More of the Same


October 6, 2011

As I write this , the S&P 500 is at a level first reached on April 1, 2010. What has changed since then? Not much. What I wrote one year ago I could write today. To wit:

“…..our economic problems are not stemming from the business cycle as we came to know it over the past 60 years. They are deeply structural in nature.

The most overriding of our structural problems is, of course, the immense debt load the private economy assumed during the two decades leading up to the financial crisis, and which is now being whittled away by paydowns, foreclosures, and bankruptcies. As it is being reduced, the public debt has soared as a result of lower tax collections and higher spending, as we have attempted to stimulate the economy, both fiscally and monetarily.

The financial system has stepped back from the edge of an abyss, but remains stressed. Bank asset quality is still lousy, and many assets remain to be written down or off. …………….

State and local governments, experiencing lower revenues from property taxes, sales taxes, and income taxes, have found themselves face-to-face with the spending excesses and contractual obligations, e.g., pension guarantees, of a bygone era. At the federal level, our politicians seemingly ignore the ticking time bombs of Medicare and Social Security, and show no signs of producing a credible plan to bring the deficits under control.”

So, as the French say,” plus ca change plus c’est la meme chose” (the more things change the more they stay the same). All the political activity and rhetoric, all the economic forecasts, all the day-by-day machinations of investors, huge federal deficits, and massive purchases of treasury securities by the Federal Reserve, have combined to produce no significant change in the economy, the economic outlook, or the level of the stock market.

Retrospectively, what has become increasingly clear is just how the stage for the financial crisis was set by what has been dubbed the “uphill flow” of capital in the form of official currency reserves. China and other less developed countries made conscious decisions to promote exports by maintaining low real exchange rates. The decision of those countries to build foreign exchange reserves, which tripled over the past five years, was also a conscious one, influenced strongly by their experiencing the financial crises of the early ‘90’s. Consumers in the U.S and Europe gobbled up goods made in China and other developing Asian countries. Their foreign exchange reserves soared.

Very high savings rates in China and other developing nations made the domestic investment of this rapidly accumulateing capital unnecessary. Hence, this capital flowed back here mainly through purchases of U.S. Treasury securities, and the effects were enormous. This capital flow set the stage for an extended period of low real interest rates and bubbles in asset prices, first in technology related stuff in the late ‘90’s, then in residential real estate. At the same time, low real interest rates pushed investors further and further out the risk curve.

To be sure, slack regulation, too much faith in the power of free markets, and an immense wave of financial innovation played important parts in causing the financial disaster, but none of that could have happened without the stage first being set by these “uphill” capital flows.

Developments since the crisis peaked in 2009 have been dubbed by some as The Great Rebalancing. But any rebalancing is quite young, as indicated by the fact that China’s reserves are still growing, albeit at a slower rate. So we are still seriously unbalanced. Recent higher values for the Yuan are encouraging, but have considerable distance still to go. We can expect increasingly strident demands for China to float or at least revalue their currency.

Since the worst of the crisis, we have been seeing just what we expected: total credit market debt in the U.S. has registered its most significant and longest decline of the post-WWII era, but is still at 340% of GDP, up from 250% in just 12 years. The flip side of this contraction of private credit, of course, is the most anemic economic recovery we have seen since WW II. The deleveraging side of what now appears to be a long-term credit cycle (65 years??) is still young and the end is not yet visible.

As I have said many times over the past year, we should expect a continuing mix of lumpy, bumpy economic news. One day it’s encouraging, the next it’s the opposite. Growth estimates are raised, then lowered. In the markets, one day risk is on and the next day it’s off. Currently, we see fears of a recession and fears of sovereign debt problems dominating the scene.

The risks emanating from the sovereign debt burdens in the southern periphery of the eurozone are not trivial and are the biggest threat to the global economy. The disorderly collapse of the euro area, or default by a major economy, could trigger a second global financial crisis. Assuming that does not happen—my hopeful forecast is that disaster will be averted — the austerity measures now in force or being planned in many EU countries will still have a dampening effect on economic growth. In fact, fiscal austerity for a country like Greece, and other European countries with lesser problems, is self-defeating. Greece’s only way out is a growing economy, and austerity is not the path to growth.

The risks that would emanate from another recession in the U.S. so close on the heels of 2008-2009, and at a time when the central bank is out of ammunition and there is zero political tolerance for any fiscal stimulation, are also serious. But it’s my strong belief that even if we do enter an actual recession in GDP, it would be mild simply because there are no excesses to be corrected. Essentially, such a recession would be indistinguishable from what we have been seeing over the past several quarters

To be sure, there are some strong headwinds holding the economy’s growth at a very low level. Yes…..consumers are still deleveraging, but consumer debt service has receded substantially from its peak, thanks inportantly to foreclosures and extremely low interest rates. And yes…the decline of housing prices has slowed but not stopped, so consumer wealth remains depressed. But residential investment is running at only 0.75% of GDP, a record low level, and the inventory of unsold new homes is down significantly.

In fact, the aggregate of the economy’s cyclical sectors (consumer durable goods, construction, and capital spending) as a percent of GDP (now 20%) has barely bounced off its 2009 bottom, which was a 60-year low. Auto sales are at a 12-13 million unit rate, compared to the range of 15-17 million units for most of the 20 years from the mid-80’s to 2007. The low was about 9 million units for a short time in 2009-10.

I should give a nod here to one of the investment fraternity’s more successful integrators of economic forecasting and the stock market, John Hussman. He believes a new recession (not a double dip within the old one) is coming, if not already here.

Hussman puts the blame for the Great Recession squarely on the policy makers for encouraging two successive bubbles and then refusing to recognize them for what they were in the name of free market economics. Hussman’s analysis of the continuing sluggish state of the economy is that the “fiscal bandaids” and “monetary distortions” applied to the economy have been entirely misplaced and are failing to deal with the core of the problem.

The problem, in Hussman’s view, is the refusal to restructure bad debts, particularly the residential mortgages still residing on balance sheets of financial institutions and that have stated values far in excess of the current value of the underlying real estate. His solution: restructure to bring down the debt of homeowners to levels more commensurate with current values, and create a pool of appreciation rights that would give the lending institutions a fair share of longer-term price appreciation. This is an interesting idea that should be aggressively explored, in my opinion. (To read more of what Hussman has been saying go to:

Obama has presented a “jobs bill” to Congress and the next few months will be spent in unproductive argument about its potential effectiveness and how to pay for it. Pretty discouraging! Meanwhile, Bernanke, looking for something the Fed can “do” to give the economy a shot in the arm, has led the way to “operation twist”, an effort to further reduce longer-term interest rates, as if that would actually do any good.
Recently, I heard Ed Lazear, Stanford prof and former head of the Council of Economic Advisers, say, “We should stop worrying about finding something that will work quickly. Nothing will work quickly.” Amen to that!

We need longer-term help that finally recognizes that it’s a structural, not a cyclical problem that we have. The debt restructuring that John Hussman suggests is one course of action. Another can be a properly structured, major infrastructure rebuilding program lasting a decade or more.

The Tea Party types will resist anything that costs money. Some strong leader must tell them that this is NOT the time to insist on fiscal austerity. Fixing the longer-term entitlements problems is applaudable, but cutting current spending is NOT okay in today’s situation.

The current mess has brought out every goldbug, every monetary kook, and every economic quack, all expressing fears of an economic/financial calamity. Professional economists have not been much help in cutting through all the nonsense and providing comfort. I’m afraid that just as it took a couple of generations of economists to figure what really happened in the 1930’s, what actually caused the Great Depression, so it will be some years before we really understand what is happening now.

Finally, I say simply, “Get used to it”; what you see in today’s economy you will continue to see for several more years.


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