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.)

<!–[if !supportLists]–>·

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]–>

<!–[if !supportLists]–>·

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]–>

<!–[if !supportLists]–>·

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.

<!–[if !supportLists]–>·

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 ( 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!