This is a post I just wrote over at Yves Smith’s site Naked Capitalism in response to a reader request. Marshall Auerback has already written a reply as well and I will post this later today.

A reader at Naked Capitalism asked us to respond to a recent article from the Christian Science Monitor asking Does US need a second stimulus to create jobs?

Marshall Auerback has already done some heavy lifting. He says emphatically yes. Now I want to take a crack at this. My short answer is no. But before I go into this, as an aside, I wanted to mention Marshall’s new smiling, happy picture up at the great blog New Deal 2.0 where he now writes.  Earlier, when Credit Writedowns was hosted at Blogger, he used a picture best described as a mug shot in his profile, but he has changed that one too (although he smiles there a little less). He thinks we haven’t noticed this sleight of hand.  Well I have! Once upon a time, Marshall wrote with a man I called all bearish, all the time this summer. Take a look at that post; you don’t see him smiling now do you? We have Lynn Parramore, New Deal 2.0’s editor to thank for making Marshall Auerback into an optimist.

Different policy choices

But all teasing aside, I do want to take the opposite side of this trade.  You see I too was a deficit hawk. And while I may have been backing fiscal stimulus, I have felt conflicted for doing so. Here’s how I see it. 

You have four options:

1. No stimulus. Let the chips fall where they may. Yves Smith calls this the ‘Mellonite liquidationist mode.’ The thinking here is that trying to avoid the inevitable bust only makes it that much larger. And the economic policies during recessions in 1991 and 2001 seem to bear that out. The Harding Recession of 1921 is commonly seen as gold standard response.
2. Monetary stimulus only. Quantitative easing mania. My understanding is this is what Ambrose Evans-Pritchard has been advocating.   The thinking here is that the flood of money and the low rates will eventually jump start the economy. No deficit spending needed.
3. Monetary and fiscal stimulus.  Full tilt Keynesian. This is the Krugman view. The thinking here is that one needs to credibly commit to higher inflation and close the output gap to avoid a deflationary spiral. If that is insufficient, then one needs to go full bore on fiscal stimulus aka deficit spending. And if that doesn’t work, subsidize jobs. The New Deal is commonly seen as the gold standard response.
4. Fiscal stimulus only. Deficit spending. I have been talking up this view. The thinking here is that we need to both close the output gap to prevent a deflationary spiral and revive private sector savings in order to promote deleveraging.

There is no magic bullet here.  We are living through a situation unique in time with few historical precedents. And there are a lot of competing ideas being tossed about. So policy makers are groping around, desperately seeking the holy grail of depression-busting economic policy.  In that regard, I don’t envy them. They are certainly going to make a lot of mistakes. It may seem at times that I don’t realize this given the harshness of my critiques, but I do.

Deficit hawks are misguided

However, there are some policies which could work and others which are flat out wrong.  One policy which is flat out wrong is the concept that we need to reduce deficit spending in order to avoid a double dip recession. This flies in the face of basic economics which says that more spending and less taxes equals greater demand and recovery/boom. More taxes and less spending equals less demand and recession/depression.

Now, it’s not as if we didn’t see this line of argument coming. As far back as November 2008, I heard the chatter (see my post here). So you knew this we-have-to-stop-or-we’ll be-bankrupt nonsense was coming. The problem is it’s just not true.  Here are a few data points:

• Private sector debt (incl. financial firms) was 292% of GDP as of Q2 but public sector debt (incl. state and local municipalities) was 67.2%. Who’s more indebted – the private sector by a factor of 4.
• Adding unfunded liabilities to any public debt number when talking about spiking treasury rates is inaccurate and artificially inflates the number. A lot of people do this to make the public debt scenario look worse. The issue at hand is whether a supply/demand imbalance in Treasury securities spikes interest rates. Unfunded liabilities have absolutely nothing to do with this.
• Cash and bonds are fungible. They are both obligations of the federal government to be repaid in full with a specific sum of fiat money. The Treasury could literally stop issuing government debt altogether and just start crediting accounts electronically to ‘fund’ its purchases. There is no operational constraint to government spending. The U.S. government is not going broke involuntarily. See my post here.

The real issue with deficits causing a double-dip has to do with inflation and overheating. If inflation increases because the economy begins to overheat, interest rates spike and the Fed raises rates to choke off inflation. That’s not going to happen any time soon – although it may be a problem down the line.  The issue at hand now is deflation not inflation. At least Morgan Stanley understands this when they take a deficit hawk position.

And as for the Chinese, they are not going to pull the plug on Treasuries unless they want to tank their export boom. The reason they must buy Treasuries is the dollar peg; they must re-invest in U.S.-based assets in order to prevent their currency from appreciating. This has caused a huge rise in their U.S. dollar reserves. If they changed the peg, their currency would almost certainly rise and this would choke off exports.

No more stimulus, just jobs

I have said my piece about the need for stimulus in the past. So I won’t repeat it here. If you are interested, see my December 2008 posts “Confessions of an Austrian economist,” “What does Mises say about trying to stimulate the economy out of recession,” and “A brief philosophical argument about the role of government.”

But, on the whole, I look at long-term deficits in a dubious light. There are practical constraints to deficit spending – and they lead to inflation, currency depreciation and lower standards of living. This is not national bankruptcy, but it is what Murray Rothbard called default by inflation and it makes you and me less well off.

This, of course, is over the long-run. In the short run, it is the spectre of a deflationary spiral we care about. Stimulus was important to stop this. I said in February that Obama was making a big mistake with his stimulus measures.

My view here is that Obama is forging a middle path that leads to a dead-end. The stimulus is not nearly enough by half to get the job done. The proposed deficit reduction measures for 2013 are outright scary as they risk repeating a mistake from the 1930s. And the banking sector and mortgage plans, both of which I failed to mention, are dubious half-measures as well. One needs to act aggressively and proactively or not at all.

If you are going to deficit spend you need to do it in a big way. You need to stop the deflationary spiral.  That means hitting the reset button by promoting private sector savings and deleveraging and purging all built-up malinvestments. The risk in addressing the situation this way, of course, is replacing the imperfect invisible hand of markets with the imperfect hand of politicians and legislative fiat.

This is a risk I no longer see as worth taking. I have bailout and deficit fatigue just like most Americans. It is abundantly clear that this Administration has absolutely zero intention of purging any malinvestment or promoting any deleveraging. All they want to do is continue business as usual and go back to the asset-based economy that caused this mess. This is why we have seen bailout after bailout coupled with easy money. It makes for record profits on Wall Street but it does nothing for the unemployed.

Moreover, the political process in the U.S. is such that any stimulus money will be diverted to pet projects and used to pay off political constituents. While this may increase aggregate demand, it does so at the risk of serious social unrest as the outrage will certainly spill over into populism.

So I say no to a second (third) stimulus package.  What the President needs to focus on is jobs. The reason Obama’s poll numbers are shrinking is because he now owns this economy.  And people are not benefitting from this fake recovery.  They are angry at the bailouts and distrustful of government – and with good reason.

Cut payroll taxes, subsidize job creation, divert some military spending to direct job creation by ending the foreign wars. But stop the madness.

Related posts:

• Japan does not demonstrate the failure of stimulus
• Don’t underestimate the power of printing money, part 2
• Inflation: The strategy that dare not state its name
• The inflation-deflation debate
• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”

Hat tip Rolfe Winkler.

Related posts:

• Steve Keen and the spectre of terminal debt
• Steve Keen: On the Edge with Max Keiser
• Bloomberg News is still after the Fed for more disclosure
• Dilbert on the asset-based economy
• What does Mises say about trying to stimulate the economy out of recession

Barack Obama has now come clean about his thinking on why his administration has decided to focus first on reducing the deficit and next on jobs. He fears a double-dip recession will occur if foreigners lose confidence in the U.S. dollar, causing interest rates to spike. 

This is nonsense and it demonstrates how much at odds Obama’s economic thinking is with reality. This is the clearest indication that the Obama Administration doesn’t understand how modern money works. In fact, by focusing on deficit reduction, he has increased the chances of a double dip instead of decreasing them.

If he wants to reduce deficits, knowing it will precipitate a double dip and would decrease malinvestment. Fine. That’s not my solution, but it is accurate view of the economics.

What Obama actually said

At issue is whether the federal government’s enormous debt burden in the U.S. could cause investors to lose confidence in the U.S. government and shun its debt.

In an interview on Fox News today, the President said the following:

I think it is important though to recognize that. If we keep on adding to the — Even in the midst of this recovery that at some point. People could lose confidence in the US economy in a way that could actually lead to a double dip recession.

Is this really true though?

How deficits really work

Think of an economy this way: the people in any economy buy goods and services from one another and from the outside. In any given time period, one person, one company or one group/sector might use credit in order to buy more goods and services than it makes in income. It’s like spending future income by using credit. This puts that individual, company or group/sector in deficit i.e. they have spent more money than they have earned. Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).

Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector.  Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus.  Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.

What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.

Scott Fullwiler has a good graph depicting how the private sector surplus/deficit moves in concert with the public sector deficit/surplus, the difference being the current account deficit:

We can look historically at how these sector financial balances have moved over time. Figure 2 shows how closely the private sector surplus and the government sector deficit have moved historically, which isn’t surprising given they are nearly the opposing sides of an accounting identity. The difference between them, more visible starting in the 1980s, is the current account balance.

Figure 2: Historical Behavior of Private Sector Surplus and Government Sector Deficit as a percent of GDP

Below, I am now providing figure three from Fullwiler’s post at reader request, as it shows the current account deficit as the missing link since the 1980s.

Unless the increasing current account deficit switches direction violently, this can only mean that reducing the government’s deficit reduces the private sector’s surplus. Net-net, the government’s decreased deficit spending will decrease savings in the private sector. And no deleveraging can occur if savings in the private sector are reduced.

Is that what we want? Reduced private savings means continued high private sector leverage. In the U.S., the private sector has much greater debt burdens relative to the size of the economy than the federal government does. You would think we want the private sector to reduce leverage more than the public sector.

Long-term deficit reduction

What I have suggested is long-term deficit reduction.  If the President is concerned about deficits as far as the eye can see, he might want to look at retiree healthcare costs.  In June I said:

Yesterday, I argued that the United States faced a policy dilemma in avoiding debt deflationary forces while maintaining fiscal prudence.  The reality is that President Obama faces political constraints in Washington right now in regards to budget deficits.  He is not likely to get another stimulus package through the Congress unless he can credibly demonstrate a longer-term deficit reduction outlook.  In my view, this necessarily means changes to Social Security and/or Medicare.

But, of course, President Obama is not going to do that because this would mean cutting Medicare benefits, a political loser.

This looks like Hoover more every day

The President just doesn’t seem to understand how the economy works frankly. Reducing deficits by cutting spending or raising taxes decreases aggregate demand. And it is a decrease in aggregate demand which would induce a double-dip recession. So, the President’s logic just doesn’t work.

But what about a strike on U.S. government debt?  As you probably surmised from the above, if the U.S. private sector is increasing its savings, there is automatically a greater domestic bid for U.S. treasury securities.  So, it is a misnomer to say the U.S. is dependent on foreigners, thinking that this must continue. If the private sector saves more, a larger percentage of government bonds will be bought with domestic savings. In Japan, interest rates did not spike when the government increased deficit spending for this very reason.

The only question we have to ask ourselves is whether we want to reduce debt by:

1. The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation. or;
2. The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.

As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:

• The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.

I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.

The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.

Obama: Debt Could Fuel ‘Double-Dip Recession’ – FOXNews.com

Related posts:

• Minsky: Turning neoclassical economics on its head
• The choice is between increasing or decreasing aggregate demand
• I am now moving from multi-year recovery to a double dip baseline
• Barack Obama as Herbert Hoover
• Japan does not demonstrate the failure of stimulus

This excerpt comes from the blog News from 1930 which gives us a day-to-day account of what was being reported in 1930 before the worst of the Great Depression hit.

“The unemployment situation in New York is critical. Unless it is speedily met, we face a winter of hunger and distress for families whose bread-earners are without work and without funds. The great majority of family men now unemployed are asking not for charity, but for a job. In the richest city of the world, where the vast majority are at work, it is unthinkable that anyone should be permitted to starve. The Emergency Employment Committee is composed of New York business and professional men, formed at the request of experienced welfare organizations of the city. It is raising funds which will be used by these organizations to give temporary work to heads of families and to relieve distress caused by unemployment without regard to race, creed, or color.” Followed by endorsement from Pres. Hoover and appeal for funds.

Sen. Smoot denies tariff is retarding business recovery, says it has saved thousands of jobs and helped maintain wages and preserve farm purchasing power; points out only one country has increased its tariff since US adopted revisions; says question now is whether tariff is high enough, not whether it is too high.

I find the parallels to present day frightening to say the least. Let’s hope for some serious divergence.

Related posts:

• Black humor on Wall Street circa 1930
• Unemployment: U-6 data versus the Great Depression
• Food insecurity: alternative measure of economic distress skyrockets
• “That’s what happens when a town full of broke people gets a whiff of free money”
• When is the next panic?

The US Department of Agriculture highlights how the United States in the last decade, despite increased aggregate wealth, slid back significantly in terms of food insecurity as measure of poverty. With everyone now focused on the unemployment situation, it bears noting that even before the downturn in the economy there had been a large surge in food insecurity nationwide.

The Guardian says:

Food insecurity – defined by the USDA as when "food intake … was reduced and their eating patterns were disrupted at times during the year because the household lacked money and other resources for food" – afflicted 14.6% of Americans in 2008. ie, some 50 million people were too poor to guarantee being able to put food on the table.

The table below, also from the Guardian, shows where food insecurity is highest. While much of the distress is concentrated in the South, there are plenty of states in the Southwest and West as well. Maine has the highest food insecurity in the Northeast.

My interpretation of the data goes to income inequality. I see this as evidence that the last decade of growth in the U.S. has not been beneficial for poorer Americans. However, I would go further in saying that the downturn in the U.S. and rising unemployment, bankruptcy and foreclosure in the middle class has made plain that the middle class has also been left behind. While distress amongst poorer Americans is plain from these numbers, the diminished position in the middle class was masked by a surge in debt. This was made plain only as a result of a drop in asset prices.

At present, U.S. policy makers are trying to make this problem go away by reflating an asset bubble, but continued high unemployment is the elephant in the room which higher asset prices can not make disappear.

As for the poor, a related Guardian article gets to the heart of things:

The report said 6.7 million people were defined as having "very low food security" because they regularly lacked sufficient to eat. Among them, 96% reported that the food they bought did not last until they had money to buy more. Nearly all said they could not afford to eat balanced meals. Although few reported that this was a permanent situation throughout the year, 88% said it had occurred in three or more months.

Nearly half reported losing weight because they did not have enough money to buy food.

The number of children living in households where there were shortages of food at times rose by nearly one-third to 17 million. The report says that most parents who did not get enough to eat ensured their offspring received sufficient food but that more than 1 million children still suffered outright hunger.

The worst affected states are in the south with Mississippi having the largest proportion of its population enduring shortages of food followed by Texas and Arkansas. More than half of those affected are minorities, principally black people and Hispanics.

Millions more Americans do not go hungry only because they are so poor they receive government food stamps or rely on handouts from food banks such as Feeding America. In some states, such as West Virginia, one in six of the population is on food stamps.

This is certainly the stuff of depressions more than V-shaped recoveries. The first Guardian article has links to the data for downloading.

Source

Hungry America: food insecurity, state by state – Guardian

Record numbers go hungry in the US – Guardian

Related posts:

• News from 17 November 1930: “we face a winter of hunger and distress”
• If you can’t afford food, steal it: lessons from Japan
• “That’s what happens when a town full of broke people gets a whiff of free money”
• Massive U.S. job loss of 598,000 in January
• 467,000 jobs lost in the U.S. in June 2009

The motivating factor?  this article in Politico:

President Barack Obama plans to announce in next year’s State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 – and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.

The president’s plan, which the officials said was under discussion before this month’s Democratic election setbacks, represents both a practical and a political calculation by this White House.

The article, while couched in the language of fiscal responsibility and political tactics, is really an ode to the likelihood of spending cuts, tax increases or both. I see tax increases and I will tell you why later. Either way, these measures will choke off aggregate demand, making a double dip a much more likely scenario.

Below is the associated video from Politico, talking about the political calculus.

Get ready for 1937 redux – it’s coming. I warned against this before Obama even took office. But, no one in the White House is listening.

From an article here on 20 November 2008:

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted…

Just as in the two previous periods of asset deflation, we are dealing with massive amounts of debt and leverage combined with severe declines in standards of living for average citizens. In both previous cases, government thought we were out of the woods and raised taxes in order to return to fiscal prudence. On both occasions, the result was a severe recession and stock market meltdown.

Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.

I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger.

Maybe the presence of so many Clinton Administration officials is skewing this Administration’s understanding of the magnitude of the problem facing us. I don’t know. But, the White House seems to think this IS the early 1990s and we are reliving a repeat of the Clinton days. It is clearly not.

I have a lot of sympathy for the Austrian school view, although I have grave misgivings due to the likelihood of geopolitical tension and civil unrest. John Mauldin simplifies the view in a recent post:

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

And Mauldin is right. Barack Obama is not focusing on deficits in order to “get all your pain at once." This is not a Libertarian solution. The President is trying to reduce the deficit to please deficit hawks, all while perpetuating the bailout culture we have become addicted to.  This is the Japanese solution and it will not work.

Witness recent comments from Arnold Kling, who is an Austrian school economist at George Mason:

In my view, the current Administration is pro-business and anti-market–the worst possible combination. By pro-business, I mean that it likes businesses that survive on the basis of subsidies and regulatory advantages.

Now, what I fail to understand is how the Administration believes it can cut the deficit and add stimulus. James Pethoukoukis, who writes in Reuters says we are likely to see more stimulus initiatives:

How much money are we talking about? Alec Phillips of Goldman Sachs calls $250 billion over three years a “conservative” estimate. And what might be in the bill? Look for more highway spending, more aid to state and local governments and some sort of business hiring tax credit.

The only way to both add stimulus and reduce the deficit is to increase taxes – on whom is the only question. Obviously, adding stimulus while increasing taxes sounds a lot like ‘tax and spend’ and opens the door to all manner of attacks from the right. This is a huge tactical error that will be both politically damaging and unlikely to actually stimulate the economy. I see this as a potentially catastrophic outcome for Democrats. It is all too predictable although Obama is rushing ahead with this even earlier than I suspected he would.

Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.

I understand the why of this i.e. the need to provide cover for moderate democrats in 2010. But the “tax and spend” onus during a period of weakness will have people talking about shifts to the left and Jimmy Carter’s presidency – both of which are poison to moderate Democrats.

If the Administration really wants to provide cover for Moderates, a payroll tax cut or a tax break for any firm that hires X % more employees will be more targeted to the jobs problem and will avoid both the more taxes and the more spending labels.

Donald Tsang is right; America is doing exactly what Japan did last time – not just on monetary policy but on fiscal policy too. It didn’t work for Japan and it won’t work for the United States either.

Sources

After spending binge, White House says it will focus on deficits – Politico

Obama eyes domestic spending freeze – AP

Related posts:

• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”
• Beware of deficit hawks
• The Great Depression II meme
• Japan does not demonstrate the failure of stimulus
• A brief philosophical argument about the role of government, stimulus and recession

Yesterday, Moody’s cut the outlook for the sovereign debt of Portugal and put Greece on negative watch for a downgrade, signaling growing concern over spiraling debts. Just as with Spain and Ireland which I discussed yesterday, Portugal and Greece are smaller countries within the Eurozone with large fiscal problems due to the recession. For example, the Wall Street Journal says that Greece expects a budget deficit of 12.5% of GDP this year – that’s more than 4 times larger than the limit set by the Maastricht treaty.

Bonds sold off on the news. The Wall Street Journal reports:

The news spooked investors in government bond markets. The yield spread between 10-year Greek government bonds and comparable German government bonds, or bunds, widened to 1.42 percentage points from 1.36 points. The impact was milder on Portuguese yield spreads, which widened to 0.56 point from 0.54 point against German bunds, because a possible downgrade appeared less imminent.

Moody’s said it hoped to complete the review process promptly, and within three months in the case of Greece. It added that it might keep Greece on a negative outlook even if it decides upon a downgrade.

Standard & Poor’s downgraded both Portugal and Greece in January, while Fitch downgraded Greece last week and revised its outlook on Portugal to negative in September.

And we should certainly expect these downgrades to continue. Back in January, when Portugal was downgraded, the spread to German Bunds moved out to a 12-year high of 146 bps. We are now only 4 beeps lower than that. So, that sounds bearish for their bonds. However, their is a silver lining as Peter Schaffrik of Commerzbank explains in the video below.  Bond investors are incredibly starved for yield and that means there is a good bid for these sovereign issues as they offer relatively more yield pickup than German Bunds.

On the other hand, Chris Wyllie of Iveagh says he is zero weight in bonds now because even these bonds and corporate issues simply do not have enough yield to make them attractive.

You should see this as further evidence that stocks are being artificially buoyed by an increased risk appetite driven by low interest rates.

Related posts:

• Spain can’t sell its bonds
• More trouble in the Baltics as S&P downgrades
• Treasury yields go below zero
• Baltics: Fitch downgrade and more downgrades to come
• Corporate defaults mean more hedge fund blow-ups

This is a post I wrote in response to an ongoing debate about financial crises, credit revulsion and deficit spending over at Naked Capitallism. See the four links in the first paragraph for the precursor articles.

DoctoRx, Rob Parenteau and Marshall Auerback have each written articles here to bring clarity to some issues I first raised at the beginning of the month in my post, “The recession is over but the depression has just begun.”

As I see it, the issue we are debating has to do with how the government responds when large debts in the private sector constrain demand for credit in the face of a severe economic shock and fall in aggregate demand. In short, if private sector debt levels are so high that a recession precipitates private sector credit revulsion, how should government respond?

Frankly, this question is as much philosophical and political as it is economic.  So I want to wait to answer it and first frame the monetary system in a way which reveals the political nature of the question. Afterwards, I hope it is apparent that there is no one answer to this question and that any society’s answer depends on and reveals its priorities as a people. I will try to make some concluding marks about government debts and taxes in a fiat currency system given the analysis Marshall’s post.

Money and the sectors of the economy

Money is a tool, a medium of exchange, which derives its value from its utility in allowing individuals in an economy to trade goods and services. It eliminates the need to barter and make direct exchanges of goods and services in order to trade. Think of any economy as a collection of individuals or groups which trade goods and services with each other and with the outside world in exchange for a money-value of those goods and services. Each transaction is an exchange of a good or service for a equivalent value amount of money.

So, in any country, the flow of goods and services should be a one for one mirror image of the money flows. Now, if you break an economy down into sectors like the government sector, the private sector, and the foreign sector, the same is also true. Two accounting identities flow from this.

• In any particular time period, the changes in both money value of goods and the changes in the financial balances must sum to zero.  As Rob, illustrated: Household FB + Business FB + Government FB + Foreign FB = 0
• One sector’s deficit is another sector’s surplus. Think of it this way, if you and I are the only ones in the economy. If I spend more than I earn in, say, one particular month to buy your goods and services, you must have spent less than you earned in that same month to buy my goods and services.

If you take Rob’s formula and combine the two sectors of households and businesses into one sector, the private sector, you are left with Private FB + Government FB + Foreign FB = 0. What this means is that in any given time period, the private sector financial balance is offset by the government and foreign sectors’ balance such that they all sum to zero.

Private sector debts and credit revulsion

Given the framework above, it should be clear that when the private sector has a net surplus, the government and foreign sectors must have a combined net deficit.

So what happens when the economy lapses into recession because of a financial crisis caused in large part by excessive leverage and debt?

The answer is credit revulsion, also known as deleveraging. And this is what we have just seen in the U.S. economy.  Credit revulsion means that the private sector (businesses and households) reduce or are forced to reduce their debt burdens. This change in behavior induces a net surplus in the private sector; the private sector increases savings.

I’m sure you know where this is going. If the private sector moves to a net surplus, the combined government/foreign sectors must axiomatically move to a deficit. 

A foreign sector deficit means that we are net exporting i.e. foreigners are buying more stuff from us than we are from them. We are talking money flows here not goods and service: more money coming in than going out (FB deficit) means fewer goods coming in than going out (current account surplus). Since the U.S. is not going to run a current account surplus, I am going to leave this out of the discussion to focus on the real issue: Government.

We can try and reduce private sector savings

So, the result for the U.S. of a private sector which is net saving is government deficits – this what naturally flows from a credit-revulsion induced private sector deleveraging. By saying this, I am stating fact, I am not making a political argument for or against deficit spending.

However, this is where the political/philosophical discussion starts. Two questions come to mind.

• Do we want the private sector to net save at this point in time?
• If so, do we want this savings to occur in an environment of more aggregate demand or less?

Policymakers today have answered no to the first question. They have said, “we do not like credit revulsion and our preferred policy choice is to work against it by reducing private-sector savings.” How do they do this? They lower interest rates in such a way that there is less incentive to save. Policymakers are in effect voting to continue the asset-based economic model.

But, there are several problems with this policy decision: it rewards debtors over savers, it prevents deleveraging from occurring, it creates asset bubbles, it keeps zombie companies and overcapacity alive, and it misallocates resources by artificially lengthening time preferences for money. In short, it is poor policy and it will end poorly as well.

Or we can maintain it and decide to either increase or decrease aggregate demand?

If you reject this policy path, you then have two options. In one, aggregate demand is reduced. In the other aggregate demand is increased.  Which option we choose, again, depends on politics.

In a July post, I outlined the choices. (Note the labels ‘surplus’ and ‘deficit’ should really be labeled ‘financial balance.’ For simplification the foreign sector isn’t depicted but one could assume it is aggregated with the government sector.):

In the Minsky world, the increase in net savings in the private sector and reduction of the current account deficit is axiomatic when the government is increasing deficits.  The point is that the private sector net saving and current account deficit must equal the government deficit.  So, when the combined private savings and current account deficit increases, the government’s financial balance must become more negative.

What this implies is this (diagram from Paul Krugman’s post with the unfortunate title “Deficits saved the world”):

To make the graph easier to follow we start with sector balances at zero i.e. where sector surplus/deficit equals zero for both the private sector including the current account deficit and for the government sector. And just to be clear, points above the line show private sector savings or public sector deficit.

1. We start where the red circle is.
2. When an economic shock hits which precipitates a massive deleveraging, the entire demand curve shifts to the left to a new lower GDP level, everything else being equal. Thus, deleveraging equals recession. And we now see the private sector curve hitting the public sector curve where the blue circle is. The private sector is now saving and the public sector is in deficit. That is where we are today.
3. However, to bring things back to neutral i.e. where sector surplus/deficit equals zero for both sectors, one could cut government spending dramatically.  That shifts the entire government curve to the red line on the left, leaving us where the green circle is: in a deep, deep depression. Krugman calls this the Great Depression outcome.

The cult of zero imbalances

In the depression post which kicked off this debate, I said “I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively.” Consider me a card-carrying member of the cult of zero imbalances. My preference is to see a neutral state where the sectors are balanced as the average long-term outcome. We may deviate from a zero imbalance state over the short-term, but we should be working toward it over the longer-term.

However, in the interim, what we want is to get back to that red circle in the chart and higher GDP and stay away from the green circle and lower GDP – also known as depression.  The difference between these two is government deficit spending.

Depressions are downward economic spirals. And when I invoke the term spiral, you should not be thinking of some stable equilibrium like the Great Moderation, Goldilocks economy, Nash equilibrium or some other close facsimile of economic Nirvana. You should be thinking war, famine and pestilence because those are the events which are historically associated with periods of high deflation and depression.

For me, the choice is clear.

The key is liquidation of overcapacity

While the picture I presented above represents a single point in time, what we want to know is how we get back to the green circle over time. In the depressionary example, we contract immediately and violently as aggregate demand is reduced in both the public and private sectors. The result is a liquidation of overcapacity and a depression. In the pro-growth example, aggregate demand is boosted by government spending whilst the private sector deleverages. In this scenario, liquidation of overcapacity also occurs if the government allows it to do so.

And this is the key: to the degree that government deficit spending is used as a vehicle for channeling funds to so-called systemically important businesses to prevent them from failing, we are merely kicking the can down the road. With the deleveraging, malinvestment must be purged for the economy to right itself on a sustainable growth path.

Government’s hidden debt?

That brings me to the last point: government debt. The first issue I want to address is unfunded liabilities.  This is something of great concern to many (including myself).  However, when we are talking about debt and credit, it is not particularly relevant. I mention this because of my statement in the original post:

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted.

A lot of people want to bolt the unfunded liabilities onto government debt to make the government’s debts appear larger than they actually are.  But when talking about the credit system, we have to be careful and distinguish between obligations and actual debt – related but different terms.

In a period of credit revulsion, the key issue is the overall credit in the system. At issue is a debtor’s inability to meet large existing obligations such that the debtor defaults, the obligation is written down, and the overall credit in the system contracts by the amount of capital that has been allocated to that writedown. The issue is credit writedowns and how they suck capital out of the system, reducing credit and leading to a potential deflationary spiral. It has absolutely nothing to do with unfunded obligations.

The governments unfunded liabilities for social security and healthcare are akin to General Motors’ unfunded pension liabilities. GM’s unfunded liabilities are germane to a credit crisis only to the degree they flow through the income statement and, thus, require credit financing in real time.

Government and its money

The difference between GM and the federal government is vast, however. General Motors is a private organization which must fund its obligations by selling products.  To quote Ben Bernanke’s now infamous words:

the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

The U.S. government has monopoly control of the currency and no other entity can print money as a medium of exchange in the United States (see my post “The origin of the U.S. dollar as legal tender and its link to Depression” for how this came to be.)  When anyone else attempts to print money, it is called counterfeiting. In saying this, I am stating fact, I am not making a political argument for or against legal tender laws.

This is a problem for states – which cannot print their own money – and for Eurozone countries – which also cannot print their own money (as I laid out in my post, “Depressionary bust in Ireland is echoed in California”) – but it is not a problem for the U.S. government. If the U.S. government so chooses, it can ‘fund’ any purchase with additional money it prints. It is not constrained in the same way private sector actors or even states and local municipalities are.

It is disingenuous for economic pundits like Marc Faber to suggest the U.S. is going to go bust. The United States will not literally be declared insolvent as long as it issues debt in its own currency. Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.  

Inflation is another issue altogether.  When the economy is operating at potential, money printing leads to consumer price inflation. But this is not the case right now, there is an enormous output gap that is not going to be closed anytime soon.  So the government can print all the money it wants and buy all the Treasuries it wants; none of this will lead to consumer price inflation in the short run except via dollar depreciation and import prices. Again, I have to remind you that in saying this, I am stating fact, I am not making a political argument for or against quantitative easing.

I should point out that the output gap is why money printing is leading to an asset price bubble both in the U.S. and globally and one reason we should reject QE even in the absence of consumer price inflation.

I hope this post adds to the debate Marshall, Rob, and DoctoRx have taken on.

Related posts:

• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”
• Minsky: Turning neoclassical economics on its head
• Will Asia’s downturn be worse than America’s?
• Japan does not demonstrate the failure of stimulus
• What are the consequences of the huge U.S. deficit?

We received word today from the British government that GDP in the UK contracted for a record sixth quarter in Q3 2009. I like Neil Hume’s headline on this one, “GDP shock flop.”  If you were listening to the

BBC’s Wake Up to Money

Bloomberg puts the right spin on things:

Britain’s failure to escape the worst recession since World War II may force the Bank of England to increase its bond-purchase plan next month, economists said.

Seven months after Governor Mervyn King’s central bank started a 175 billion-pound ($287 billion) program to rescue the economy, the Office for National Statistics said today gross domestic product unexpectedly shrank 0.4 percent in the third quarter. None of the 33 economists surveyed by Bloomberg predicted a contraction.

“Having pumped in so much money and still seeing a decline in GDP is damaging from a perspective of confidence and expectations for recovery,” said Stephen King, chief global economist at HSBC Holdings Plc, in an interview with Bloomberg Television today. “They’ll be thinking very hard about whether to extend quantitative easing. They need to do something to show they care about the economy.”

Britain is still mired in recession even after pledges of about one trillion pounds in stimulus and banking aid from the Bank of England and Prime Minister Gordon Brown. King, whose push to expand bond purchases to 200 billion pounds in August was defeated, may win more support at the next Bank of England decision on Nov. 5.

The yield on the two-year gilt declined 6 basis points to 0.88 percent after the GDP report. The 10-year gilt yield slipped 3 basis points to 3.67 percent.

I would add that Sterling is getting crushed in the foreign exchange market – even against a weak US Dollar.

So, riddle me this: if the economy is so bad, why are house prices in London at an all-time high?  The explanation I came up with on Monday was that this is the natural  response to easy money when the economy has a large output gap – namely asset price inflation.  And this is certainly helping to pad bonuses in the City of London, a contributing factor to the increase in residential property prices in London.

Meanwhile, in the rest of Britain, the only thing keeping the country from economic freefall is budget-busting government stimulus. The Telegraph’s Angela Monaghan has a good article out today showing the emergency measures still in place including record low interest rates, quantitative easing, sales tax cuts, and the car scrappage scheme, not to mention the government’s backstops in the financial services industry. Where this leads is anyone’s guess at this point.

What should be clear, however, is that now is not a good time to tout a need for people to “tolerate the inequality as a way to achieve greater prosperity for all” as Lord Griffiths has done. He only brings greater scrutiny onto the financial sector. I found this statement particularly unconvincing:

I believe that we should be thinking about the medium-term common good, not the short-term common good … We should not, therefore, be ashamed of offering compensation in an internationally competitive market which ensures the bank businesses here and employs British people

This is an argument for good times, not recession – and even then one must question whether large bonuses in the financial sector are truly in the medium-term common good.

Related posts:

• London house prices at an all-time high
• Random Musing: London house prices
• French economy contracted in Q2
• Recession ‘95% likely’ in Britain
• Recession nears in New Zealand

There is an enormous dichotomy in foreign exchange markets that has wide-ranging implications for the global economy.  In Europe, most currencies float freely against the U.S. dollar. In Asia and the Mideast, most do not.

What this has meant in practice is two things. First, as the U.S. dollar has weakened, it has done so only against those currencies which are free floating. This has meant the lion’s share of any adjustments in global imbalances have fallen on the likes of Japan and Germany. Second, those countries which are pegged have had to resort to currency intervention and a massive build-up of foreign reserves to stop their currencies from appreciating.  This is inflationary for those countries, and is one reason there is a housing and equities boom in Asia right now.

But, as the dollar continues to weaken, those countries with pegs will be under pressure to drop their peg or to revalue their pegs higher.  The Bloomberg video linked below explains. The dichotomy whereby the adjustment process is done only through free-floating currencies is inherently unstable – and invites a nationalistic response.

A busted peg in any major U.S. trading partner’s currency is likely to have a very negative psychological impact on currency markets and severe knock-on effects.  These are what I call digital events.  It’s all or nothing, on or off. Either the peg is revalued enormously or there will be continuing pressure.

As an example, look back to 1998 when the Russians attempted to devalue the ruble.  The immediate effect was a sense that the ruble was not devalued enough, leading to an all-out assault on the currency and a much more massive devaluation which in turn triggered default.

I would anticipate a similar albeit less pronounced dynamic were the Chinese or the Saudis to revalue significantly.  There would be tremendous downward pressure on the greenback globally, more pressure on the busted pegs and increasing pressure on other pegged currencies to revalue. The result, of course, would be higher interest rates in the United States and a likely double dip.

Busted pegs are not something I necessarily expect. However, this is the type of exogenous shock that is a clear downside risk to my more benign muddle through baseline scenario – and one reason to prefer gold over bonds in reducing exposure to equities.

Currencies Pegged to Dollar May Abandon Greenback: Video – You Tube

Related posts:

• The dollar is rising against floating currencies
• The Big Mac Index
• The Dollar
• Is the Fed just jawboning?
• U.S. Dollar: Cliff Diving Again

Last year at this time I posted “The Economy’s Four Horsemen,” which described macro cause and effect leading into and out of recessions.  When looking at income, spending, output and employment, it is income which is the steer variable going into a downturn.  Year-on-year changes in income precede changes in spending, output, employment and recession. So, in order to gauge what is likely to occur in any business cycle downturn and plan your business spending accordingly, you need to know what is happening to personal income.

To get a grip on this, I am going to look back at prior monthly data series on personal income dating to 1929.  What I am looking for is to pinpoint when in the economic cycle the change in personal income reverses course and whether this presages recoveries as well as recessions.

Here goes.

(click on image to enlarge)

*Note on data: I am using a six month average of the year-on-year change in inflation-adjusted personal income.

Top in personal income growth precedes recession. What I found is that a downturn in the change in personal income almost always precedes recession – and often by a large margin.  This proves that an individual business could look at the data on personal income and get a hint of an impending downturn – and react accordingly.

War used to stoke domestic income growth. There were a few false tops, however.  Most of them were war-related. For example, during World War II, there was a false top in 1941. But, by mid-1942, wartime production caused a renewed boom in personal income. the lag between the false top of Sep 1941 and the renewed turn in Jun 1942 was pretty significant. But, this was a clear aberration. As were the false tops in Dec 1950 associated with the Korean War and the ones in Feb 1966 and Nov 1968 associated with the Vietnam War. It seems post-depression, the ginning up of the military industrial complex was a significant factor in preventing economic bust.

Near-recessions in the mid-1970s and 1980s. After the Wars, a mid-1970s and mid-1980s dip were evident as well. However, in neither case did the change in inflation-adjusted personal income go negative.  Think of these as almost-recessions.  The markets went lower as well. In the mid-1970s, the near-recession personal income trough came in Jul 1977. The Dow peaked in Dec 1976 and kept falling until Feb 1978. In the mid-1980s, the numbers hit a trough of 1.9% in September 1987 when the stock market crashed. There were relapses in 1993 and 1996 as well. But, markets did not fall.

Recovery seems to precede uptick in income growth. While incomes suffer before recession on the way to recession, they lag on the way out, making recessions that much more painful. (See chart above). An increase in the change in personal income does not presage recovery.

Income-less recoveries in 1991, 2001, and 2009.  In each of the last three recessions, average year-on-year real income changes were negative. It is still negative now (-2.6% year-on-year, –2.5% average year-on-year, and –1.3% year-on-year adjusted for inflation).

So what does this say about the current cycle?

There are no false bottoms in the real income data. So,the data suggest that we are in recovery (maximum decline in personal income was November 2008), but that we are still in a very weak period in which a double dip is possible (average real personal income change is still –1.3%). Also, average real personal income losses have been less than they were in 1980 when we were in the first dip of the last double dip recession – one benefit of not having high inflation.

As far as I can ascertain, the data don’t really reveal any patterns between the stock market and personal income.

Related posts:

• Do the personal income data demonstrate unbalanced reflation?
• US personal income data for September shows pullback
• Why the personal consumption data is important to the stock market
• Recession: How Long and How Deep?
• Data on past consumer deleveraging during recessions

Marshall Auerback here.  I want to add a few thoughts on the situation in Latvia which Ed has highlighted on several occasions. His allusion to Argentina to describe the situation in the Baltics last July was on the money. I have a solution here out of the Argentine playbook.

In Latvia, the neo-liberal insanity continues.  The EU and IMF have told the government to borrow foreign currency to stabilize the exchange rate to help real estate debtors pay the foreign-currency mortgages taken out from Swedish and other banks to fuel its property bubble, raise taxes, and sharply cut back public spending on education, health care and other basic needs to “absorb” income. Higher taxes are to lower import demand and also domestic prices, as if this automatically will make output more competitive in export markets.

But Latvia doesn’t produce much to export. The Baltic States have not put in place much production capacity since gaining independence in 1991. Latvia, like other post-Soviet economies, has scant domestic output to export. Industry throughout the former Soviet Union was torn up and scrapped in the 1990s. (Welcome to victorious finance capitalism, Western-style.) What they had was real estate and public infrastructure free of debt – and hence, available to be pledged as collateral for loans to finance their imports. Ever since its independence from Russia in 1991, Latvia has paid for its imported consumer goods and other purchases by borrowing mortgage credit in foreign currency from Scandinavian and other banks. The effect has been one of the world’s biggest property bubbles – in an economy with no means of breaking even except by loading down its real estate with more and more debt. In practice the loans took the form of mortgage borrowing from foreign banks to finance a real estate bubble – and their import dependency on foreign suppliers.

So instead of helping it and other post-Soviet nations develop self-reliant economies, the West has viewed them as economic oysters to be broken up to indebt them in order to extract interest charges and capital gains, leaving them empty shells.

The sad part about this whole episode is that Latvia’s problems could be fixed over a weekend. Here’s what I would do:

1. Drop the peg to the euro, which functionally acts like an gold standard external constraint.
2. Don’t answer the phone when the foreign creditors call the government.
3. Have the banks declared insolvent, convert their external debt to equity, and then have them reopen that way on Monday with full deposit insurance guaranteed in the now free floating local currency.
4. Enact a 0% rate policy (use fiscal policy to regulate demand going forward).
5. Offer a local currency minimum wage job that includes healthcare to anyone willing and able to work as was done in Argentina after the Kirchner regime repudiated the IMF’s toxic package of debt repayment.

Full employment and economic prosperity would come in no time at all.

The last line is the key.  Improve employment and aggregate incomes and demand follows – as does creditWORTHINESS.  At the final stage, credit will follow.

Even a banker can figure that one out.

Related posts:

• China is set up for a big fall
• China issues bonds to “promote the RMB in neighbouring countries”
• Bloomberg talks Eastern Europe as Latvia downgraded
• Latvia as the new Argentina redux
• China can handle collapse of speculative inflows

I found the recent consumer credit data unsatisfying because the data seemed to point in two directions. The seasonally-adjusted data showed a large $12 billion decrease in consumer credit which received headlines. Meanwhile, the non-seasonally adjusted data showed a large $7 billion increase in consumer credit. I suspect this divergence has a lot to do with cash-for-clunkers (post here), but we can’t be 100% sure until we get another month or two of data.

Let’s delve into this issue a bit more because we are at  a critical stage in the economy right now. A lot of pundits are talking about a V-shaped recovery, while others are pointing to a secular move toward consumer deleveraging which basically spells no recovery.

I am somewhere in between, believing we will get a weak recovery that could or could not last more than a couple of years depending on the path of consumer deleveraging. While I do believe the U.S. economy is fast approaching ‘terminal debt,’ I am not convinced we are there in this particular cycle, largely due to the massive stimulus and easing. The posts which best outline this view are two recent ones, “The recession is over but the depression has just begun” and “A brief look at the Asset-Based Economy at economic turns.”

So, here are my questions on consumer credit:

• What happened to consumer credit in past downturns? 
• Specifically, how much did it decline from peak to trough?
• Was the decline mirrored by a similar fall in output as measured by nominal GDP?
• Is the pattern this time around any different?
• And what does that say about the thesis of secular deleveraging?

The way I am going to attack these questions is by looking at past recessions and peak-to-trough declines in both nominal GDP and consumer credit (note: the credit series is monthly, but the GDP series is quarterly – and I am leaving out the recessions in 1945 and 1949 because of wartime anomalies).  Here goes.

1953-54

• GDP declined 1.8% peak to trough. Consumer Credit declined 1.6%. It took 8 months to hit the previous credit peak.

1957-58

• GDP declined 2.7% while credit declined 1.6% from January to June of 1968.It took 11 months to hit the previous credit peak.

1960-61

• GDP declined 1.0% and credit also declined 1.0%.It took 8 months to hit the previous credit peak

1970

• Nominal GDP did not decline due to inflation. Credit did decline from October to November 1970 by 0.2% however.It took 2 months to hit the previous credit peak.

1973-75

• Again inflation meant nominal GDP did not decline. Meanwhile credit declined 1.8% from September 1974 to June 1975.It took 13 months to hit the previous credit peak.

1980

• Again inflation meant nominal GDP did not decline. Meanwhile credit declined 1.8% from February to June 1980.It took 12 months to hit the previous credit peak

1982.

• GDP declined 0.3% and credit also declined 0.1%.It took 2 months to hit the previous credit peak.

1990-91

• Inflation meant nominal GDP nearly did not decline (down –0.08%). Meanwhile credit declined 2.0% from November 1990 to well past the recession’s end in June 1992. It took an enormous 27 months to hit the previous credit peak. This was the worst credit cycle to date.

2001

• We cruised through this recession with neither a decline in nominal GDP or credit.

2007-2009

• GDP declined 2.7% and credit has already declined a massive 4.6%. This is the largest decline in consumer credit to date.

The table of data looks like this:

I draw the following conclusions :

• In an economic downturn, consumer credit has generally declined more than nominal GDP.
• The 1990-91 recession saw a very drawn out drop in credit and easily generated the longest time before credit regained its previous peak.
• The 2001 recession was unusual mild as it was the only time in the last 56 years that the U.S. has experienced a recession without a drop in consumer credit.
• The 2007-2009 recession has been unusually severe. The drop in nominal GDP is the largest in the last 56 years. However, the drop in consumer credit has been even worse at more than twice the largest previous decline.

None of this necessarily helps me decipher whether we are in a secular deleveraging cycle. But, the severity of the fall-off in consumer credit relative to output may point in this direction.

Related posts:

• Consumer credit down, but does it show deleveraging?
• Consumer credit falls 4.4% from year ago levels
• Unemployment claims falling faster than in half of past recessions
• Why is everyone saying consumer credit is falling? It’s not.
• Jobless claims rise slightly, weakness remains

Here’s the joke of the day via Steve Keen:

Ten reasons the economy is so bad (I suggest this as a top ten for David Letterman?):

• #10: I got a pre-declined credit card in the mail.
• #9: I ordered a burger at McDonalds and the kid behind the counter asked, “Can you afford fries with that?”
• #8: CEO’s are now playing miniature golf.
• #7: if the bank returns your check marked “Insufficient Funds,” you call them and ask if they meant you or them.
• #6: Hot Wheels and Matchbox stocks are trading higher than GM. [this one is true]
• #5: McDonalds is selling the 1/4 ouncer.
• #4: parents in Beverly Hills have fired their nannies and learnt their children’s names.
• #3: a truckload of Americans was caught sneaking into Mexico. [this one’s actually true too ]
• #2:  Dick Cheney took his stockbroker hunting.

And finally, drum roll please, the #1 reason you know the economy is bad is:

Bernie Madoff, the guy who made $50 Billion disappear, is being investigated by Congress, the people who made $1.5 Trillion disappear!

Related posts:

• All your bank are belong to us
• Black humor on Wall Street circa 1930
• Bank of Canada blames Geithner for financial mess
• A bearish view on Eastern Europe
• Through a glass darkly: the economy and confirmation bias in the econoblogosphere

The banks have been the ones benefitting most from free money via the Federal Government and U.S. taxpayers.  Given 9.8% base unemployment and 17.0% comprehensive unemployment, it is a bit galling for ordinary Americans that these same institutions are making record profits and poised to hand out record bonuses. Detroit is one of the hardest hit cities with the base rate of unemployment a depression-era 17.1% that is the highest in the nation. People who have watched corporations hoover up the handouts are desperate for some relief.  They are finally getting some (hat tip Andrew):

Thousands hoping to get applications for federal help on rent and utility bills turned Cobo Center into a chaotic scene today.

They came by foot, wheelchair, bicycle and car. About six left by ambulance after tensions rose and people were trampled, according to a paramedic on the scene. One unfortunate soul got his car booted.

Detroiters were trying to pick up 5,000 federal assistance applications from the city at Cobo because Detroit received nearly $15.2 million in federal dollars under the Homeless Prevention and Rapid Re-Housing Program, which is for temporary financial assistance and housing services to individuals and families who are homeless, or who would be homeless without this help.

People in wheelchairs and others using canes were being leaned on by people too weak to stand. Emergency medical technicians on the scene said they treated applicants who were injured during the rush to get inside the venue.

That’s what happens when a town full of broke people gets a whiff of free money, said Walter Williams, 51, who came before the sun to get an application and a shot at some federal assistance.

"This morning, I seen the curtain pulled back on the misery," he said. "People fighting over a line. People threatening to shoot each other. Is this what we’ve come to?"…

Yes, this is what we’ve come to.

Response had been so great that Detroit police and fire officials considered shutting down the process because of the volume of people.

Kelley Turcotte, a Detroit dishwasher, was near the end of the line around 10:30 a.m. today. The 27-year-old just had a son and said he is only squeaking by on his bills.

"I hope the government sees this and realizes the city needs a lot more help than they are giving," Turcotte said…

"This absolutely is representative of the struggling middle class in America," he said. "We’ve been betrayed by the government, Realtors and those who’ve got. The promise has been broken."

And you’re telling me this is not a depression?

Source

Chaos at Cobo: Detroiters turn out for federal help – Detroit News

Related posts:

• Paulson is handing out free money like candy to a baby
• GM and Chrysler to get more bailout money
• Volkswagen: if the American carmakers can get bailout funds, so can we
• Ten eastern European countries now looking to IMF for bailouts
• GM looks to use US and Canadian tax money to bailout Opel

For the last few months I have been casting around looking for bullish data points as counterfactuals to my more bearish long-term outlook. I have found some, but not enough. If you recall, early this year, I stated that we are in depression, making the case for the ongoing downturn as a depression with a small ‘d.’ Nevertheless, I was quite optimistic about the ability of policymakers to engineer a fake recovery predicated on stimulus and asset price reflation and I certainly saw this as bullish for financial shares if not the broader stock market. But, I saw these events as temporary salves for a deeper structural problem.

As a result, I have been on a quest to find data which disproves my original thesis – signs that the green shoots that everyone keeps talking about (and a term I had banned from my site) are part of a sustainable economic recovery. Unfortunately, I have concluded that they are not. This post will discuss why we are in a depression, not a recession and what this means about likely future economic and investing paths. I will try to pull together a number of threads from previous posts, add some context via Wikipedia links and draw in some good discussion via recent posts by Prieur du Plessis on balance sheet recessions and Marshall Auerback on the sector financial balances model of economics which completed the picture for me.

This post is very long and I have had to shorten it in order to pull all of the ideas into one post. Please do read the linked posts for background as I left out some of the detail in order to create this narrative.

Let’s start here then with the crux of the issue: debt.

Deep recession rooted in structural issues

Back in my very first post in March of 2008, I said that the U.S. was already in a recession, the only question being how deep and how long – a question I answered in the next post saying “we are definitely in recession. And according to Gary Shilling, this recession is going to be a big one. Worse than 2001, 1990-91 or the double dip recession of 1980-82.” This has certainly turned out to be true.  The issue was and still is overconsumption i.e. levels of consumption supported only by increase in debt levels and not by future earnings. This is the core of our problem – debt.

I see the debt problem as an outgrowth of pro-growth, anti-recession macroeconomic policy which developed as a reaction to the trauma of the lost decade in the U.S. and the U.K.. This was a period of low growth, high inflation and poor market returns, in which the U.K. became the sick man of Europe and labor strife brought that economy to its knees.  It is a period that saw the resignation of an American President and the humiliation of the Iran Hostage Crisis.

In essence, after the inflationary outcome that many saw as an outgrowth of the Samuelson-Keynesianism of the 1960s and 1970s, the Reagan-Thatcher era of the 1990s ushered in a more ‘free-market’ orientation in macroeconomic policy. The key issue was government intervention. Policy makers following Samuelson (more so than Keynes himself) have stressed the positive effect of government intervention, pointing to the Great Depression as animus, and the New Deal, and World War II as proof. Other economists (notably Milton Friedman, and later Robert Lucas) have stressed the primacy of markets, pointing to the end of Bretton Woods, the Nixon Shock and stagflation as counterfactuals. They point to the Great Moderation and secular bull market of 1982-2000 as proof. This is a divisive and extremely political issue, in which the two sides have been labelled Freshwater and Saltwater economists (see my post “Freshwater versus saltwater circa 1988”).

However, just as the policy of the 1950s to the 1970s was not really Keynesian (read Keynes’ General Theory as Richard Posner did and you will see why), the 1980s-2000 was not really an era of true ‘free markets.’ I call it deregulation as crony capitalism.  What this has meant in practice is that the well-connected, particularly in the financial services industry, have won out over the middle classes (a view I take up in “A populist interpretation of the latest boom-bust cycle”). In fact, hourly earnings peaked over 35 years ago in the United States when adjusting for inflation.

Remember, the 1970s was a difficult period in which the U.K. and the U.S. saw jobs vanish in key industrial sectors. To stop the rot and effectively mask the lack of income growth by average workers, a new engine of growth had to be found. Enter the financial sector. The financialization of the American and British economies began in the 1980s, greatly increasing the size and impact of the financial sector (see Kevin Phillips’ book “Bad Money”). The result was an enormous increase in debt, especially in the financial sector.

This debt problem was made manifest repeatedly during financial crises of the era. Not all of these crises were American – most were abroad and merely facilitated by an increase in credit, liquidity, and international capital movement. In March 2008, I wrote in my third post on the US economy in 2008:

From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.

Eventually, the debt burdens became too large and resulted in the housing meltdown and the concomitant collapse of the financial sector, a looming problem that our policymakers should have seen. This is why my blog is named Credit Writedowns. But, make no mistake, the housing and writedown problems are only symptoms. The real problem is the debt – specifically an overly indebted private sector (note the phrase ‘private sector’ as I will return to this topic).

This is a depression, not a recession

When debt is the real issue underlying an economic downturn, the result is a period of stagnation and short business cycles as we have seen in Japan over the last two decades.  This is what a modern-day depression looks like – a series of W’s where uneven economic growth is punctuated by fits of recession. A recession is merely a period of recalibration after businesses get ahead of themselves by overestimating consumption demand and are then forced to cut back by making staff redundant, paring back inventories and cutting capacity. Recessions can be overcome with the help of automatic stabilzers like unemployment insurance to cushion the blow. Depression is another event entirely. Back in February, I highlighted a blurb from David Rosenberg which summed up the differences between recession and depression quite well.

Depressions marked by balance sheet compression
Recessions are typically characterized by inventory cycles – 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper. Unfortunately, as our former investment strategist Bob Farrell’s Rule #3 points out, excesses in one direction lead to excesses in the opposite direction.

The next day, I highlighted Ray Dalio’s version of this story because it takes a historical view and rightly emphasizes the debtor instead of the lender as the crux of the problem. Notice the part about printing money and devaluing the currency if the debt is in your own currency.

… economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring…

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.

It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue…

The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Commence the fake recovery

So where are we, then?  We have left the fake recovery and are entering a new era of growth that could last as long as three or four years or could peter out very quickly in a double dip recession. By now, you have seen my post on the fake recovery, so I won’t cover that ground here.  However, I do want to highlight how I came to believe in the fake recovery and how asset prices have played into this period (the S&L crisis played out nearly the same way).  I see writedowns as core to the transmission mechanism of debt and credit problems to the real economy via reduced supply and demand for credit. Again, this is why my site is called Credit Writedowns.

In March, at the depths of the downturn I wrote:

The problem is the writedowns. You see, if you get $30 billion in capital from the government, but lose another $40 billion because of credit writedowns and loan losses, you aren’t going to be lending any money. To me, that says the downturn will only end when the massive writedowns end, not before.

The U.S. government has finally realized this and is now moving to stem the tide. Their efforts point in four directions:

1. Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.
2. Increase asset prices. If assets on the balance sheet are falling, why not eliminate the accounting rules that are making them fall? Get rid of marking-to-market. This is the purpose of the newly proposed FASB accounting rule change.
3. Increase asset prices. If asset prices on the balance sheet are falling, why not reduce interest rates so that the debt payments which are crushing debtors ability to finance those assets are reduced? This is why short-term interest rates are near zero.
4. Increase asset prices. If asset prices on the balance sheet are falling, why not create Public-Private partnerships to buy up those assets at prices which reflect their longer-term value? This is what Geithner’s Capital Assistance Program is designed to do.

So I lied, there is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ)

I was more on target in my thinking here than I could have known. Within two weeks, the mark-to-market model was dead and mark-to-make believe had begun. It was then that I knew a recovery was likely to take hold. And it was going to be bullish for bank stocks and the broader market. What you should realize is that, despite the remaining problems in credit cards, commercial real estate or high yield loans, limiting credit growth, the changes instituted by government definitely have meant 1. that banks will earn a shed load of money and 2. that house price declines have stalled, underpinning the asset base of lenders. This necessarily means an end to massive writedowns, a firming of banks’ capital base, and a reduction in private sector deleveraging.

As an aside, I should mention that this dynamic called the asset-based economy, where economic well-being is dependent on asset prices, is far more pronounced in Anglo-Saxon countries like the U.S. and the U.K. (and Australia, Ireland, and Canada to a degree). While the free market ideal has gained sway globally, it is viewed with much more skepticism elsewhere. In Germany, for example, the term Anglo-Saxon is often bandied about as an epithet for political demagoguery to represent free market ideology. These cultural differences are something I explored in my post “Cultural attitudes on work, leisure and wealth in Europe and America.”

As for the recent asset-based economic reflation, be under no illusion that these measures ‘solve’ the problem. The toxic assets are still impaired and banks are still under-capitalized. But the increased asset value and the end of huge writedowns has underpinned the banks and led to a rise in the broader market in a feedback loop that has been far greater than I could have imagined at this stage in the economic cycle.

The double dip or the economic boom?

So what’s next?  A lot of the economic cycle is self-reinforcing (the change in inventories is one example). So it is not completely out of the question that we see a multi-year economic boom.  Higher asset prices, lower inventories, fewer writedowns all lead to higher lending capacity, higher cyclical output, more employment opportunities and greater business and consumer confidence. If employment turns up appreciably before these cyclical agents lose steam, you have the makings of a multi-year recovery. This is how every economic cycle develops. This one is no different in this regard.

However, longer-term things depend entirely on government because we are in a balance sheet recession. Ray Dalio and David Rosenberg make this case well in the previous quotes I supplied, but it was a recent post about Richard Koo from Prieur du Plessis which got me to write this post. His post, “Koo: Government fulfilling necessary function” reads as follows:

According to Koo, American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The banks are not lending mainly because nobody wants to borrow and, furthermore, the banks want to build their own balance sheets (raise cash) and get rid of toxic garbage…

Again, when asked what would happen if the government cuts back on its fiscal stimulus, Koo replies: “Until the private sector is finished repairing its balance sheets, if the government tries to cut its spending, we’re going to fall into the same trap Franklin Roosevelt fell into in 1937 (a crushing bear market) and Prime Minister Hashimoto fell into in 1997, exactly 70 years later.

“The economy will collapse again and the second collapse is usually far worse than the first. And the reason is that, after the first collapse, people tend to blame themselves. They say, ‘I shouldn’t have played the bubble. I shouldn’t have borrowed money to invest – to speculate on these things.’

This view of a second, more serious downturn mirrors the one I wrote of when I wrote about high structural unemployment last week. And, again, it is predicated on what government does.  I wrote last November that if government stops the support, recession is going to happen.

The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression.

Right now, if you listen to what President Obama is likely to do when we see more economic growth, you know that the government prop for the economy is going to be taken away. Koo again:

So the fact that Larry Summers was talking about ‘temporary’ fiscal stimulus had me very, very worried. That whole Larry Summers idea that one big injection of fiscal stimulus will get the US out of the recession, and everything will be fine thereafter, probably led to President Obama’s saying he’s going to cut his budget deficit in half in four years.”

Get ready because the second dip will occur. It will be nasty: unemployment will be higher and stocks will go lower than in 2009. I am convinced that it is politically unacceptable to have the government propping up the economy as Koo suggests it should. The question now is one of timing: when will the government stop propping up the economy? The more robust the recovery, the quicker the prop ends and the sooner we get a second leg down.

So to recap:

1. A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.
2. The effects of this depression have been lessened by economic stimulus and government support.
3. Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.
4. In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized
5. Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

Why is government spending necessary?

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted. So while, the private sector rebuilds its savings and reduces debt, the public sector must pick up the slack.  Why do I say must? It’s because of an accounting identity which comes from the financial sector balances model. Marshall Auerback says it best in a recent post:

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts.

If the private sector is a net saver, the public sector must, I repeat must, run a deficit. That’s the law of double entry book-keeping. The only other way to prevent the government from running a deficit when the private sector is net saving is to run huge current account surpluses by exporting your way out of recession – what Germany and Japan tried in the 1990s and in this decade. But, of course, the G20 and the IMF are all talking about global re-balancing. This cult of zero imbalances is something Marshall first brought forward back in April. And it ignores the accounting identity inherent in the financial sector balances model. I highlighted this model in my post, “Minsky: Turning neoclassical economics on its head.” However, I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively – a recent cartoon shows why.  It is this knee-jerk aversion to what is viewed as fiscal profligacy which is at the core of the cult of zero imbalances.

So, what does this mean for the American and global economy?

1. The private sector (particularly households) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect).  That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
3. Since state and local governments are constrained by falling tax revenue (see WSJ article) and the inability to print money, only the Federal Government can run large deficits.
4. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
5. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with.  While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver.  However, when the prop of government spending is taken away, the global economy will relapse into recession.
6. As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
7. Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
8. From an investing standpoint, consider this a secular bear market for stocks then.  Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

Not particularly uplifting, but hopefully well-documented. Your comments are very greatly appreciated.

Related posts:

• We are in depression
• Household debt as an indicator of secular bull and bear markets
• What is an economic depression?
• Some tidbits about stimulus, recovery, and the Great Depression
• What’s different about 2008?

Today, Moody’s warned that Iceland, Latvia and Hungary were stabilizing but that their economies remained fragile. The problem is high debt levels, which is restraining consumer spending. Recovery in the Eurozone has been the main aid to stabilization, the report said. Absent this support, the outlook is considerably worse.

Moody’s re-affirmed Iceland and Hungary’s ratings of Baa1 and Latvia’s of Baa3, one notch above junk. But, Moody’s refused to remove its negative outlook to the countries’ credit ratings.

The Wall Street Journal reported:

"These three countries are the only ones whose government ratings have experienced multiple downgrades over the past two years," says Kenneth Orchard, vice president in Moody’s sovereign-risk group. The ratings of these countries still carry negative outlooks, signaling the possibility of further downgrades in the next 12 to 18 months.

As I mentioned in my last post, it is the debt that is holding these countries back. The report states:

The domestic sides of the economies remain weak as households and corporates struggle with elevated debt levels, the aftermath of housing bubbles in the cases of Latvia and Iceland, and weak banking sectors that are unable or unwilling to extend credit.

As a result, the FX Team at brown Brothers Harriman think these countries are over-rated. In a note released today Win Thin said:

All three of these countries saw improvements in their sovereign risk profiles this past quarter, but all three still remain overrated.  Our model puts Iceland at B, Hungary at BB, and Latvia at B.  Moody’s has always been too generous with its Eastern European ratings, and we have to question why all three remain investment grade still…

All three are also likely to contract in 2010, so the stresses on their economies and their social fabric won’t be going away anytime soon.  Downgrade risks are likely to persist for these three well into next year, as well as for Estonia and Lithuania.

I can’t help but see this as yet another data point demonstrating that this whole house of cards is being stitched together via fiscal and monetary stimulus. Absent this stimulus, the U.S., the U.K., the Eurozone, Japan, and China would all relapse into recession, dragging weaker economies like Latvia or Spain deeper into Depression.

Watch for any signs of premature policy normalization in the the Eurozone or the U.S. as a prelude to a double-dip. The silver lining here is that Moody’s also upgraded Brazil to investment grade today, showing that the emerging markets outside of eastern Europe are doing quite well (story here).

Related posts:

• Hungary cut to a notch above junk by S&P
• More trouble in the Baltics as S&P downgrades
• Baltics: Fitch downgrade and more downgrades to come
• A bearish view on Eastern Europe
• The EU promises to bail out eurozone members

I have been very interested in the concept of legal tender of late because of the revelation this summer that the State of California was issuing I.O.U.’s to honour its debts instead of paying in U.S. Dollars, which are legal tender and I.O.U.’s from the U.S. government (see posts here and here). What I found most interesting about the California case was how the I.O.U.’s allowed a state experiencing a depression and prohibited from printing money to settle debts.  Given the similarities between California and Ireland, I felt this could be a model for that state (see post here).

The question was: how can a government without the levers of the money printing press use money as an escape-hatch in a depressionary environment? So to answer that question, I wanted to look at the origins of legal tender laws in the U.S.. When the United States was established, the U.S. Constitution outlined the basic framework through which government – both state and federal – could act on behalf of America’s citizens.  Nowhere in the U.S. Constitution was legal tender mentioned, and this is a bone of contention still amongst those who see the Federal Reserve as an illegitimate institution. Below, I want to outline a brief (and hopefully non-ideological) history of how the greenback became legal tender in the United States. I have some related comments at the end on Depressions and their lasting consequences on politics and history.

The Constitution

The Constitution mentions the word money in three sections (8, 9 and 10) of Article 1.  Below are the individual citations as they pertain to Congress acting on behalf of the federal government:

Section. 8. The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States;

• To borrow Money on the credit of the United States;
• To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;
• To raise and support Armies, but no Appropriation of Money to that Use shall be for a longer Term than two Years;

Section 9 is no longer applicable, but here it is.

Section. 9. The Migration or Importation of such Persons as any of the States now existing shall think proper to admit, shall not be prohibited by the Congress prior to the Year one thousand eight hundred and eight, but a Tax or duty may be imposed on such Importation, not exceeding ten dollars for each Person.

• No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.

In Article 1, Section 10 of the Constitution, the authorities regarding money and taxation for individual states are outlined. It states:

Section. 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.

No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports, except what may be absolutely necessary for executing it’s inspection Laws; and the net Produce of all Duties and Imposts, laid by any State on Imports or Exports, shall be for the Use of the Treasury of the United States; and all such Laws shall be subject to the Revision and Controul of the Congress.

No State shall, without the Consent of Congress, lay any Duty of Tonnage, keep Troops, or Ships of War in time of Peace, enter into any Agreement or Compact with another State, or with a foreign Power, or engage in War, unless actually invaded, or in such imminent Danger as will not admit of delay.

You have probably noticed that nowhere in here was the term ‘legal tender’ used. Why? The intention was to allow anyone to issue coins and notes backed by gold or silver. In fact, foreign coins backed by gold and silver were accepted in the U.S. because 80 percent of money in circulation in the U.S. pre-1800 was foreign.

Centralisation or de-centralisation?

But, when the United States was created, there were factions. One faction led by Alexander Hamilton, a U.S. Constitution signatory and the first Treasury Secretary, favoured a strong central government.  The other, headed by Thomas Jefferson, favoured states’ rights and a more de-centralised government and was more in favour of the Articles of Confederation, which was the original constitution that created the United States. One reason the term Confederacy was used for government in the south during the Civil War was opposition to a strong central government, which was seen to favour money interests over farming interests and thus the North over the South.

(Hamilton is one of two non-Presidents on circulated paper money. His face is on the front of the ten-dollar bill.  Read the sordid details of his death at the hands of a sitting Vice President. The other non-President is Benjamin Franklin, on the face of the hundred-dollar bill. Since the 100 is the highest circulating U.S. bill, Benjamin Franklin has gained a certain notoriety as a result.)

As a result of the Civil War and the large costs associated therewith, the factions favouring more centralisation gained sway on money matters. Basically, the government was broke and needed to control the money supply in order to alleviate these debts. Heavy taxation was the only other alternative, not something likely to get one re-elected.  So Abraham Lincoln created the Legal Tender Act for the United States.

However, in 1870, the U.S. Supreme Court ruled these laws unconstitutional in a 4-3 decision in the case Hepburn v. Griswold.  What was peculiar about the ruling was that Salmon P. Chase was the chief justice presiding and voted against the greenback as legal tender. He was also Treasury Secretary at the time the legal tender law was enacted. He also happens to appear on the face of the 10,000 dollar bill, a denomination not in circulation today.

Chase was concerned that the legal tender law was legalizing theft through inflation (the government was printing so many greenbacks that they had plummeted in value vis-a-vis gold). In his opinion, Chase wrote:

We confess ourselves unable to perceive any solid distinction between such an Act and an Act compelling all citizens to accept, in satisfaction of all contracts for money, half or three-quarters or any other proportion less than the whole value actually due, according to their terms. It is difficult to conceive what act would take private property without process of law if such an act would not.

We are obliged to conclude that an Act making mere promises to pay dollars a legal tender in payment of debts previously contracted, is not a means appropriate, plainly adapted, really calculated to carry into effect any express power vested in Congress, that such an act is inconsistent with the spirit of the Constitution, and that it is prohibited by the Constitution.

However, President Ulysses S. Grant expanded the size of the court to the present nine, adding two members who favoured legal tender laws.  So, fifteen months after Hepburn, came Knox v. Lee. The  case decided in favour of the Legal Tender Act in a 5-4 decision. This is still the law of the land.

Knox v. Lee led indirectly to Jim Crow

I don’t have an opinion on this issue. You will see why below.  But I do have an opinion about the effects of the Legal Tender Act and Knox v. Lee.

First, the purpose of legal tender is to centralise the creation of money by creating monopoly control of the money printing press.  This might be done to reduce the chaos associated with allowing anyone to issue bank notes. But it also might be done to inflate and increase leverage for taxation purposes. There are competing ideas on this issue but it boils down to a centralisation versus de-centralisation/States’ Rights versus Federalist argument.

More crucially to me, the Legal Tender Act did lead to inflation after the Civil War and an artificial boom in Railroad investment created by this inflation. The inflation ended when Grant signed into law a bill restricting money growth by making greenbacks redeemable in gold. The boom turned bust in the Panic of 1873 when Jay Cooke & Company, a bank that was highly leveraged to the railroad industry, was brought down.  The period that followed was known as the Great Depression before 1929 ushered in another Depression.

The economic downturn created a backlash against the Republican Party of Grant, which was also the party of Reconstruction and black politicians in the south. As a result, the Democrats swept the 1874 Congressional elections and almost eked out a win in 1876 for the Presidency. To keep the Democrats happy, the Compromise of 1877 was made, which effectively ended Reconstruction and threw millions of southern blacks into a near-century of humiliation, disenfranchisement and subjugation known as Jim Crow. It was an abomination, the legacy of which stains America to this day.

I am no fan of States’ Rights as a result.  I see increased States’ Rights and de-centralisation as likely to lead to explicit measures of disenfranchisement. So when I look back to the history of legal tender laws, my point of view is very much biased by this fact.

What should also be clear from this Great Depression and the one after 1929 is that booms which turn into extraordinary busts lead to populist outcomes and the rise of populist leaders which have unpredictable negative long-term consequences.

Notes

A book that I like on this issue and Money and Banking more generally is called “A History of Money and Banking in the United States” by Murray Rothbard.  the view presented is a relatively anti-central bank, anti-legal tender one. Rothbard is a Libertarian of the Austrian School variety, so read his book keeping his biases in mind.

Related posts:

• Weakest employment market since the Great Depression
• Zimbabwe: The 100 Trillion Dollar Note
• When Giants Fall: No green shoots here
• Some tidbits about stimulus, recovery, and the Great Depression
• Bear Stearns: Last 72 hours chronicled in new book

via the Hartford Courant (Hat tip Scott).

Related posts:

• Jobless claims may signal the end is near
• When will the U.S. recover?
• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• What does a double dip recession look like?
• Recession while GDP is growing?

In 2002, the global economy was weak and equity markets around the world were at multi-year lows following the greatest equity bubble and bust in world history. Many policy makers including Alan Greenspan, chairman of the U.S. Federal Reserve, feared a deflationary spiral of Great Depression proportions resulting from the stock market collapse.

To prevent such an outcome, the United States embarked on an historic monetary experiment to reflate a post-bubble economy by lowering interest rates to 1%, the lowest in 50 years. The result was a huge global economic boom which benefitted nearly every economy and every asset class on the planet. But the boom has turned to bust. In its wake, the cozy relationship between China and the United States that developed during boom time is unravelling.

Just Friday, Barack Obama slapped Chinese tire imports into the United States with tariffs of up to thirty-five percent. China was outraged and immediately threatened to retaliate. I now see a trade war between China and the United States as the biggest threat to global economic recovery.

With this trade war looming, one must wonder if Chimerica, the marriage of China and America as one economic entity, will end in murder-suicide, taking the global economy down with it.

Chimerica’s origins

Niall Ferguson and Moritz Schularick invented the term “Chimerica” in 2006 to describe the underpinnings of the 2000s boom. In their view, this economic upswing resulted from an America and China joined at the hip in a state of economic interdependence. Americans were the spenders and the Chinese were the savers and producers. The United States spent far in excess of what it saved. Meanwhile China ran a huge current account surplus, accumulating a $2 trillion stash of largely U.S. dollar-denominated international reserves, effectively funnelling America’s borrowed money back into the U.S. economy.

This state of affairs was always unsustainable – more so after the collapse of the associated credit and asset bubble exposed fissures in the global financial system in 2007. However, the flashpoint came in 2008 when the U.S. dollar plummeted to record or multi-decade lows against a host of other major currencies, leaving China’s reserves diminished in value. For the months since, the Chinese have expressed growing concern that they could get the short end of the stick if the marriage which created Chimerica dissolves.

Chimerica’s unravelling disturbs China

If one looks at any one incident involving China and the United States during the global economic crisis in isolation, it is easy to lose sight of the big picture. However, threading the events of 2008 and 2009 together makes a compelling case that the Chinese – U.S. marriage is coming apart.

The first indication of Chinese concern which I detailed came as the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac collapsed last August. The Chinese had put much of their reserve money into GSE debt, believing it as safe as U.S. government debt. It was evident that the GSEs were not a safe investment except through an implicit government guarantee (as I said in May 2008). But when the GSEs collapsed, the Chinese were caught out and warned they could dump dollar-denominated assets unless they were made whole.  Subsequently, Fannie Mae and Freddie Mac were nationalized and creditors were made whole.

The next flashpoint was created by comments by incoming Treasury Secretary Tim Geithner at his confirmation hearings before Congress. Geithner charged China with ‘manipulating’ its currency in an environment in which many western policy makers were openly blaming Asia’s mercantilism for the economic crisis.  The Chinese retaliated, with Chairman Wen slamming the U.S. as a profligate nation in unusually stark terms that raised quite a few eyebrows.

At just about this time, the first hints of real American protectionism came into being in the form of the Buy America provision attached to the stimulus bill. There was quite an uproar from America’s major trading partners like Canada and China – and I saw this as a 21st Smoot-Hawley at the time, a view I still hold. (To make matters worse, the provision has had perverse consequences.)

By this point – early 2009, the Chinese were done. They had suffered the potential for massive losses through the dollar’s weakness and the failure of the GSEs. Now, they were being blamed for a crisis which began in the west.  It was at this time that I noticed a steady drumbeat of ditch-the-dollar talk coming out of China. By the G-20 meeting in April, the Chinese central bank head Zhou outright called for a new international reserve currency.

The drumbeat of anti-Dollar news coming from China got louder and louder during the spring. The Chinese started settling trade in Yuan (Apr. 9) instead of dollars. The Chinese were discovered to be stocking up on gold supplies (Apr. 24). The Chinese central bank attacked the policy of quantitative easing in its quarterly report (May 9). The Chinese positioned themselves as the champion of emerging market nations and assembled support from Russia, Brazil and India for reforms in the international reserve system (Jun. 12).

And then came the retaliation.

Protectionism rises

On June 16, I wrote a post “Beijing starts a ‘Buy China’ policy” which clearly demonstrated that the Chinese were incensed by the Buy America provision in America’s stimulus bill. The trade war was on.

The ‘Buy America” and the “Buy China” provisions were nationalistic and prevented goods from other countries being bought. However, they were merely passive protectionism i.e. legislative exclusion of foreign goods and services. No tariffs were assessed.

But when Barack Obama chose to slap 35% tariffs on Chinese tire imports, this was an unmistakable act of active protectionism. This was the proverbial serving of divorce papers.

Expect prices to rise as a result:

Marguerite Trossevin, who represents a coalition of U.S. tire companies that import Chinese tires, said the tariff decision is “very disappointing.” She predicted price increases for U.S. consumers and losses for U.S. tire importers.

The Chinese have now said they will look to retaliate on U.S. poultry and auto products:

China announced dumping and subsidy probes of chicken and auto products from the U.S., two days after President Barack Obama imposed tariffs on tires from the Asian nation.

Chinese industries complain that they’re being hurt by “unfair trade practices,” the nation’s Ministry of Commerce said on its Web site yesterday. The dumping investigation relates to poultry alone, a spokesman said in Beijing today. The ministry didn’t specify the value of imports of the products.

To be honest, the protectionism should not be a surprise.  Obama is no free-trader. And I certainly foresaw a rise in protectionism and indicated in December 2008 the United States was the likely first mover:

Tariffs, export subsidies and currency devaluations will roil the desire for free trade.  Initially, countries will seek relief at the WTO (World Trade Organization) but later they will begin to act unilaterally.  The U.S. will be the first to unilaterally retaliate.

Even the resistance to unwinding excess capacity and global rebalancing are all very predictable as nations retreat into nationalistic thinking when the chips are down. As far back as March 2008, I warned of a likely multi-cycle W-recession predicated on resistance to unwinding the status quo:

The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.

This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors. However, this also serves to transfer wealth from domestic consumers to domestic producers by increasing the price of goods in the protected sectors, ultimately reducing consumption demand.

For these reasons, I am cautious about the long-term outlook for the global economy and the U.S. economy in particular. The likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession.

Yes, trade and dumping are difficult issues. But, protectionism makes most everyone a loser. In June, I wondered should we expect a protectionist China. But I ended saying it was how the Obama administration responded to the green light given by the WTO to impose sanctions which would be most instructive. Obama has gone protectionist.

Chimerica marriage is ending in divorce

All need not be lost. Global re-balancing, where the American partner in this marriage does a little bit more of the saving and a little less of the spending and the Chinese partner does just the opposite, is what most economic counsellors suggest. This could save a strained relationship and put the partners on a sustainable path. This does seem to be happening.

Nevertheless, could this relationship between China and America be coming to an end?

I say emphatically yes. 100%. There is no going back now. Each partner in this marriage, China and the United States, has a bevy of domestic constituencies which are forcing a dissolution of the relationship. Hardliners in China want to move away from the dollar. And populists in America want to punish the Chinese for allegedly manipulating their currency and dumping goods below cost in America.

So, as surely as day turns to night, this arrangement between China and the United States will end.  This marriage is over. The question is whether it will end gradually and peacefully in divorce or violently in murder-suicide. Right now, it’s looking like the latter.

Related posts:

• Tariffs: Other industries may line up for sanctions against China
• The U.S. is exporting unemployment with ‘Buy America’
• China slams U.S. profligacy
• Should we expect a protectionist China?
• The protectionism bogeyman

Back in February, I asked you if we were experiencing a recession or depression.  A plurality said it was a depression with a small ’d.’ I agreed and went on to explain why. Since then, things have changed and we seem to be on the verge of what I call a technical recovery (or a fake recovery – take your pick).  We may even be on the verge of a multi-year economic expansion – something bears like David Rosenberg should not rule out. But vigilance is still required. I will explain why.

Since the recovery talk has gathered steam, a lot of well-respected economists and policy makers have begun to construct what I consider a revisionist history of events. It goes something like this:

We have just experienced a major economic downturn. Coupled with a financial panic of major proportions, the global economy suffered a severe shock.  However, we have learnt how to deal with such crises due to our experiences during the Great Depression. The liquidity crisis was overcome through deft monetary policy. And fiscal expansionary policy aided a return to business as usual much sooner than many would have believed.

As a result, it is quite obvious we have been through a severe contraction, but nothing more than a garden-variety recession complicated – of course – by a financial panic. Back in February, a lot of economists made alarmist predictions of woe, foretelling a global Depression. This was wrong-headed and reckless as we see today. GDP has likely turned up in this third quarter and will continue rising for the foreseeable future. With the worst of things behind us, we can normalize monetary and fiscal policy and return to a more robust economic path.

On the surface, this narrative is compelling.  But, I believe it is based on a flawed analysis.  I would like to present a different narrative here for you to dissect.

GDP is a poor measure of growth

As Joseph Stiglitz recently wrote, GDP is a very poor measure of growth and economic health.  And he is right. There are many questions of statistical accuracy in its measurement. But, more than quantity, I have problems with GDP as a measure because of quality. Robust 4% growth that is underpinned by savings and capital investment is not the same as robust 4% growth underpinned by debt and consumption.

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings.  As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsdayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe. Knowing this shapes the psychology of economic forecasting and is why missing the turn is disastrous for one’s career. Efforts to avoid missing the turn are also part of a very large pro-cyclical psychological force underpinning a cyclical bull market.

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Marc Faber: “Don’t underestimate the power of printing money”

You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, “Don’t underestimate the power of printing money.”  This quote has stuck with me as asset markets have soared in the intervening time.  What Faber was alluding to was the fact that printing money works.  It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China.  Are you telling me stimulus is not working? It most certainly is.

In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. it is doing just that. In response to a Spanish-language article on just this topic, I wrote in today’s links:

Europeans are abandoning savings accounts in favour of riskier assets as low interest rates have created a liquidity-seeking-return dynamic. This is true as much in the US as it is in Europe and it proves that a wall of liquidity can induce a cyclical recovery based on asset price inflation aka the fake recovery. The question is what comes next?

Liquidity is seeking return. It is pure speculation whether the upturn that underpins this dynamic has legs. I see an even chance that it does, which is why, despite my recent mild bearishness, I am a lot more upbeat about the economy and markets than a lot of others in the blogosphere.

So where does that leave us?

The outlook is unclear.  The Obama Administration looks ready to take a victory lap judging from recent statements. Officials say they are also withdrawing liquidity in anticipation of an upturn in the economy (though some believe these claims exaggerated). So, that is the one side – which Goldman’s Jim O’Neill takes.

On the other side of the argument is the fact that employment is still weak and incomes are down – the most since the Great Depression. After a decade with no income gains and still weak employment prospects, the ability of households to refuel a debt-induced upturn seems limited – as the recent data on consumer credit demonstrates. This is the side that David Rosenberg takes.

I take neither side. I am just not that clairvoyant. Both scenarios are plausible outcomes. But, I am still very worried about the low quality of any growth we will get in an upturn and the widening gulf of economic fortunes that result. I am equally worried about how even a low quality upturn will sap the will for reform in the financial arena. Mostly, I am worried that the eventual collapse – if it doesn’t happen now – will be much worse when it does happen.

Background

Please listen to the half-hour audio clip with Marc Faber from yesterday.  He does an excellent job of giving voice to some of the ideas I just laid out in his usual semi-apocalyptic style.  The clip comes via Bloomberg’s On the Economy podcast, a show I recommend highly. Click here for the show’s webpage and instructions on how to listen to broadcasts.

(mp3 Audio embedded below)

Related posts:

• When Giants Fall: No green shoots here
• Economic recovery and the perverse math of GDP reporting
• Andrew Smithers’ view on economic outlook
• Subprime housing bubble timeline
• The psychology of economic forecasting

This comes from the blog News from 1930:

An out-of-work broker asked a friend who owned a circus for work. His friend said the circus gorilla had recently died, and if the broker wanted to get into the gorilla’s skin, swing around, growl, and amuse the children, he could have the job. Things went well until one day the rope the “gorilla” was swinging on snapped and catapulted him into the lions cage. The lion let out a roar, which the “gorilla” answered with a timid yelp. The lion roared louder, and the “gorilla” lost his nerve and started screaming for help. The lion came closer and whispered “Shut up, you damned fool, you’re not the only broker out of a job.”

Related posts:

• News from 17 November 1930: “we face a winter of hunger and distress”
• WSJ Video: The End of Wall Street – Part One
• WSJ Video: The End of Wall Street – Part Two
• News from around the web: 2009-11-16
• Bear Stearns: Last 72 hours chronicled in new book

Refining margins have been absolutely decimated, especially for refiners of heavy, sour crude like Valero Energy (VLO) and Tesoro Petroleum (TSO).  This is taking a toll on profits in the oil and gas sector, with both oil majors highly leveraged to downstream operations like ConocoPhillips (COP) and independent refining outfits showing steep falloffs in operating margins.  I see this as a proxy for the underlying economic demand in the U.S. economy.

Refiners

Refining is a cyclical business and this same pattern has been repeated for decades. When times are good, refining margins are high.  But, margins crash down at a moment’s notice, leaving some flat-footed and generating the waves of oil-sector busts of yesteryear. The desire of large firms to move away from Refining and Marketing reflects their desire to be insulated from these swings.

Independent refiners like Tosco, Valero, Premcor, Tesoro, and Giant grew up because of this vacuum left by the majors. Because the world’s refineries are leveraged to light sweet crudes like West Texas Intermediate (WTI), heavy and sour crudes like Maya and Alaska North Slope (ANS) normally sell for large discounts on the spot market. This generated a demand for complex refining capacity capable of processing these crude varieties and offers the independents a natural area of competitive advantage.

Refiners as a proxy

However, this cycle has been especially severe for refiners leveraged to heavy, sour crudes, with WTI-Sour Crude margins averaging $1.34 a barrel for all of 2009. Valero, the largest independent refiner had never had layoffs until now. Below is the beginning paragraphs of today’s VLO press release.

Valero Energy Corporation (NYSE: VLO) announced today that the company is continuing to take action to improve its profitability by rationalizing underperforming operations. As a result, the company’s subsidiary, The Premcor Refining Group Inc., intends to shut down the coker and gasifier complex at the Delaware City refinery. The coker is expected to be idle at least until the outlook for coking economics improves, while the closure of the gasifier complex is for an indefinite period. The company also noted that the plant-wide shutdown of the Valero Aruba refinery is now expected to be for an extended period, and, as announced earlier this year, the shutdown of a coker and a fluid catalytic cracking unit at the Corpus Christi refinery continues, and that cokers at certain of its refineries would run at reduced rates until coking margins improve.

The company expects that these decisions will reduce headcount at the Delaware City refinery by at least 150 employees and 100 contract workers. Valero has notified its employees and contractors along with the appropriate regulatory agencies and union officials. At the Aruba refinery, the company expects that more than 700 contract workers will be released in September.

I imagine this was a hard decision for Valero, a company that was #3 on the list of best companies to work for in America as recently as 2006 and prides itself on taking care of its employees. It is now #91.  But, this is the reality of the refining business in 2009 and it doesn’t speak well to underlying demand in the U.S. economy.

Back in July of 2008, before oil prices collapsed, I saw the reduction in refining margins as a telling sign of weak demand.  The fact that margins remain weak despite incipient signs of recovery suggests that underlying U.S. consumer demand remains weak.  In the last business cycle, margins did not improve materially until 2004 when the employment market picked up and underlying demand growth improved.

Related posts:

• Refiners as a canary in the coalmine
• Largest U.S. refiner Valero now permanently shutting capacity
• Valero crushes earnings: I was wrong
• Stocks pummeled as value plays increase
• Oil down below $138

Recently Allan Meltzer, a former Vice Chairman of the Federal Reserve, wrote a widely noted and provocative article in the Wall Street Journal called “What Happened to the ‘Depression?’” He called for an end to deficit-inducing stimulus because the cries of Depression from noted mainstream economists has been proven false.  His thesis is that these economists, most notably Paul Krugman and IMF Chief Economist Olivier Blanchard, are hyping the downturn to support a specific policy agenda with which he vehemently disagrees.

Conflating issues for ideological purposes

While his opinion piece deserves discussion, I find his argument disingenuous as he too is promoting a specific policy agenda.  The crux of the matter is three-fold:

1. How severe is this downturn and financial crisis?
2. How severe would it have been had specific policy measures not been taken?
3. Irrespective of the severity of the downturn, were these the right steps to have followed?

I delineate the argument as such because Meltzer, I believe purposely and misleadingly, conflates these issues for political purposes.  His goal is to present a narrative in which stimulus, especially deficit-inducing stimulus is seen as wasteful and misguided.  This may be the case (although I do believe certain types of stimulus are purposeful).  I don’t intend to examine that issue because it is as much political and ideological as it is economic.  It distracts from the real question: how severe could this downturn have been?

Nowhere near the Depression

When it comes to this core question, I agree wholeheartedly with Meltzer. This is not the Great Depression II, nor will it be, nor was it likely to have been.  I wrote a fairly personal post on this very point at the height of the panic last year called “Worse than the Great Depression.”  My point was that America, the world really, is much richer than it was in 1929.  The social safety net is much more robust. And policy makers are more knowledgeable than they were eight years ago. Comparisons to the Great Depression are misplaced.

But, Allan Meltzer is incorrect when he compares this downturn to 1973-75.  The present downturn is clearly more severe. The financial system has been hit very hard with a number of prominent institutions either dying (Lehman, Bear Stearns, Washington Mutual, Merrill Lynch and Wachovia) or being critically wounded (Citigroup and Bank of America).

When one looks globally, the same is also true.  Large or venerated institutions like RBS, Lloyds/HBOS, Hypo Real Estate, Dresdner/Commerzbank, Fortis, Dexia and UBS have all collapsed or been forced into the arms of government.  In 1974, we had a financial crisis that centered on the death of Herstatt in Germany and precipitated the first real modern crisis of financial contagion since Creditanstalt in 1931 (hence the term Herstatt risk and the reason for Bear Stearns’ bailout in 2008). But, this financial crisis was mild in comparison to what we have seen recently.

Employment is the difference

The real difference is the weakness of consumers, particularly in Anglo-Saxon countries and Spain.  Here, we see a mountain of debt, huge losses in wealth and a bevy of macroeconomic disequilibria without parallel – even in the Great Depression.

What’s more is this is indeed the worst period of employment growth in the U.S. since record keeping began during the Great Depression. Below is a chart showing the 100-month change in seasonally-adjusted non-farm payrolls.  This could generally be considered a length of time which spans an entire business cycle.  In April of 2009, we saw the first period during which non-farm payrolls decreased over a 100-month span.

What this data should make plain is that the downturn we are experiencing is really an outgrowth of the recession and jobless recovery of 2001-2003.  Only through the extraordinary efforts of Alan Greenspan in inflating a housing bubble to replace the telecom and technology bubble were we able to escape this downturn relatively unscathed.

Bubble economics has created a calamity

So, my conclusion is three-fold.

1. This is not the Great Depression II, but it is indeed a serious crisis – much more serious than 1973-75.  That makes this downturn more akin to the Great Depression than it does to other economic recessions in the post World War II period.
2. The downturn would have been greater had it not been for the policy response.  Policy makers have thrown everything they could at the problem – some would say too much! It is simply misleading to suggest that economic stimulus including fiscal stimulus has not pumped up the economy.  I would argue that we are about to see that not enough stimulus was provided to avoid a potential relapse – something I have been saying since before Obama came to office. It is this fact that has left the door open to claims like Meltzer’s.
3. I will leave it to the ideologues to debate the correct response. But if a 1937 outcome arrives, you will know why. I have said my piece about easy money; it was ineffective in bringing on sustainable recovery in 2001 and precipitated a more calamitous downturn.  I don’t think things will be different in 2009.  But, that leaves the question of budget-busting fiscal stimulus – the crux of Meltzer’s article.  There are some who think it better to swallow a bitter pill and let the downturn happen a-la Warren Harding in 1920-21 (see Wikipedia here and here). I have sympathy (as I suspect Meltzer does) for that view because of malinvestment that stimulus is likely to induce; Just look at China today. But I do think it is that sort of severe downturn which gave us Hitler and Mussolini and I worry about a 1937-style outcome.

There are no easy answers here.  Difficult policy choices must be made and the outcome based on these choices is far from clear.  However, Allan Meltzer is demagoguing this issue and not being straight about his ideological agenda.  It would be infinitely preferable if we could discuss this issue on the merits and not based on a fiction of ideology.

Related posts:

• Some tidbits about stimulus, recovery, and the Great Depression
• Unemployment: U-6 data versus the Great Depression
• The Great Depression II meme
• Bernanke expects recovery later this year
• Worse than the Great Depression

According to the results of a study by the Spanish savings bank Caixa Catalunya, consumption will fall 4.1% this year, making the reaction to this downturn four times as severe as during the last big downturn in 1993.  Back then consumption only fell 0.9%.

The results are not only an indication of the deteriorated employment outlook in Spain but also of pressures due to the collapse in housing and shares as well as a loss of confidence by consumers.

The greatest falls are expected in the Canary Islands (-6%), Cantabria (-5.1%), Extremedura (-5%) and Navarra (-5%).

More here in Spanish from Finanzas.

Related posts:

• House price declines accelerate in Spain
• Spain gets deflation
• UBS: ‘The disaster in Spain will continue’
• Consumer credit down a massive 33% in Spain
• Spain: Bleak forecast puts unemployment at 22% in 2010