with many bumps in the road. The good news is that if we make it, we’ll have a much healthier, more soundly-based economy than what we had over the past twenty or so years.


A Personal Note


I have had a couple of people ask what size staff I have. I tried not to laugh when I told them that I had none. Zero. True, one of my daughters designed the blog for me, but I do all the postings myself. If there are any volunteers out there who would like to do some economic research for free, I will gladly accept their services. Oh, and large advertisers, in fact, no advertisers, have yet approached me with propositions. But I’m open to that also!

An Extraordinary Letter (posted 4/2/09)

April 2, 2009

Jamie Dimon, the CEO of J.P. Morgan has written an extraordinary letter to his shareholders.

For anyone who wants a clearer understanding of the financial crisis we’re in, and what is needed to prevent another one, this is MUST reading.

Warning: it is long; but it covers the waterfront………..  what went wrong with the financial system, JPM’s part in taking on and controlling risk in the cases of Bear Stearns, and WAMU, why they took TARP money, the inadequacies of regulation, thinking about future regulation and structure, and much more.  It is the clearest piece I have read.  You’ll understand after reading it, why JPM is standing above its competitors.

Click HERE to go to the JPM site, then click on Letter to Shareholders

A Light at the End of the Tunnel?? (Posted 4/1/09)

April 1, 2009

Paul Kasriel and his team at Northern Trust were way ahead of the curve in calling the economic decline.  They are as good as they come in economic  forecasting.  In their March 20 Economic Review they, for the first time in this cycle, see some light at the end of the tunnel.  It is a meaty article, and well worth your time.

Among the things touched upon are the sharp increase in housing affordability, and the huge difference between the growth in money supply in the current contraction and what happened to money supply in the depression of the 1930’s.

Click Here to link with the Northern Trust,  Click on  Economic Research, then choose March 2009.