Three Pictures of a Depressed Economy

July 18, 2010

These three graphs show dramatically just how far the U.S. economy has to go to get back where we were!

(Click on an image to enlarge)

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Economy is Slow and Sluggish, Social Contract Fights Lie Ahead, and the Stock Market is Range Bound……… 6/23/2010

June 23, 2010

“The world is on a journey to an unstable destination, through unfamiliar territory, on an uneven road and, critically, already having used its spare tire(s).”

This metaphorical sentence, which came from PIMCO’s annual Forum, nicely encapsulates the uncertainty I feel; the sense that all is not quite right, and that we don’t yet understand exactly what it is that’s not quite right about it.

For now, as I have predicted for almost a year, we are in a recovery that is moving in an irregular and sluggish fashion, and insufficiently strong to reduce unemployment.

The two spare tires in the metaphor, fiscal stimulation and monetary ease, have been used and are wearing thin, and the next crucial step must be to construct a credible plan to reduce the federal deficits. On this point I see no progress.

  • Housing and commercial construction remain in a distressed state, with no recovery yet in sight.
  • Employment gains remain anemic, below previous recoveries
  • Personal income minus transfer payments, relative to the previous peak, is at the lowest level of any recovery in the past 50 years.
  • Inflation is dormant, even bordering on deflation.
  • Retail sales are still well below (about 7% on a per capita basis) pre-recession levels.
  • Auto sales are bumping along at about 11 million units, down from over 16 million.
  • A rise in net exports that I and others had hoped for has not developed; exports have risen but imports have risen more.
  • States and municipalities, facing serious fiscal problems, are reducing spending and employment.
  • While there has been some strength in infotech spending,  it’s not a large enough sector to significantly affect overall activity or employment.
  • The stimulus package is close to having run its course, and any new stimulus faces strong political headwinds.

I do not believe we will see the much-feared “double dip”.  GDP gains will be positive, in the area of 3%.  But what we have been seeing, irregular pockets of strength alternating with disappointments, is what we will continue to see for some considerable time (6 to 12 months) ahead.

At Last….A Tiny Bit of Help From China

In several postings to this blog I have expressed the hope for a revaluation of the Chinese currency, but until a few days ago, the Chinese stonewalled the rest of the world on this. Now they have said they will make gradual adjustments.  From 2005 to 2008, the yuan was allowed to rise at a 3% annual rate, inadequate at best. Will the appreciation rate now be allowed to rise faster than 3% annually?  I seriously doubt it.  I think it’s very safe to say that China will remain a very strong net exporter for some time to come.

The Coming Social Contract Fights

I have written several times about social contracts, both here and abroad, coming under stress as it becomes both more obvious and more urgent that we deal with unaffordable social benefits.

After watching Greek workers riot in the streets, and the French unions striking in protest over raising the retirement age to above 60, I was both chagrined and amused by a recent Blackstone-Byron Wien incident.  It seems that Byron, a respected Wall Street strategist now with the Blackstone organization, made a public statement about state and municipal retirement benefits being too high. Here is what he said:

“The retirement benefits for state workers, really not only in New York, California and New Jersey but throughout the country, are very generous, too generous……………… We literally can’t afford the benefits we have given our retirees in state and local governments and we have to change that.”

The problem is that Byron works for a firm that is a major manager of City of New York pension money. So the next scene was Blackstone’s management apologizing on bended knee to their client.

I cite these instances because they are forerunners of the immense controversy, political fighting, and nastiness that is coming.

It will not be confined to state and municipal pensions.  Social Security and Medicare tax revenues and benefits must also be modified.

Social Security, according to the report of The Senate Special Committee on Aging, can be “fixed”  by tweaking some combination of eligibility requirements, taxes, and benefits.  Such changes don’t appear to be very painful, and are conveniently outlined in the Senate Committee report on pages  12-15. But there seems to be no sense of urgency about doing anything.

A bigger problem is Medicare.

While the tax burden on Americans will be increasing to begin to address the problem, the sheer magnitude of the promised entitlements makes a solution solely based on taxation a practical impossibility. I admit to complete puzzlement and skepticism about the CBO’s conclusion that the healthcare legislation will actually shrink the deficit. The necessity of moving toward reduced and/or more tightly controlled benefits and means-based testing will be painfully obvious at some point. What a political circus that will be!

Some Comments on the Stock Market

The U.S. stock market has been range bound now for over seven months, responding to fluctuating degrees of optimism about the economy. Only two months ago I remember listening to the talking heads at CNBC who were slightly mocking the “new normal” outlook originated by PIMCO. At that point the economic news seemed to be all good, and some analysts were saying that we were in an “old normal”, robust variety of economic recovery.

I warned against that thinking, and it has now become painfully obvious that a robust recovery was just a fleeting mirage.

What has not been a mirage is corporate profits. The benefits from cost-cutting have been quite dramatic as volume, even though still well below pre-recession levels, has recovered from the depths of late 2008 and early 2009. The more optimistic analysts are now estimating 2010 S&P 500 earnings at $85-$90, and 2011 at over $100. If they are correct, and such earnings are sustainable, the stock market is historically quite inexpensive.  It’s important to recognize, however, that such estimates have often been too optimistic, so use them only with caution.  Here’s a chart covering the past 25 years to prove that:




If Stability Breeds Instability, What Does Instability Breed?

May 19, 2010

Okay, so all the financial engineering of the past 20 years didn’t add much to our stock of wealth did it? True, it was part of GDP and inflated many incomes in the financial sector But in the role that many, including Fed Chairman Greenspan, saw for it, that of spreading risk and creating greater financial and economic stability, it failed. It aided and abetted the creation of a huge bubble, than aggravated the pain of the inevitable bust.

Hyman Minsky, whose thesis was that long periods of economic stability would lead to instability created by the financial system was right and Greenspan was wrong. We now know that. But we’re not sure what the instability is leading us toward.

The knee jerk response is that it will create a lengthy period of risk aversion. The way the stock market has soared back, and bond spreads have calmed down seems to belie that. But the raised lending standards of banks, the relative absence of financially-motivated equity buyouts, low venture capital fund activity, and the avoidance of equity mutual funds by the investing public support the actuality of increased risk aversion in financial markets.

One novel and optimistic viewpoint revolves around the thought that we had a glimpse of what a depression looks like, and through prompt governmental reactions were able to avoid it. According to this view, this success in preventing economic disaster should minimize the lurking worry about economic depression that has hung over the markets since 1932. This view notes that during the 1950’s and 1960’s, as we conquered every recession, the valuation level of equity assets rose. Perhaps that will happen again, they say.

The fear of depression died gradually and only by the late 1960’s was it no longer significant. Then inflationary fears took over in the 1970’s and were conquered only slowly with some very big medicine. There followed the so-called Goldilocks economy…not too hot, not too cold, just right. The tech boom came along and became a bubble. But we overcame the dot.com bust that followed, then created the mother of all modern bubbles, in real estate. It was fed by easy credit, relaxed lending standards, and financial engineering that created securitization (which created anonymity between borrowers and lenders), CDO’s, CMO’s, and credit default swaps The latter became a huge side-bet market, similar to the side bets that are prevalent in a noisy game of craps. Just as you didn’t have to be the person rolling the dice to play, you didn’t have to own the bonds to bet for or against their default.

Then…Kazam!!…subprime mortgages became a problem and a possible depression was in front of us. Hey! Wow! Good reaction time team! Stimulus packages, easy money, many pieces of special legislation, prevent big failures……and to hell with the cost. Now that we know how to run that play let’s go on to the really big game!

Translated: Now that we have proved that we know how to conquer inflation and prevent depression the world is our oyster! Spend! Borrow and spend! Buy stocks! Speculate! Have some financial fun!

I don’t think this will happen, nor do I think it is a credible view. It lacks any reference to the continuing high cost of what we have done to avoid depression, namely our soaring debt with no plan to bring it under control. Financial markets are of true global scope, and with our federal debt increasingly held by foreigners, these markets will force the creation and execution of such a plan. We have just witnessed in Europe what financial markets can force politicians to do. Our politicians are not immune. Even California may be forced to do something! It’s enough to dampen the most optimistic scenarios.

Yes, ladies and gentlemen, significantly higher taxes are in your future. At every level, from local to federal. And they will be accompanied by inter-generational and ideological squabbles as we start to grapple with the unavoidable problems of entitlements. If you have been chagrined by the high degree of political and ideological turmoil in recent years, you ain’t seen nothin’ yet! All the while the baby boomers will be retiring, putting increased burdens on the younger population. (Europe’s demographics are much worse than ours, and Japan is out of sight.)

Just what kind of taxes will be imposed, while not irrelevant, is not our major concern, which is the increased tax load in general and its effect on growth. (My personal preference is a sizeable value added tax because it’s not subject to avoidance, is very efficiently collectible, and can be well-tailored to protect the most vulnerable populations.)

It’s not going to be a lot of fun. We will be seeing first-hand and in real time the conclusions of Professors Rogoff and Reinhart in their book, This Time is Different, to wit: countries that have debt to GDP ratios of 100% experience a reduction of their annual economic growth of about one percentage point. Yep. That’s where we will be very shortly, and that’s what is happening, even as I write this

By year-end 2010 we will be urgently seeking sustainable growth forces to take command of the economy. The effects of stimulus actions will be gone. Unemployment will still be high ………. and we have to raise taxes at all levels of government. Lousy timing.

Back to what it is that instability breeds, we can now see the true cost of avoiding financial collapse and depression. If the long-term trend growth of the developed world is 3%, and we may be pushing that by at least 0.5%, we have probably knocked off as much as full percentage point for some years to come. That’s big time stuff. As is the political infighting that comes from a combination of high unemployment and a lack of fiscal capacity to do anything about it.

Another outcome of instability is increased regulation. Our wonderful congress is very busy trying to fix the blame for letting the horses out of the barn before they do anything about closing the door. My personal view is that much needs to be done in securing better and more effective regulation of financial institutions. Banks should be prohibited from proprietary trading. Derivatives need to be standardized, derivatives trading should be on an exchange with the parties remaining anonymous to each other, hedge funds must be registered and forced to be transparent, credit and debit cards must be at reasonable cost, and we must have a super regulator whose job it is to continuously assess systemic risks.

A final thought on inflation and interest rates: this morning the core inflation rate was reported as zero, which means the Fed can keep interest rates low for some time to come. In my opinion, inflation is likely to remain dormant for a considerable period ahead. In fact, I believe that the so-called bond market vigilantes are a bigger threat to the bond market than inflation and Federal Reserve action. Europe is currently getting a taste of this, and unless we get our act together to reduce deficits we will too. Time is running out.

To summarize: the aftermath of instability will be that risk aversion will subside slowly, taxes will rise significantly, political turmoil will increase, and the intermediate-term economic growth rate will be frustratingly low. Not a confidence inspiring environment. Nor one in which returns to shareholders are likely to be high.


New Normal, New Mix, Rebalancing….Whatever

April 6, 2010

There are still some naysayers, but it is increasingly clear that the economy is slowly, lethargically, recovering from its worst period since the Great Depression. Many weak spots and vulnerabilities remain, but the direction of movement seems certain.

PIMCO has labeled it the “new normal”, others have called it the “new mix”, and The Economist, in the current issue, calls it a “rebalancing”.  All three labels are, in my opinion, apt descriptions. It seems inescapable that both the private economy and financial markets will be considerably less leveraged than in the decade preceding the recession and financial crisis.  That means that personal consumption will be tied more tightly to changes in disposable income and considerably less dependent on borrowing as an income supplement.

It also means we will have new drivers of growth.  These will be capital spending, particularly spending on infotech and telecom related equipment and software, and net exports.  At some point, not yet visible, growth will also be seen in residential construction, which, even if it rose by 50% would still be at a depressed level.  Even automobiles have some hope for an eventual recovery. Currently, auto sales have been at the annual rate of between 10 and 11 million, below the scrappage rate and far below the 16-17 million range of a few years ago

For those of us trying to make sense of the economy and financial markets there is a huge amount of sheer noise that can confuse the picture.  We are endlessly exposed to talking heads who anxiously await the next important set of statistics on jobs or retail sales or GDP and then call upon three or four experts to analyze the data instantly. Earnings results stream across the TV screen being instantly compared with “the estimates”.  At a time when being correct about the big picture is paramount, most of the stuff we see and hear is providing more obfuscation than clarity.

So, okay, what is the big picture?

Here is the broad economic/political context for the next two years as I see it:

Even though net job creation is likely to begin soon, the economy’s response to the huge monetary and fiscal stimuli has so far has not been adequate, particularly in a political sense. I have called it a “low quality recovery”. Private-domestic-final demand has simply not yet kicked in a substantial and sustainable way. Consumer income has become quite reliant on government transfer payments.  Financial markets are too accustomed to extremely low interest rates. Politicians are restless. But the mood of the electorate seems dead set against any further big fiscal stimulation.

Interest rates are certain to climb.  Even if the Federal Reserve is not vigilant as the economy recovers (I think they will be) and inflationary expectations begin to rise, the bond market will be standing guard and will react quickly.

The most cyclical parts of the economy (consumer durable goods, residential and commercial construction, and capital expenditures) are all extraordinarily depressed.  Together, these components currently have only an 18.5% share of GDP. Their average share for the past 50 years was about 24%, with cyclical peaks soaring to over 26%. An 18.5% share appears to be unsustainably low if the economy is to generate any significant growth.  Eventually, demand backlogs in these sectors will begin to grow, ultimately resulting in a somewhat faster and more sustainable growth pace by 2011-2012.

Conversely, personal consumption is at a record 71% share of GDP, higher than a year ago, and while the personal savings rate has risen from plus or minus zero to  over 3.0% it is still low by historical standards. Further consumer deleveraging would seem to be ahead of us. Spending will be tightly tied to growth of disposable income, largely unsupplemented by borrowing.

One phenomenon of the recession is worth noting. Imports acted like a big shock absorber to domestic economic activity.  That is, as domestic aggregate demand declined, imports fell substantially more than exports.  Both exports and imports peaked in the 3rd quarter of 2008. Net exports at the time were negative by $758 billion. By the 2nd quarter of 2009, net exports were negative by $339 billion, thus contributing a positive difference to GDP of $419 billion.  Over that same period, Gross Private Domestic Investment (construction, capital expenditures and inventory change) plummeted by $582 billion.  That’s where the decline in aggregate demand was centered. But the performance of net exports offset over 70% of that decline. Query: As the economy recovers will imports reverse course and increase faster than exports and thereby be growth limiting? The president, in his State of the Union speech, adopted an objective of doubling exports in 5 years. That’s 15% per year when global demand is likely to grow 5-6%, implying a huge gain in share of market. Can we really do this without devaluing the dollar?  I seriously doubt that we can reach the president’s objective, but I do think that we have a shot at growing exports faster than imports, especially if China becomes more realistic about the value of the yuan.

The question uppermost in the minds of investors concerns how and when the federal government can gain a credible degree of control over the budgetary process. Proceeding along the current path, camouflaging the problem with overly optimistic growth projections for the economy, and coming up with incremental solutions without a credible master plan will not be long tolerated by global financial markets. Longer-term, how will we deal with the unimaginably huge liabilities facing us over the next 20 years from Medicare and Social Security.  Currently, I see nothing that even remotely suggests that the political system has the will to face these problems.

Okay, so sizeable tax increases at the federal and state levels, are both necessary and inevitable. But tax hikes are growth dampeners.  Thus, we have a growth conundrum. How do we simultaneously get higher, sustainable growth along with higher taxes and higher interest rates? By late 2010 or early 2011 the economy, even as fiscal and monetary stimuli wind down, will begin to show some solid, sustainable growth possibilities.  But both higher interest rates and higher taxes will be growth limiting at the very time when higher growth is the best answer to the problems of debt and deficits. (The only other answer is to inflate)  We seem to have painted ourselves into the proverbial corner. It’s what happens when you treat the ills of an over- leveraged economy by increasing debt in excessive amounts.

Another important question has yet to be answered. How do we best put our financial system back in order? Do we have the political guts to overcome the Wall Street interests lobbying for no substantive change in the way the financial system is structured?  It may be true that the “Volcker Rule”, which would prohibit banks from engaging in proprietary trading, private equity, and hedge funds does not address directly what got us into the mess, but such activities are full of potential conflicts of interest and put the financial integrity of an entire enterprise at risk. And how about the badly needed standardization and regulation of derivatives and the way they are traded?  Such changes are absolutely crucial to creating confidence in the markets.

The brightest force in the mix for investors is the performance of corporate earnings.  As volume turns from negative to positive, the cost-cutting efforts of American companies are paying off big time.  Analysts who are better equipped than I to estimate earnings are forecasting S&P 500 earnings for 2010 in the range of $75-80.

In the table below are the operating earnings of the current constituents of the S&P 500, including estimates for 2010 and 2011.

S&P 500 Operating Earnings
(current constituents)
Operating Ex Energy &
Earnings Financials
2005 74.72 47.99
2006 86.71 53.01
2007 86.69 57.01
2008 67.52 54.27
2009 62.84 50.43
Est. 2010 78.93 58.44
Est. 2011 95.37 67.22

Source: BankAmerica Merrill Lynch

What I find quite remarkable is the earnings’ resistance to decline in the worst recession since the 1930’s. This is especially true if the earnings of the financials and energy are removed. Looking at these numbers it is hard to spot the recession.  This relative earnings stability for so much of corporate value is a legitimate reason for longer term confidence in earnings, and is a key reason for the sharp advance in stock valuations since last winter.

So There! Now you have no need to listen to the talking heads in the morning.  Just keep the Big Picture in mind.


Big Problems for the European Union (the rest of us are not immune)

February 15, 2010

Europe and the European Union have some very big problems.  These problems will almost certainly detract from the economic growth of Europe over the next few years and have some dampening effect on the rest of the world.

Attention has been focused on Greece, but other countries in the EU, namely Spain, Portugal, Ireland and Italy, are also suffering from debt loads that will make it difficult to generate satisfactory growth while, at the same time instituting fiscal austerity. Members of the European Union have pledged to constrain fiscal deficits to 3% of GDP and government debt to 60% of GDP.  Greece’s deficit is 13% of GDP and debt is 120% of GDP. The unemployment rate is 10.6%. Spain’s numbers are 11% and 66%, with an unemployment rate of 20%.

While Greece is in the most serious position by a considerable margin, all of the so-called PIIGS (Portugal, Italy, Ireland and Spain) have problems with the same basic roots.  When the European Monetary Union was created, they were admitted with currencies that were overvalued relative to the more northern countries, Germany in particular.

Let me quote John Mauldin’s latest letter, which has an articulate explanation of what has and is happening:

“That (the undervalued currency) meant that Greek consumers could buy products and services that previously may have been out of their reach. Plus, with government debt at low rates, the Greek government could borrow more to finance deficit spending, without the threat of higher interest rates. And Greece began to increase its debt with abandon.

Additionally, as it now turns out, Greece basically lied about its finances in order to gain admission to the union. It never complied with the fiscal discipline that was required for entrance.

With the high exchange rate, however, came the consequence of higher labor costs relative to, above all, Germany. While reviewing some economic facts about Greece, I came across the factoid that Greek workers had the second highest level of actual hours worked. But even with that, Greece was running a trade deficit that is currently 12.7% of its GDP.

And with the onset of the current recession, their fiscal deficit went from bad to worse. Their total debt is now €254 billion, and they need to finance another €64 billion this year, €30 billion of it in the next few months.

Bottom line, without some help or a bailout, they simply will not be able to borrow that money. And since a lot of that money is for “rollover” debt, that means a potential for default if they cannot borrow it.

European leaders said today that Greece will not be allowed to fail, hinting of a bailout. But there are a lot of “buts” and conditions.

Between Dire and Disastrous

While German Chancellor Merkel has indicated a willingness to help, the German finance minister and other politicians are suggesting German cooperation will either not be forthcoming or only be there at a very high price; and the price is a severe round of “austerity measures,” otherwise known as budget cuts. Greece is being told that it must cut its budget to an 8.7% deficit this year and down to 3% within three years.

For my American readers, let’s put that into perspective. That is the equivalent of a $560-billion-dollar US budget cut this year and another such cut next year. That would mean huge cuts in entitlements, Social Security, defense, education, wages, subsidies, and on and on. And repealing the Bush tax cuts? That would just be for starters. No “let’s freeze the budget” and try and grow our way out of it, as we effectively did in the ’90s, or gradually cutting the budget a few hundred billion a year while raising taxes. That combination of tax increases and budget cuts would guarantee a US recession. Unemployment, already high, would climb higher.

And yet, that is what the Greek government is being asked to do as the price for a bailout.

A few facts about Greece. Some 30% of its economy is underground, meaning it is not taxed. In a country of 10 million people, only 6 (!!!!) people filed tax returns showing in excess of €1 million in income. Yet over 50% of GDP is government spending, and Greece has one of the highest public employee levels as a percentage of population in Europe. And its unions are very powerful. Nearly all of them have gone on strike over this proposal.

A National Suicide Pact

Now, here is where it actually gets worse. If Greece bites the bullet and makes the budget cuts, that means that nominal GDP will decline by (at least) 4-5% over the next 3 years. And tax revenues will also decline, even with tax increases, meaning that it will take even further cuts, over and above the ones contemplated to get to that magic 3% fiscal deficit to GDP that is required by the Maastricht Treaty. Anyone care to vote for depression?

And add into the equation that borrowing another €100 billion (at a minimum) over the next few years, while in the midst of that recession, will only add to the already huge debt and interest costs. It all amounts to what my friend Marshall Auerback calls a “national suicide pact.”

Normally, a country in such a situation would allow its currency to devalue, which would make its relative labor costs go down. But Greece is in a currency union, and can’t devalue. Or it would restructure its debt (think Brady bonds) to try and resolve the problem.

The dire predicament is the one where Greece cuts its budgets and more or less willingly enters into a rather long and deep recession/depression. The disastrous predicament is where they do not make the cuts and are allowed to default. That means the government is plunged into a situation where it has to cut the entire deficit to what it can get in the form of taxes and fees, immediately. As in right now. And defaulting on the interest on the current bonds wouldn’t be enough, although it would help.

Why not just let Greece go under? Part of the argument has to do with moral hazard. If Germany bails out Greece, Ireland, which is actually making such cuts to its budget, can legitimately ask, “Why not us?” And will Portugal be next? And Spain is too big for even Germany to bail out. At almost 20% unemployment, Spain has severe problems. Its banks are in bad shape, with large amounts of overvalued real estate on their books (sound familiar?) and a government fiscal deficit of almost 10%. While Spanish authorities say they can work this out, deficits will remain high.

The fear is one of contagion. Some argue that Greece is only 2.7% of European GDP. But Bear Stearns held less than 2% of US banking assets, and look what happened.

I have been trading emails with Lisa Hintz of Moody’s, and she sent me the following note:

“It turns out from the BIS [Bank of International Settlements] numbers, that the largest holders of Greek debt are French, followed by the Swiss, although my guess is that a lot of that is hedged, and I don’t know that the BIS picks that up, and then the Germans. The numbers as of last June were France €86 billion, Switzerland €60bn, and Germany €44 billion. I have seen more recent numbers of France €73b, Switzerland €59b, and Germany €39b. In terms of GDP, for Germany it is minimal – just over 1%. Of more concern, for France it is nearly 3%, and for Belgium 2.5%. For Germany, the debts of Ireland, Portugal and Spain are much bigger problems. They may, however, worry that if there is a contagion, they will have to take marks on that debt. That would be a real problem – nearly 15x the size of the Greek issue.”

The recent credit crisis was over a few trillion in bad, mostly US, mortgage debts, with most of that at US banks. Greek debt is $350 billion, with about $270 billion of that spread among just three European countries and their banks. Make no mistake, a Greek default is another potential credit crisis in the making. As noted above, it is not just the writedown of Greek debt; it is the mark-to-market of other sovereign debt.

That would bankrupt the bulk of the European banking system, which is why it is unlikely to be allowed to happen. Just as the Fed (under Volker!) allowed US banks to mark up Latin American debt that had defaulted to its original loan value (and only slowly did they write it down; it took many years), I think the same thing will happen in Europe. Or the ECB will provide liquidity. Or there may be any of several other measures to keep things moving along. But real mark-to-market? Unlikely.

The entire EU is faced with no good choices. It is coming down to that moment of crisis predicted by Milton Friedman so many years ago. And there is no agreement on what to do.”

So Europe is not a pretty picture. It is difficult to imagine a painless solution that will preserve the  economic integrity of the EMU and the Euro. I have to believe that the growth of the entire region will be affected by the austerity budgets that must be instituted by the PIIGS. There will be increased labor strife, and bitter political fights, both internal and external.

The implications for investment portfolios?  Unless you think you are expert enough to navigate these waters you should be very cautious about having significant portfolio positions in European securities. Other parts of the world should be strongly preferred.

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Note: John Mauldin’s Thoughts from the Frontline, a weekly newsletter, is available at no cost.  Go to http://www.frontlinethoughts.com/subscribe.asp to subscribe.


Will We Deal With Our High Debt/GDP Ratio by Purposely Inflating?

January 15, 2010

Will we inflate away our soaring high federal debt to GDP ratio??

Some people have raised the possibility that we will simply inflate our way out of debt.  They say we have strong incentives to do so and they point to the years following World War II as an example of how we did it once before.

Joshua Aizenman of U.C Santa Cruz and Nancy Marian of Dartmouth published a timely paper on this subject in November entitled, Using Inflation to Erode the U.S. Public Debt. It’s worth your attention. This blog has used some of Aizenman’s and Marian’s data.

At the end of World War II, the ratio of publicly held debt to GDP was 108.6 percent.  Currently it is over 50% and is projected to reach 100% in ten years.

From 1946 to 1956, the ratio was reduced 40% by inflation alone.  The inflation rate over this period was 4.2%. Inflation turned bonds into certificates of confiscation.

Will this happen again?  Are the comparisons of the two periods valid?  My answers to these questions are “no” and “no”.

First, it needs to be said that the 4.2% inflation of 1946-1956 was not a conscious policy choice. As early as 1948-49 economists recognized that the Fed’s commitment to pegging the Treasury Bill rate at under 1% made the Fed “an engine of inflation”.  Monetary policy was rendered impotent by the pegging.  It was finally abandoned in 1951.

Also, the wage and price controls of the war years had suppressed prices.  When abandoned, prices rose very rapidly for a short period of time, and accounted for a significant part of the inflation of the first post-war decade

The average maturity of the debt in 1946 was 9.2 years.  It is now 3.9 years. Inflation does its nastiest work over extended time periods, so the shorter average maturity creates less incentive to inflate today than in 1946.

In 1946, an inconsequential amount of our public debt was held by foreigners. Today about 48% is held by foreigners; China and Japan account for 44% of that 48%.  One the one hand it is much easier politically to let inflation confiscate foreigners’ wealth than our own.  But, at the first whiff of inflation, foreign debt holders would act fast to protect the real value of their dollar holdings.  The dollar and financial markets would crash.

While Treasury Inflation Protected Securities (TIPS) certainly detract from the temptation to inflate the debt away, but only 7.5% of the debt is in TIPS.

In 1946 there was a huge backlog of demand for goods, created by both the depression and the war.  Additionally, there was a very low level of private debt, and an immense store of liquid savings available to activate that demand. The situation is quite different today.  The store of savings is low, and debt is high.  There is no great demand backlog.

Today, the Federal Reserve has considerable ability to become restrictive.  I believe that, if necessary, the Fed will consider fighting inflation a priority, even if it were to restrict economic growth.  For the time being, when we are operating the economy at well below capacity,  inflation is not going to happen, and the Fed will not face that kind of unpleasant choice.  But at some point in the decade, choosing between growth and inflation will be on the table.

There probably is some long-term rate of inflation that is compatible with reasonable economic growth, perhaps even necessary for growth. What that rate is is just a guess, but let’s say it’s 2%, and that any rate above that would be the result of either purposeful monetary policy or irresponsible fiscal choice at a time when excess capacity was no longer present.  (By the way, a 2% inflation rate raises the inflation index 22% in ten years and 4.2% raises it 51%.)

My conclusion?  Inflating away the debt load is not likely to tempt the Fed or Treasury.  But Congress is another story.  If they try it, either consciously or unconsciously, the markets would turn chaotic very quickly.  The dollar would collapse and interest rates would soar.  That’s why a credible plan to deal with the deficit is so crucial.


The Trend is Good, but its Speed is Not

January 9, 2010

The chart below is intriguing.  It was compiled by  Mark Zandi, a quite reputable economist at Moody’s economy.com.  I am not an econometrician, but I thought the major effect of the stimulus was later than indicated here, perhaps by as much as two calendar quarters.  If Zandi is correct, it means that the economy ex the stimulus was in even deeper trouble than we thought in the first nine months of 2009.

It also says loudly that the economy will increasingly have to make it more on its own as we travel through 2010.  That’s another argument in support of  weak, unsatisfactory growth ahead.

Where is the growth going to come from?  In my judgment it will come from the following (listed in order of magnitude): (1) a switch from inventory liquidation to inventory accumulation, (2) a slow but consistent rise in consumer spending, (3) an improvement in our trade balance, (4)a solid increase in corporate capital spending, primarily on info tech equipment and software, and (5) some improvement in residential construction from the current extremely depressed level.

Altogether, an educated guess would put real GDP growth from 4Q2009 to 4Q2010 at around 3%.  There will be some job growth, but not enough to reduce unemployment significantly if at all.  The 2010 Census will employ as many as 1.5 million short-term workers, then disappear.  By year-end 2010 we’ll be hard pressed to reduce unemployment significantly.

The best we can say now is that there is trend of improvement in place. It’s slow moving and will continue that way.  The 4Q 2009 GDP growth will look pretty good thanks to less negative numbers for inventories and net exports, but  it sure felt lousy.

Corporate earnings are expected to be up strongly in 2010 as higher volumes combine with reduced cost structures.  Wall Street expects earnings for the S&P 500 to be up 35-40%, to $75-$80, with the largest gains in materials and industrial companies.  The stock market has already registered it’s optimistic earnings expectations in substantially higher prices, resulting in a price-earnings ratio of 14-15.  Not cheap, but not very expensive IF the earnings expectations come true.

Lot’s of unanswered questions still out there. The Fed’s exit strategy strikes me as necessary to longer term confidence.  Investors need to have faith that the Fed has a strategy and understand what it’s main elements are.  The condition of the banking system is still questionable, given the weakness in commercial real estate, and the”shadow inventory” of houses, houses still owner-occupied, but with no mortgage payments being made and lenders hesitant to foreclose. And there is also a huge volume of mortgage resets coming this year, some substantial number of them being interest-only that will now have to begin repaying principal.

I would also mention oil prices as an important unknown.  A substantial increase in energy prices amounts to a large tax increase on consumers that, if it occurred, would hold back the recovery.

The chart below (from Contrary Investor) compares the stock market recovery of 2003-2004 to the recovery since March of 2009; over 50% then, and about 72% now.  Rather interesting to see how these recoveries followed about the same track.  (read 2003 on the left scale and 2009 on the right scale)

It’s also interesting to examine, as Contrary Investor did last week,  the contrast between the end points of the recoveries, year-end 2003, and year-end 2009.  Here are a few of the statistics:

2009         2003

Final Sales to Domestic Purchasers (yr to yr)

(3.5)          6.0

Industrial Production  (yr to yr)

(5.1)          2.1

Housing Starts

574k          2.06 mill

Disposable Personal Income (yr to yr)

1.4             5.9

Cap Goods Orders ex defense and aircraft

(10.2)       10.2


Extremely different environments, as you can see.  Earnings in 2003 had risen by about 17% and would rise another 25% in 2004. In 2009 earnings gained about 10% and are expected to rise 35-40% in 2010.  Stocks were entering a two-year flat period at the end of 2003.  It’s better than 50-50 that we are entering a similar flat period today, in my judgment, even if the current high earnings expectations are met.

SOME THOUGHTS ON VOLATILITY

I think most of us recognize that stocks, while rewarding over the long-term, carry a higher degree of risk than we might have thought prior to the financial crisis/recession.  In fact, after you look at the numbers below, documenting large market moves over the past 13 years (a very short period for true long-term investors such as endowments and pension funds, but a long period relative to an individual’s prime years of investing) you might well conclude that stocks are very, very risky.

MAJOR STOCK MARKET CHANGES 1996-2009

January 1996 to September 2000                                         +156.3%

September 2000 to  October 2002                                            -46.0%

January 2002 to October 2007                                                   +104.9%

October 2007 to March 2009                                                           -57.7%

March 2009 to January 2010                                                             +71.7%

Some person in the future, looking at this astoundingly volatile record, would ask what the hell was going on? Digging deeper he would see the bursting of two bubbles, the tech/dot.com bubble of the late 1990’s, and the housing bubble of 2003-2007.  He would also find that the U.S. economy grew at below trendline rates, despite an explosion of private and public debt, leading ultimately to a financial crisis, deleveraging,  a severe recession, and growth that was inadequate to prevent a chronic rise in unemployment.

This future researcher will, of course, know what follows, whereas we don’t.  Did we learn from this period how to make both the economy and the stock market safer and more stable? Or did we, after seeing how government policies were effective in preventing a depression, embark on the future with high confidence that ‘anything goes’, and return to using high leverage to play financial games again?