Illusionomics?? March 2, 2011

The stock market is up and has continued to rise. Thus, all must be better with the economic world. At least that seems to be the current consensus view, a view that appears to be confirmed by the numbers that are streamed by us. This year is likely to see real growth in the vicinity of 3%, or so most of the economists are forecasting.

 However, several of my respected friends and associates in the investment world are questioning the reality and sustainability of the improvement we are seeing. One of them, my friend Robert Marcin, an experienced and clever investor, calls the whole scene “illusionomics”.

 Robert’s view, one shared by David Rosenberg, formerly economist of Merrill Lynch and now with Toronto-based Gluskin Sheff, looks at the truly massive monetary and fiscal stimulus that has been applied to the U.S. economy relative to what has been accomplished in the way of recovery and asks, “Is that all we’ve got for our money?”

 Here are some quotes from Robert:

 “Ben (Bernanke) is selling real hard these days with infinite QE, 0% short rates, and a bailout for every bondholder extant. Don’t get me wrong, corporate profits and M&A activity are real. Global growth is decent. But until we have a normal budget, free market interest rates, and no Bernanke put, no one knows how sustainable economic activity and financial asset prices are. Until we have the death of the Fed salesman’s relentless manipulations in financial markets, we cannot know what’s real or an illusion, even if it feels good.

The structural imbalances that helped cause the Great Decession of 2008-2009 have not really been addressed and solved. Rather most of the world has borrowed and stimulated, back-stopped and printed its way to trillions of dollars/renminbi/yen/euros/etc in order to avoid restructuring the financial system and meaningfully reduce the excess leverage. Most countries/economies are guilty, and many are still vulnerable.

Quite simply its INSANE to believe in US economic normalcy with a one thousand billion dollar, structural federal deficit, US taxpayer ownership/guarantee for 50%/95% of existing/new mortgages, 0% interest rates, near record u-6 unemployment, record government transfer share of gdp, record food stamp usage, depression like housing price action, and debt/GDP at obscene and unsustainable levels.

However, near universal belief in this artificial stimulus policy of Illusionomics has generated a profound complacency regarding economic cyclicality and risk taking. And it has led to massive amounts of speculation in stocks, commodities, precious metals, and credit.”

My opinion? While I think Robert’s doubts about economic normalcy are on target, I believe his negative/cynical implications regarding monetary policy, and fiscal and other forms of stimulation are misplaced.

The idea that we have received so little for what has been expended gives no recognition to how serious the economic and financial situation was. The edge of a huge brink was very close, and we pulled back from it only because of the massive actions that were taken. It’s frightening to think about what might have happened had we been reluctant to be fiscally “irresponsible”, or too scared of inflation to have the Fed push new money into the economy. In my view, policy actions have been very effective, not in the sense that they have created real growth or reduced unemployment, but in preventing economic disaster.

It’s certainly true that we are far from “normalcy”, as ill-defined as that may be, and those that are betting heavily the other way may ultimately be gravely disappointed. The idea that recent stronger economic statistics are the beginning of a smooth, strong, and extended period of healthy growth is probably wrong.

Rather, we continue to be in an economy and financial system with serious structural problems ranging from federal, state and local government deficits, to stubbornly high unemployment, to energy profligacy, to huge numbers of homeowners whose mortgage debt is in excess of their home value, even while home values are still receding. Add to this list the over-promised, underfunded healthcare and retirement benefits, and a woefully inadequate educational system, and it’s enough to make one become more than a bit cynical, even depressed!

During the next few years we must and will chip away at these problems, and that chipping away will work to limit growth. Think about tighter lending standards, higher taxes, lower government spending, and reduced social benefits that will need to be offset by higher personal savings. Think also about the huge wave of baby-boomers passing from productive years into retirement. This is not the kind of environment that is productive of robust growth.

For the past two years, global growth led by the developing nations has proceeded to drag the rest of us along at sufficient strength to keep our heads above water. Now, however, commodity price inflation, particularly food and oil, are denting the growth of the emerging nations where food and energy costs absorb a much greater proportion of consumer incomes than in the developed world. Thus, still another headwind has appeared.

Fortunately, the profitability and financial strength of U.S. corporations has never been better. Their weathering of the financial and economic storm was truly remarkable, a fact which by itself has reinforced investors faith and carried valuations substantially higher despite the problem-laden environment in which they operate. Is the higher stock market just rampant speculation spawned by Ben Bernanke’s profligacy, as Robert has said?  I don’t think so. It is caused by increased confidence, spawned by evidence of a bit more economic strength, and the earning power, strong financial condition, and surprising recession immunity that the corporate world has demonstrated.

We are still nursing wounds, but maybe we are at the beginning of a beginning to reckon with huge structural problems. Yes, I know, we have many reasons to be cynical about our politicians lack of courage even while being full of courageous rhetoric. But I think the better bet is that we will peck away at the problems and see some progress over the next several years.

Shorter term, we face the withdrawal of certain sustaining economic forces, particularly the end of the Fed’s quantitative easing, known popularly as QE2, and the end (at year-end) of the suspension of the payroll tax. Additionally, government spending levels, both federal and state and local, appear certain to decline. Finally, while we can’t predict oil prices, if they stay where they are currently or move higher, the world economy will experience a heavy suppressant. Financial markets will not be immune.

So far the markets’ reaction to the North Africa/Middle East turmoil has been quite muted. That makes an anchor to the windward seem a sensible stance.



One Response to Illusionomics?? March 2, 2011

  1. robert marcin says:

    Paul, 12 months after QE2 ends we will see whether we have a self sustaining recovery or Illusionomics…I suspect we will be in phase QE3 and still at 0-1% Fed funds rate. I can’t imagine the treasury bond market surviving at current price levels without Bubbles Ben monetization of around 75% of the budget deficit. I don’t know which QE will destroy the dollar and be perceived by the markets as the Oh-no! QE moment.

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