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?

There are a lot of threads to tie together in today’s reporting of news in the auto sector.

General Motors has reported a third-quarter loss of $1.15 billion. But all indications are that car sales continue to outpace expectations in the United States.  Meanwhile, there are conflicting stories that GM both plans to pay back its bailout money, and to use it to help its ailing European operations. I will try to tie all these stories into a common thread.

First are the earnings. This is the first report by General Motors since leaving bankruptcy.  The results are decidedly mixed showing increasing sales, but a large loss and declining liquidity.

The video above points to losses and negative cash flow. But Bloomberg has reported that GM had significantly positive cash flow in Q3: $3.3 billion worth. Irrespective, sales are up.

The New York Times’ Deal Book says:

Excluding taxes and one-time items like the costs related to restructuring its dealership network, G.M. said its operations lost $261 million from July 10 and September 30. The loss in North America was $651 million.

For the entire third quarter, including the final 10 days of G.M.’s bankruptcy, the company said its revenue was $28 billion, up 21 percent from the second quarter.

In addition, retail sales have revealed that car sales in the U.S. are still relatively brisk for October despite the expiration of cash for clunkers. So, GM is benefitting from more sales, but is still not making money and still seeing cash go out the door. Obviously, they are going to need to cut costs even more, unless they count on sales returning to pre-crisis levels.  However, all indications are that they do, as CEO Fritz Henderson says revenue growth is their number one priority.

“We have significantly more work to do, but today’s results provide evidence of the solid foundation we’re building for the new G.M.,” the chief executive, Fritz Henderson, said in a statement. “With a healthier balance sheet and a competitive cost structure, our focus is on driving top line performance.”

See the Bloomberg video below for my comments by Henderson.

Meanwhile, in what should be seen as a PR move, General Motors has also announced it will begin repaying government money. The first $1 billion to be repaid in December. The company will make $1 billion payments to the U.S. government and $200 million payments to the Canadian government every quarter. It has said it could repay all the aid money by 2011, four years ahead of schedule. Presumably, this does not include the equity government stakes which can be sold on in the open market in an I.P.O.

Given the fact that General Motors is still losing money, it would make sense for them to delay repayment. However, I reckon they are going to repay early in order to tamp down criticism about their government-funded bailout.

The same is true in Germany as well as GM has also announced it will repay ALL German state aid before month’s close.  That is big. It significantly reduces the German government’s leverage over GM plans for restructuring in Germany.

This makes the recent statements about using bailout funds to bolster European operations seem inexplicable. If GM is losing money and needs to use bailout funds to plug up holes in Europe because it has decided to renege on an agreement to sell operations, why is it paying back bailout funds?  Is it not obvious the company needs the money?

My interpretation of GM’s actions is this: they are still a loss-making company and their cost basis is unprofitable at present sales levels. In order to return to profitability, they will need to further reduce costs or increase sales. At present, management have opted to grow the top line – and this makes retaining the European operations vital as the auto technology at Opel is considered first class.

So, GM has reneged on the Opel sale, risking the political backlash, because it is flush with bailout cash.  However, it knows that its desire to use these funds to stabilize the European business is likely to invite populist outcries in North America. This is why they have announced the repayment schedule today; it is purely a public relations maneuver to quell any anti-bailout sentiment. They are repaying German state aid for similar reasons, but also because it gives them greater flexibility in making operating decisions about job cuts and plant closures.

As GM is not publicly traded, we do not have stock prices as a gauge of how receptive investors are to these latest moves. But, according to Bloomberg, GM 8 3/8 bonds maturing 2033 jumped significantly, adding $2.63 to move to $20.3 on $100 par value.

You can expect to see GM as a topic in both the business and political press for some time to come.

Related posts:

• GM looks to use US and Canadian tax money to bailout Opel
• GM and Chrysler to get more bailout money
• GM headed for bankruptcy
• GM considers keeping Opel, raising capital
• Chrysler: bulls make money, bears make money, pigs get slaughtered

Nouriel Roubini, writing in the New York Daily News , said on Sunday that “unemployed Americans should hunker down for more job losses” given the likelihood of a job less recovery. This was as gloomy a piece as I have seen from Roubini in the past few months. He has clearly become more downbeat about the long-term picture for the U.S. economy.

The article begins:

Think the worst is over? Wrong. Conditions in the U.S. labor markets are awful and worsening. While the official unemployment rate is already 10.2% and another 200,000 jobs were lost in October, when you include discouraged workers and partially employed workers the figure is a whopping 17.5%…

…we can expect that job losses will continue until the end of 2010 at the earliest. In other words, if you are unemployed and looking for work and just waiting for the economy to turn the corner, you had better hunker down. All the economic numbers suggest this will take a while. The jobs just are not coming back.

This sounds dire. As a result, Roubini goes on to call on the Obama Administration to take direct action on jobs. Extending unemployment benefits is not going to cut it.  Roubini says we need:

a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation.

With statistics showing that the rate of long-term joblessness is at the highest since the Great Depression, Roubini joins an increasing number of economists who are calling on the Obama Administration to take the employment situation more seriously.

Paul Krugman has said that we are now in a liquidity trap. Therefore, we need to subsidize jobs and promote work sharing as Germany is doing.

I have made similar arguments about quantitative easing for the past year. Monetary policy is effectively useless – and is merely creating bubbles.

The Obama Administration is moving into deficit hawk mode at the wrong time as this will only worsen the jobs situation and lead to a double dip recession. Instead, I have called for a payroll tax cut or a job subsidy.

Randall Wray, a professor at the University of Missouri-Kansas City, has also offered a unique job solution.

All of this is urgent, as Roubini indicates:

Based on my best judgment, it is most likely that the unemployment rate will peak close to 11% and will remain at a very high level for two years or more.

The weakness in labor markets and the sharp fall in labor income ensure a weak recovery of private consumption and an anemic recovery of the economy, and increases the risk of a double dip recession…

The damage will be extensive and severe unless bold policy action is undertaken now.

The Obama Administration is taking an ‘indirect’ approach. They do so for three reasons. First, they are afraid of being boxed in politically by taking more direct measures. They also see a need to defend their previous policy decisions.  But, Mark Thoma thinks part of the resistance to more direct measures is ideological.  In a post earlier today, he says:

Growth policy is an attempt to make the economy grow faster, and stabilization policy attempts to keep the economy as close as possible to that trend, i.e. to avoid business cycles.

When Republicans had the political microphone, they emphasized growth policy (because it allowed them to argue for what they really wanted, lower taxes, growth policy was simply the vehicle that allowed them to get there), and this was supported by academic work from people such as Robert Lucas who claimed that, from a welfare perspective, stabilization was of second order concern, growth policy was where policymakers should focus their effort if they wanted to enhance welfare. Summers’ remarks reflect this type of thinking.

The Obama Administration’s approach of focusing on deficit reduction without enough direct job measures is sure to keep unemployment elevated. In looking at the politics of economics I said recently:

I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

The Obama Administration is doing the opposite. They seem to have received the ‘deficit reduction comes first takeaway’ from recent state elections in Virginia, New Jersey, and New York instead of the ‘jobs come first takeaway.’ That is bad news for Democrats and it is also bad news for the hopes of a sustained recovery.

Source

The worst is yet to come: Unemployed Americans should hunker down for more job losses – Nouriel Roubini, NY Daily News
Job Losses Mount, Enduring and Deep – Floyd Norris, NY Times (the long-term unemployment image is also from this story)

Related posts:

• Comprehensive unemployment rate is 17.5%
• 467,000 jobs lost in the U.S. in June 2009
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• 10.2% unemployment, 190,000 jobs lost
• Unemployment rate to 9.7%, 216,000 jobs lost

Today, I want to run a few thoughts by you courtesy of John Mauldin.  In his recent weekly newsletter, he makes a number of points I have made here over the past few weeks and comes to a similar conclusion about the weakness of recovery and the likelihood of a double dip recession.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting.

If This is Recovery, Where Are the Taxes?

I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let’s look at sales taxes first.

First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we’re in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010.

There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%.

On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf.

The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com)

Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising?

Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them.

Last Business Standing

Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business."

Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter’s creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors.

So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%.

Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out?

And the answer is that we won’t know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report)

But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes:

Stimulus, What Stimulus?

"Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating?

"The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market."

The Reality of Unemployment

All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts.

In August, I did an interview with CNBC from Leen’s Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.

That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we’ve lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000.

Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom.

Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade.

I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios.

All three scenarios are based on assumptions, so let’s see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result.

You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below.

For those interested, you can read Mish’s very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let’s look at his assumptions:

• Job losses are likely to continue for a minimum of another year.
• When job gains start, they will be very slow at first, then pick up.
• An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs.
• A falling participation rate (boomers retiring) will continue to mask reported unemployment.
• Starting in 2013 the labor pool will start decreasing because of Boomer demographics.
• The noninstitutional population will rise by 2.5 million workers a year.

The spreadsheet below needs a little explanation. Let’s start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number.

By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike’s blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let’s look at scenario 1.

This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario.

Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession.

Let the Good Times Roll

What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let’s be optimistic.

And the graph below shows the unemployment numbers for the Good Times Scenario.

Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner.

The Quick Double-Dip Scenario

When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession.

I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax.

Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept.

Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn’t look like that will be the case. So, let’s quickly see what a double-dip scenario might look like. Let’s be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives.

Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph.

Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right.

We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario.

The letter is getting long and it’s getting late, so let me close with a few thoughts.

First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years.

Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other.

Third, the only way out of this morass is to create an environment where small business can thrive. As I’ve noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that.

Related posts:

• Comprehensive unemployment rate is 17.5%
• Payroll data mixed despite the bullish headline job loss figure
• Are jobless claims pointing to structurally high unemployment?
• Unemployment numbers still point to partial recovery
• US unemployment hits 5-year high of 6.1%

Hat tip Barry Ritholtz

Related posts:

• Hugh Hendry: China – The Emperor has no clothes
• Jon Stewart’s indictment of CNBC
• Which homebuilder will go bankrupt next?
• National City is on probation
• Circuit City as canary in the coalmine for commercial real estate

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

The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners. You can reach the firm by email at info@arpllp.com.

This post on taxes and budget deficits should remind one of three recent posts here which take varying views of the fiscal position in Japan. See "Marshall Auerback’s "Japan does not demonstrate the failure of stimulus" and “The new Japan, domestic consumption, and the neo-liberal thought machine “ and my “Japan: stimulus without reform leads to a policy cul de sac.”

While I am personally no fan of supply-side economics or Arthur Laffer (actually, in full disclosure, I have to admit to being generally anti-Reagan/Thatcher as well – in large part due to a lax regulatory environment on both counts and some heinous racial politics in Reagan’s case), I do favour lower taxes as a way to stimulate the economy (through a payroll tax cut, for example).

“The only thing worse than rescuing the system would have been not to do so.”   – Martin Wolf

Welcome to the third letter in our four letter series about major trends defining the future of the world we live in. I kicked off back in September with a piece on energy supplies and last month I took a closer look at the demographic outlook. This month my focus will be on government and why our leaders need to think outside the box to solve the crisis we find ourselves in. I have found this topic particularly difficult to handle – probably because I am somewhat outside of my comfort zone. I sincerely hope you enjoy it anyway.

Let me introduce the main characters: First, the banks which are veering out of control (again!). Next, our central bankers and regulators who are doing a better job than broadly perceived; however, they lack the political support to tackle a financial system which thrives on excesses. And, just to complete the picture, we are up against a political system which is institutionally corrupt and politicians who are hopelessly narrow-minded and unable to look beyond the next election.

Less means more

Since the early 1980s, we (or at least those of us living in an Anglo-Saxon country) have lived in a world where less has carried the meaning of more. Reagan and Thatcher both genuinely believed in small government. Fundamentally, they shared the view that people respond to economic incentives, but it was not only about tax. The public sectors in both countries were slimmed down and much red tape removed. Even the City of London underwent drastic transformation – the so-called Big Bang. The economy reacted favourably in both countries and stock markets began a journey which lasted more than two decades and delivered the most powerful bull market of all times.

But, as we all know now, it ended in tears. Like children in a candy shop, we couldn’t control ourselves. Greed took over and whatever control mechanisms there were in place failed miserably when we needed them the most. It is therefore perfectly understandable that both regulators and politicians want more control. I just wish that our elected leaders would put their self-interest to the side for once and do what is right for the country. Unfortunately, that is about as likely as the sun not rising tomorrow morning.

Too big to fail or…?

Central to the discussion is the role of our banks. Are some banks really too big to fail or are they just too politically connected to fail? Following last year’s near Armageddon, most banks desperately need fresh capital and our monetary authorities – with plenty of encouragement from our Government – have created an environment which has handed banks a license to print money. In a budget constrained world, such a policy was always considered a more palatable way to re-finance the banking sector than the alternative – pumping more hard earned tax payer money into the banking system. So far so good.

Unfortunately, little seems to have been learned from the excesses of recent years. As we have seen time and again, easy money leads to carelessness, paving the way for future bubbles, and why should it be any different this time? A system where profits are privatised and losses socialised is destined to fail. It is the old moral hazard argument all over again and it encourages extreme risk taking. It is nevertheless the system which is being practised all over the world at the moment. And if politicians believe they can solve the problem by capping bonuses, they are less intelligent than even I thought.

In a recent article in the Financial Times, Willem Buiter made some interesting observations on this subject:

Will things be different during the next boom/bubble?  The next credit and asset market boom will generate massive profits and generous tax revenues.  The same phalanx of lobbyists will again descend on regulators, legislators and members of the executive branch of government.  New and exciting financial instruments – superprime lifegages perhaps – will be demonstrated by highly paid hirelings from academia to have unprecedented potential for diversifying, sharing and extinguishing risk.  It will be different from every other boom in the past.  It will be a truly sustainable euphoria – a high for humanity.  And the regulators/supervisors will be convinced, seduced, intimidated or co-opted.

Bank of England Governor Mervyn King recognises the problem:

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble.

As a possible solution, King has proposed a re-introduction of the rules which used to be in place, prohibiting retail and investment banking activities under the same roof. For speaking his mind, he was publicly reprimanded by the Prime Minister, who deemed such a policy response “simplistic and out-of-date”. Perhaps I should mention that banks are amongst the largest contributors to the political parties in this country. So much for integrity.

It is time to move on

A friend of mine attended an investment conference recently, where one of the speakers was the CEO of a world famous investment bank. When the talk turned to bonuses, the CEO stated flatly that “it is time to move on” (no prizes for guessing which bank). Perhaps it is time to move on, but not in the direction he wants to go. When US tax payers were forced to cough up $185 billion last year to save AIG which in turn saved an entire industry bar Lehman Brothers, the man on the street would be forgiven for expecting a touch more humility and sensitivity from those running our banks.

I am not for one second arguing that bonuses should be regulated. It is simply the wrong way to address the problem. But society is faced with a much broader problem when bankers carry on living in their ivory towers whilst the canyon between them and the rest of society grows bigger and bigger. “Take risks and you will be amply rewarded; fail and the tax payer will bail you out” is about the only lesson they seem to have learned from the past two years. The solution? Force banks to take less risk. It is absurd that many of our banks are still levered 30, 40 and some even 50 times. With less risk, their profits in good times will be much lower (and their losses in bad times correspondingly smaller), and the reduced profits will automatically drive down bonuses.

Here in the UK, two banks (Royal Bank of Scotland and Lloyds Banking Group) are being forced to break up their businesses. If you are too big to fail, you are too big to exist, seems to be the philosophy. However, the government deserves little or no credit for that decision. It is in fact the EU Commission which is forcing the government to take this draconian step. Who said nothing good comes out of Brussels? It is a much more constructive move than the pathetic focus on bonuses, but it doesn’t address the basic problem – banks must reduce their gearing.

The Laffer curve

Regulating banks more effectively is only half the story, though. As already alluded to, governments all over the world are faced with rising debt, threatening to bankrupt many countries. Several political leaders have already stated publicly that taxes will have to rise, but is that really the appropriate policy response to a dire fiscal outlook? Let’s turn our attention to the so-called Laffer curve. The Laffer curve simply states that there is always a revenue optimal tax rate. The Laffer curve does not provide any evidence as to what that tax rate actually is. As illustrated in chart 1 below, not surprisingly, when the tax rate is zero, the tax revenue is also zero; likewise when the tax rate is 100%. Somewhere in between, the optimal tax rate is to be found. The obvious implication of this relationship is that, over and above a certain point, the tax revenue falls once the tax rate is increased.

Behind the relationship between the tax rate and tax revenues lies the simple notion that a change in the tax rate has an arithmetic as well as an economic effect on tax revenues. The arithmetic effect of a tax hike is always positive whilst the economic effect is always negative due to the effect it has on output, employment, consumption, etc. In other words, the two effects always move in opposite directions.

  Chart 1:  The Laffer Curve

Source:

http://www.heritage.org/research/taxes/bg1765.cfm

It was this basic idea which drove President Reagan to lower tax rates in 1981, yet he was by no means the first US president to do so. In the early 1920s Presidents Harding (1921-23) and Coolidge (1923-29) had reduced the top rate from a whopping 77% to 25% and, in the early 1960s, President Kennedy had also introduced massive tax cuts. The top rate had peaked at 94% (!) by the end of World War II and he brought it down to 70% (see chart 2).

Chart 2:  US Marginal Tax Rates

Source: http://www.heritage.org/research/taxes/bg1765.cfm

Compelling evidence

So how did these tax cuts actually affect tax revenues and overall economic growth? The evidence is quite compelling (see table 1 below). During the four years prior to 1925 (the year in which the 1920s tax cuts were fully implemented, US tax revenues declined by 9.2% per year. In the following four years, tax revenues rose 0.1% per annum. The Kennedy experience was equally convincing. In the four years prior to the 1965 tax cuts, tax revenues rose by 2.6% per annum. In the following four years, revenues rose by 9.0% per year. Finally, in the Reagan years, tax revenues declined by an annual rate of 2.6% during the four years leading up to 1983, whilst revenues grew by 3.5% annually during the subsequent four year period.

Table 1:  US Tax Revenues around Major Income Tax Cuts

Source:  http://www.heritage.org/research/taxes/bg1765.cfm.

All numbers are inflation-adjusted.

Furthermore, in all three instances, economic growth accelerated following the tax cuts. For example, between 1978 and 1982, US GDP growth averaged 0.9% per year in real terms. Between 1983 and 1986, the economy grew by 4.8% in real terms, so the case in favour of tax cuts appears to be pretty compelling.

Other factors to be considered

It is not always one-way traffic, though. In his first term as President Clinton actually increased taxes in 1993 and what followed? One of the biggest economic booms of all times. Other factors impact tax revenues as well. In the case of Clinton, he presided over an economy which benefited immensely from globalisation and an IT boom, the likes of which had never been seen before.

Here in Europe, total tax revenue as a % of GDP is, on average, much higher than it is in the United States (chart 3). Whilst European growth rates have, admittedly, been modestly below US growth rates in recent years, there is no evidence to suggest that the higher tax rates have done significant damage to European growth. If that were the case, Denmark and Sweden should suffer the lowest growth rates amongst developed nations. In fact, the two Scandinavian countries have enjoyed comparatively high economic growth in recent years.

Also, corporate earnings have been as strong here in Europe as is the case in the US, and European stock markets have actually vastly outperformed the US market in recent years. So it is hard to drive the argument that lower taxes always lead to higher economic growth and stronger stock market performance. However, it is noteworthy that, in the United States, 3 major income tax cut programmes have been implemented in the last 100 years. In each and every case, tax revenues have grown, GDP growth has accelerated and there has been significant job creation. Can you ask for any more than that?

The canary in the coal mine?

One thing is sure, though. Given the rapidly rising public debt all over the OECD area, economic growth must be secured at any price. Anything else will be devastating longer term. Japan stands out as the black sheep with public debt-to-GDP reaching 218% this year. Japan has tried many things to drag itself out of the quicksand but to no avail.

Chart 3:  Total Tax Revenues as % of GDP (2006)

Source: OECD

Its stimulus programme has been very Keynesian with a multiple of public spending projects over the past couple of decades, most of which have been a terrible waste. Now, 20 years later, Japan is falling into the precise trap our economic adviser Woody Brock is warning so vehemently about. GDP growth is slow or non-existent. Debt continues to grow rapidly and sticky deflation makes an already difficult situation almost impossible to deal with.

So far, Japan has just about gotten away with it because they have had easy and cheap access to credit. But what will happen if (when) that changes? It is no longer inconceivable that Japan will default on its sovereign debt at some point over the next decade. Ambrose Evans-Pritchard has written an excellent piece in the Daily Telegraph recently about Japan’s predicament, which you can read here.

Woody Brock did a study earlier this year where he pointed out the danger of allowing public debt to grow much faster than GDP for an extended period of time. As is evident from chart 4, should the United States (or any other nation for that matter) fall into that trap, the implications could be very dire indeed. Think Zimbabwe. Therefore, given the large escalation of public debt, policy makers should aggressively pursue a pro-growth policy. Anything else could have fatal consequences.

Chart 4:  US Federal Debt Outlook

Source: www.sedinc.com

Cut income taxes! 

Empirical evidence suggests that recessions destroy tax revenues; tax cuts don’t. And increased tax revenues are precisely what we need to solve our fiscal crisis. It is therefore tempting to argue that now is the time for a reduction in income tax rates. Unfortunately, and true to form, our politicians will most likely do exactly the opposite. And the Swiss will be laughing all the way to the bank as more and more disenchanted people in this country flee Britain and Gordon Brown’s strait jacket to start a new life in Switzerland.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is authorised and regulated by the Financial Services Authority. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance.  Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009
• A Country for Old Men and a Bit of Samba – Oct 2009

Related posts:

• Japan does not demonstrate the failure of stimulus
• Obama takes middle road on stimulus and taxes that leads nowhere
• Are US corporations feeding at the trough of low taxes?
• Japan: stimulus without reform leads to a policy cul de sac
• A note on Japan’s experiment with quantitative easing

When I read Ed’s recent piece “Japan: stimulus without reform leads to a policy cul de sac,” I couldn’t help but think he is wrong about Japan.

Supporting aggregate demand

The problem is taxes. In Japan, taxes are too high relative to the desire for spending and savings. Policy makers need to stop taking so many yen away from working people, so that they are able to buy all of the output which they can produce at full employment levels.  

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen.  But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance.  In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

Again, a fiscal adjustment can restore domestic demand immediately.

Savings in Japan

The savings rate in Japan is down as a consequence of falling net exports and what was until recently a falling budget deficit. The deficit trend is now reversing in a very ugly way- falling revenues and increased transfer payments.  True, private sector savings have fallen which means that Japanese policy makers have run out room for error.  I would contend that the vast scale of private savings allowed them to continue to screw up for so long by, for example:

• hiking the VAT in 1996
• introducing ‘fiscal consolidation’ in 2001 (and finally relenting in 2003 when the economy finally started to grow again, until this latest fiasco). 

Issuing one’s own fiat currency debt

But, the notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous.  Debt is serviced by data entries by the BOJ- debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will.  It’s just data entry.  Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success.  Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

It’s really that simple.

Related posts:

• Japan: stimulus without reform leads to a policy cul de sac
• Do the personal income data demonstrate unbalanced reflation?
• Unrealized gains in wealth
• South Korea going gangbusters in contrast to UK
• Depression in Japan

This article by Peter Tasker, a well-regarded financial analyst in Asia, comes via the Financial Times (hat tip Marshall). He sees an enormous bubble forming in China – and parallels to Japan circa 1987:

Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory. No surprise, then, that US emerging market mutual funds are experiencing record inflows. The stellar performance of the Brics markets – Brazil, Russia, Indian and China – is due to continue into the distant future.

Such is the narrative now forming among investors. To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei’s dizzy rise to 39,000 forced the bears to throw in the towel…

But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster…

Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China’s interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that "imported" it. The result could only be a massive misallocation of capital…

At the 2008 peak, the price-to-book ratio of the Shanghai stock exchange was over seven times, well above the five times achieved by Japanese stocks in 1989. After the turbulence of the past 18 months, the ratio has fallen to 3.3 times, still the world’s second highest after India, and residential real estate trades at multiples of income that make the US housing boom look tame…

What is scary is that the current frothiness of emerging markets, centred on China, may be only a taste of what is to come.

There is a lot more in the original article. Link below.

Source

China rushes towards a Japan-style bubble – Financial Times

Related posts:

• China: reflation play spells trouble for rest of the world
• Subprime housing bubble timeline
• Marc Faber: China’s numbers are fake
• Hong Kong: “America is doing exactly what Japan did last time”
• Huge property bubble in China

Christopher Wood, the well-noted market strategist at CLSA and writer of the classic Japan crash warning book “The Bubble Economy,” is now warning of a market correction in the West.  According to CNBC India, Wood believes that the markets’ extreme upward move is increasing the chances of a major correction.

Wood is still cautious. He says there is some initial indication of a technical breakdown in the US. "The US market will be vulnerable early next year the US market. If it becomes clear, after this inventory cycle, that consumption, employment is not really recovering, then the market will go down. You will then get renewed stimulus in the US and measures trying to generate growth. The key variable in the West is government policy." CLSA’s best case scenario is 1,200 on the S&P 500 by year-end, he added.

I agree with Wood that underlying economic demand may indeed be weak and all we may be seeing is an inventory and stimulus induced cyclical upturn (see my July post “ISM: Is this the mother of all inventory corrections?”). Of course, the worry is about the employment cycle not turning up before these measures’ positive effect wears off.  This is the question for 2010. If this happens, we get  a double dip and a huge market-sell off. Even if the employment situation starts to improve slowly while stimulus and the inventory cycle recede, this will lead to a muddle-through scenario, again inducing a correction. This is the heart of Van Hoisington and Lacy Hunt’s call about partial recoveries and stock market weakness.

For those of you who want to believe and want to load up on junk, there’s a clap for that too, via bear turned bull Richard Bernstein:

Richard Bernstein of Richard Bernstein Capital Management is a lot more bullish. "Right now, there is a blurring between the secular issues and the cyclical ones. There are people, including me, who are concerned about the secular issues, but we can’t ignore the fact that the economy is getting better, employment is improving. When that happens you will see a cyclical rebound."

Just in September, Bernstein was saying America “practically invites another catastrophe.” What happened to that guy? He better be right on his bullish turn or he is going to have a lot of egg all over his face.

Source

Chances of a deeper correction are rising: Chris Wood – CNBC TV18 India

Related posts:

• Whitney Tilson: "A pullback of some sort is likely"
• Richard Bernstein: Once a huge market bear, now a bull
• Bill Gross: Sell equities and buy Treasuries
• Marc Faber: “Monetary policy in the United States will stay expansionary”
• Partial recovery will mean new lows for stocks

If one wants to see what happens when you use stimulus to help keep zombie companies alive and to resist reform efforts, look no further than Japan. 

For twenty years now, Japan has been dealing with the consequences of a burst asset bubble in shares and property. And for twenty years, the body politic has been unwilling to make the necessary reforms which would eliminate zombie companies while still helping to repair balance sheets in the private sector. Instead, the Japanese have piled government deficit upon deficit like Sisyphus trying to get consumers to reflate the economy. It has not worked.

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default".

The IMF expects Japan’s gross public debt to reach 218pc of gross domestic product (GDP) this year, 227pc next year, and 246pc by 2014. This has been manageable so far only because Japanese savers have been willing – or coerced – into lending for almost nothing. The yield on 10-year government bonds has been around 1.30pc this year, though they jumped to 1.42pc last week.

"Can these benign conditions be expected to continue in the face of even-larger increases in public debt? Going forward, the markets capacity to absorb debt is likely to diminish as population ageing reduces saving," said the IMF.

The savings rate has crashed from 15pc in 1990 to near 2pc today, half America’s rate. Japan’s $1.5 trillion state pension fund (the world’s biggest) has become a net seller of government bonds this year, as it must to meet pay-out obligations. The demographic crunch has hit. The workforce been contracting since 2005.

Japan Post Bank is balking at further additions to its $1.7 trillion holdings of state debt. The pillars of the government debt market are crumbling. Little wonder that the Ministry of Finance has begun advertising bonds in Tokyo taxis, featuring Koyuki from The Last Samurai. If Japan’s bond rates rise to global levels of 3pc to 4pc, interest costs will shatter state finances.

What this illustrates is that stimulus cannot be seen as a cure-all in an economy which lacks in domestic demand or in which debt burdens are high. I see this as a cautionary tale for The Europeans and Americans looking at stimulus as some magic bullet which will make structural problems disappear.

I increasingly ask myself whether any advanced democracy has the foresight to implement a targeted monetary stimulus campaign without knee-capping efforts to induce more private sector savings – fiscal stimulus is a whole different affair. Right now, the savings rate in Japan is even lower than in the United States, a direct result of easy money.

In my view, fiscal or monetary stimulus are bridges to a sustainable economic future built on the back of deleveraging, a purge of malinvestments and industry consolidation. Right now, the stimulus in Japan is looking more like a bridge to nowhere.

It is Japan we should be worrying about, not America – Ambrose Evans-Pritchard, Telegraph

Related posts:

• Japan does not demonstrate the failure of stimulus
• Pushing on a string and similar notions on monetary policy ineffectiveness
• The new Japan, domestic consumption, and the neo-liberal thought machine
• Don Kohn says Fed policy has kept rates down 100 basis points
• Japan’s easy money policy was the trigger for the tech wreck

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?

Former Morgan Stanley economist Andy Xie joins other famed prognosticators like Nouriel Roubini in worrying about an incipient asset bubble. The Rosetta Stone Advisors board member sees the huge increase in money supply created by central banks as fuel to an asset bubble fire. He even goes so far as to call the central banks ‘arsonists.’

The financial crisis exposed gross inefficiencies in the massive amounts of money financial institutions received from central banks. Supplying so much money to the same people who caused the crisis — and with the same incentives — does not feel right. The argument in favor of this policy is that, when the house is on fire, you have to do whatever to extinguish the fire and find the culprit later. The problem is that, in this case, the arsonists have been asked to put out the fire. How can we be sure they won’t start another fire?

Most argue that the answer is not to limit the money supply but to reform the financial system. In this way, future demand for money would be efficient. But so far, no corrective reforms have been implemented in response to the financial crisis. Why? Because the global financial system became so big over the past decade that it has co-opted central banks, legislators and entire governments. Any reforms that do come will not address the main factors leading to the current crisis.

Even the best reforms will never resolve a problem based on the fact that financial professionals generally risk other people’s money: They get big rewards when bets go right and don’t have to pay when bets go wrong. The problem with this incentive system suggests the global financial system is structurally biased toward taking on more risk than what would be taken in an efficient market. The only way to counter this is for central banks to limit money supplies. Asset inflation over the past 10 years and the catastrophe incurred when it burst lend credibility to this argument.

Xie sees stagflation as a threat and a double dip coming, as a result. He warns bond market speculators, “you’ll want to run for your life” when the bond market tanks.

A word of caution for all would-be speculators: You’ll want to run for your life as soon as the bond market takes a big fall. And the case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimuli are behind the current economic recovery, and when these run out of steam next year, the odds are quite low that western consumers will take over. High unemployment rates will keep incomes too weak to support spending. And consumers are unlikely to borrow and spend again.

Many analysts argue that, as long as unemployment rates are high, more stimuli should be applied. As I have argued before, a supply-demand mismatch rather than demand weakness per se is the main reason for high unemployment. More stimuli would only trigger inflation and financial instability.

The post is very entertaining, if scary. (“monetary growth is being used to support leverage, mostly in the financial sector.”) While I am not in the stagflation camp, I agree that money supply growth is fuelling unsustainable increases in asset prices globally. Xie concentrates on China where retail investors dominate the equity markets, operating under the assumption that government will not let assets prices fall. My view is that prices must eventually fall if they are too high relative to the income streams that underpin that price. The resultant crash in prices will be deflationary. Xie believes that this discrepancy between price and value will be closed via inflation.

However, you see it, I recommend reading this article. It asks some very important questions for investors, businesspeople and economists alike, the most important of which is a variation on theme of the Stephen Roach article:

While workers and businesses struggle, asset players are reaping substantial paper profits again. As the central bank’s monetary policy is behind the asset boom, we should ask whether the policy is achieving its goal by helping the real economy, or whether it is just helping speculators and hoping they have something left over for the real economy.

Much, much more here.

Related posts:

• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Inflation: The strategy that dare not state its name
• Central banks will face a Scylla and Charybdis flation challenge for years
• Is this the way to fight inflation?

As a follow-up to my post on debt and it’s exclusion as a subject of merit amongst several schools of economic thought, I wanted to bring a New York Times article from 1988 to your attention. This article by Peter Kilborn, a Washington, D.C. based and long-time former correspondent for the New York Times, is timeless.

It reads like an article right out of 2008 or 2009 and highlights how little has been decided in the debate about the economic effect, size and role of government. Many of the key players – Paul Krugman, Larry Summers, and Robert Lucas to name a few – are the same. At issue is the divide between freshwater and saltwater economists that has been raging for at least a generation now. Kilborn says:

To tinker or not to tinker? For decades most politicians and professors of economics have taken it for granted that the Government must adjust the engines of the economy to avoid recessions and create jobs. But lately, a long-belittled school of skeptics who think the Government usually just gums things up is gaining attention and influence.

The skeptics are known as ”fresh water” economists, less for the purity of their thought than for their origins at universities along the shores of the Great Lakes.

The school’s views are filtering into such lofty citadels of mainstream ‘’salt water” economics as Harvard, the Massachusetts Institute of Technology, Princeton and Stanford. Its theories also appeal to economists who are advising the Presidential election campaign of George Bush, and, to a lesser extent, those working for Michael S. Dukakis.

The fresh-water people build their case for minimal intervention on the view that workers, consumers, business executives and investors anticipate changes in the economy faster than the Government and can adjust to them better on their own.

On some level, one could say this divide is manifest in how the political fault lines in the U.S. are forming. Larry Summers, President Obama’s chief economic advisor, is a saltwater type with definite freshwater sympathies. 

On the other side of the political spectrum are those who want small government, a view championed by Ronald Reagan in the 1980s. Republicans are drawn to this positioning because it invokes the Reagan presidency, which was a high point for the post-Nixonian Republican Party. 

You will have noticed my post earlier today on Sarah Palin walking in the small government, Libertarian mantle as she crafts a strategy to take control of the party.

In the article, Krugman sums up the crux of the divide nicely, with Robert Lucas taking the other side:

”The basic distinction,” he said, ”is do you think recessions present a problem? And do you think the Government can do something to avert them? The fresh-water people say that recessions either are nothing to worry about or that in any case, the Government can’t do anything about them.”

Robert E. Lucas, the undisputed dean of the fresh-water school and chairman of the economics department at the University of Chicago, said, ”What we’re turning against is the idea that you can fine-tune the economy with any policy at all.” The university has long been the home of monetarist economics, which maintains that steady, noninflationary growth results from steady growth of the money supply and of which the newer theory is an offshoot.

So, if you are wondering where all of the back and forth is coming from on economic theory and why it has failed us, take a step back in time to the late 1980s. The debate is pretty much the same today.

Source

‘Fresh Water’ Economists Gain – NY Times

Related posts:

• Links: 2009-01-18
• The Fed wants inflation
• Why the personal consumption data is important to the stock market
• A brief philosophical argument about the role of government, stimulus and recession
• The Fed is on the easy money trip

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

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

This entry from Gary Shilling comes via John Mauldin’s site InvestorInsight.com where he highlights commentary from some of the best economic thinkers. Shilling, who correctly predicted problems in residential real estate in the US, is in the deflation camp.  He thinks the US will be a slow growing economy prone to recession and high unemployment over the next decade. A major factor in this is the anticipated increase in savings due to withdrawal from the asset-based economy and the beginning of a balance-sheet recession.

As I indicated in my last post, it is this prospect which should keep policy makers up at night because it will mean the US government is going to continue as a major economic actor for years to come.  I should point out that the Great Depression, while much more severe than what we have experienced thus far, had significant periods of high growth, but was largely characterized by short business cycles and a general deleveraging – the D-process, now my short-hand for depression.  Just sayin’.

(excerpted from the August 2009 edition of A. Gary Shilling’s INSIGHT)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we’ve discussed in past Insights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow — so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in past Insights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis — U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids’ education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices — the vast majority of most Americans’ net worth — are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we’re forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we’ve discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn’t want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes aren’t so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won’t qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% won’t qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We’ve already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore’s huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won’t stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It doesn’t plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed’s lending powers to require the Treasury Secretary’s approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It’s ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one’s job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don’t vote in domestic elections.

As noted earlier, initially this recession was in the financial arena — the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it’s not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country’s financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe’s excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps.

Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand wasn’t caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We’ve consistently predicted the good deflation of excess supply, but we’ve also said clearly that the bad deflation of deficient demand could occur — due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation. They’ve never seen anything but inflation in their business careers or lifetimes, so they think that’s the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we’ve cited in past Insights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) — the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall — are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply over demand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it’s got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. Meanwhile, prices — already down 32% from their second quarter 2006 peak — are likely to fall to reach a total 37% decline we’ve forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by the unusually large slashing of consumer spending. It’s hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That’s a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7 ) to 2.1%.

So with the five other inhibitors to growth in coming years — financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation — our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We’re also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s – mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same long run phenomenon of past decades that was measured in different ways — the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption’s share of GDP, reflecting what consumers did with the money they didn’t save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption’s share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we’re forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption’s share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years — the saving rate fell from 12% to zero, or 12 percentage points while consumption’s share of real GDP rose from 67.5% to 71%.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption’s share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation’s share of national income falling while corporate profits’ share leaped during those years.

In the years ahead, however, it’s unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits’ share was at its zenith, a big decline in corporate earnings’ piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one’s share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where’s The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it’s unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined — and they hadn’t on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future — which means chronic declines with chronic deflation — are shattering the scales that blinded homeowners. So they’re beginning to separate places to live from investments. That means they’ll want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we’ve run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead — except for federal government stimuli that’s spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California’s latest budget stopgap will take, temporarily, $4 billion from local government funds.

We’re forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there’s no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s — electrification of homes and factories and mass-produced automobiles — was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June’s 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we’re right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising — absent huge federal intervention. And that intervention is assured since no government — left, right or center — can withstand high and rising joblessness for long. And don’t forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it won’t be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what’s left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment — the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In future Insights, we’ll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, don’t expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It’s likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.

Source

Slow Long-Term Growth, And Government’s Response – Gary Shilling

Related posts:

• Chart of the day: Real GDP growth
• Chart of the day: consumer credit growth
• Switzerland gets deflation too
• Recession: How Long and How Deep?
• U.S. CPI: Lowest since 1954 – deflation here we come

When the stimulus bill was being crafted, I wrote three posts lamenting the protectionist Buy American provision attached to the bill.

• ‘Buy American’ will translate into a 21st century Smoot-Hawley
• The U.S. is exporting unemployment with ‘Buy America’
• Canada is furious about U.S. protectonism

The last of these three demonstrated that the provision was needlessly creating lots of ill will north of the border.  As I am in Canada right now, I found the following story from the Sydney Morning Herald particularly laughable:

US President Barack Obama’s stimulus spending has run into a problem: A shortage of General Electric water filters.

GE makes them in Canada. Under the program’s `Buy American’ rules, that means the filters can’t be used for work paid for by the $US787 billion ($935 billion) fund.

Contractors are searching the US in vain for filters as well as bolts and manhole covers needed to build wastewater plants, sewers and water pipes financed by the economic stimulus. As officials wait for federal waivers to buy those goods outside the US, water projects from Maine to Kansas have been delayed.

“It’s added a whole new level of difficulty,” said Kathy Emery, a senior engineer for the West Virginia Department of Environment. “We’re continually having changes and further guidance” from federal rule-makers, she said.

At stake are the president’s efforts to fuel an economic recovery in the US by funneling stimulus funds to communities, including $US6 billion for municipal water projects. Lawmakers mandated that the money be spent on US products, with exceptions to meet international trade obligations.

GE says it assembles high-tech filtration systems for North American markets at its plants in Toronto and Oakville, Ontario, with parts from Hungary and elsewhere.

These are the absurdities that result from protectionism. In a globalized economy, it is often difficult to say where a product was actually made.  For example, there is a huge transfer of parts to GM Detroit from GM Canada in Windsor, Ontario, which is actually geographically south of Detroit and right over the border.  Were GM building cars under the Buy American provision, this type of transfer would be illegal.

The article points out that, just as the plants in GM Canada are fully integrated with GM Detroit, the GE facilities in Oakville and Toronto are fully integrated with GE’s US operations as well.

The purchasing rules are hurting the stimulus program, said US Representative Kevin Brady, a Texas Republican. He has called for a congressional review of the Buy American plan.

Losing jobs

“There are some real downsides to Buy American,” Brady said in an interview. “It delays projects. We have to look at what jobs we are losing.”

Lawmakers in America who pander to voters who do not live in these communities might think these provisions are justified.  However, this one example is one of scores of similar logistical minefields created through protectionism. Here is another from the same article.

At Aquarius Technologies, which sells equipment to US wastewater plants, domestic business has slowed to a trickle, said Tom Pokorsky, president of the closely held company in Port Washington, Wisconsin.

`Buy American has stopped US wastewater work this year,” he said. “I’m surviving by selling to Canada.” Even that market won’t be safe if Buy American sparks a “Buy Canada” retaliatory initiative, he said.

After watching trucks send manhole covers flying, officials in Auburn, Maine, switched to hinged covers years ago. The ductile-iron ones they used were made across the border in Canada.

While they waited for weeks for a waiver to buy more covers for a new sewer project, Norm Lamie ordered steel plates placed over the exposed holes. “EPA did eventually give us the waiver,” and the manhole covers are in place, said Lamie, general manager of Auburn’s water and sewer district.

To my mind, the biggest takeaway here is that this is what should be expected when the government inserts itself into a relatively free market legislatively.

Source

‘Buy American’ backfires – Sydney Morning Herald

Related posts:

• ‘Buy American horror stories’ in Canada
• ‘Buy American’ will translate into a 21st century Smoot-Hawley
• Congress ready with second stimulus package
• Canada is furious about U.S. protectonism
• The U.S. is exporting unemployment with ‘Buy America’

This comes from David Rosenberg:

Perpetuating the spending and borrowing cycle
We couldn’t believe this when we saw this quote from the U.S. Transportation Secretary (Ray Lahood) in yesterday’s NYT (page B3) on the "Cash for Clunkers" program: "There obviously is a real pent-up demand in America … people love to buy cars, and we’ve given them the incentive to do that. I think the last thing that any politician wants to do is cut off the opportunity for somebody who’s going to be able to get a rebate from the government to buy a new vehicle."

Are you kidding me? If there is pent-up demand for autos why do we need a rebate? If there are 20% more vehicles than there are licensed drivers, why the need to perpetuate this cycle of overspending? Why is it a politician’s job to create incentives to spend? Shouldn’t they be focusing their attention on health, education, defense, infrastructure, public safety, job skills and productivity growth (and perhaps the youth unemployment rate of around 20%)? We’re not exactly espousing an Ayn Rand libertarian view but at a time when the deficit is running at 13% of GDP, at what point is enough? These rebates are not manna from heaven – it’s a future tax liability to hasten a decision that the auto buyer would have made in any event.

Call this another data point demonstrating the desire to return to excess consumption and the asset-based economy of the bubble years.

More here (registration necessary).

Related posts:

• Why the personal consumption data is important to the stock market
• April U.S. retail sales: upside surprise?
• South Korea going gangbusters in contrast to UK
• Conspicuous consumption in China
• Rosenberg: ’Asia Revival May Be For Real’

Dick Berner, Chief North American Economist at Morgan Stanley, thinks we are in for a sizable uptick in GDP for Q3.  I must be honest; I am sceptical about this, but Berner is a well-regarded economist  whose views can’t be dismissed out of hand.  He says:

Incoming data… confirm that the deepest and longest post-war recession is now ending.  And it’s ending with a roar: A temporary surge in vehicle production is likely to pace a much stronger rebound from recession than we thought only a month ago, so GDP may rise 3-4% annualized in 3Q.  The recession and recovery are starting to look more ‘V’-shaped: Revised data now show that the economy declined by 3.7% since the recession began in 4Q07, making it the deepest post-war downturn.  But significant economic headwinds mean that the 3Q surge is unlikely to spill over into a stronger overall recovery.  And with inflation declining, a tighter monetary policy is unlikely soon.  We continue to think that the Fed will remain on hold until mid-2010.

Ingredients for a rebound.  There’s no mistaking the ingredients for a sharp summer rebound, including a classic inventory snapback and modest improvements in some components of final demand.  Aggressive vehicle production cuts (a 46%, seven-quarter plunge in motor vehicle output, with the first half down at a 36.3% annual rate) have brought motor vehicle inventories in line with sales.  Indeed, the cuts in output overshot, pushing annualized US production 2-3 million units below the pace of domestic sales in the past three months.  Just to catch up, vehicle production surged about 60% in July over June, and seems likely to rise further through the summer.  As a result, motor vehicle output likely will add about 4 percentage points, or roughly double our estimate last month, to overall GDP.

A reduced pace of inventory liquidation elsewhere in the economy will probably also contribute to growth.  Apart from motor vehicles, companies liquidated about US$100 billion in real inventories in 2Q, bringing the level of inventories in relation to sales down somewhat from its 4Q08 peak.  And even if companies are still liquidating stocks, a slower pace of liquidation (which means that the change in the change in inventories is positive) will likely add more to growth in output than we expected last month.  Indications of stronger orders and production in July’s ISM report suggest that manufacturing outside of motor vehicles is beginning to bottom.

Better-than-expected gains in housing and construction will probably add another half point to 3Q output. Despite the obvious headwinds that still face housing, imbalances are smaller, and activity is starting to improve by more than we thought previously.  The vacancy rate in one-family housing, now 2.5%, has fallen 40bp from its 4Q08 peak.  And modest improvements in sales and continued declines in inventories have brought inventories of new, one-family homes down to 8.8 months’ supply -from 12.4 months in January.  The 2.4% June surge in one-family construction outlays signals that activity began to turn at the end of 2Q.  With financial conditions gradually improving, despite lenders requiring higher downpayments, further gradual improvements in demand seem likely, and housing construction is also likely to improve further.  Moreover, thanks to the funding from the American Recovery and Reinvestment Act (ARRA), it appears that state and local infrastructure outlays are starting to pick up a bit sooner than we expected a month ago.

Limited ‘payback’.  This 3-4% 3Q surge in GDP growth is not sustainable, but neither a significant ‘payback’ nor a double dip is likely.  Vehicle sales illustrate the point.  The blowout response to the ‘cash-for-clunkers’ incentive program has been far stronger than we expected.  With the initial US$1 billion in funding used up in a few days (even if some of the deals were booked at dealers in anticipation of the July 24 initiation date), this fiscal stimulus is getting a lot of bang for the buck.  It is timely, targeted and temporary: The incentives have an immediate effect; combined with matching dealer incentives, consumers are getting a 30-40% discount off the sticker price, and consumers must use them or lose them.  The deals will run out soon even if the Senate approves the US$2 billion in additional funding voted by the House before they recessed last week.  If each billion in funding spurs an extra 250,000 vehicle sales, as seems possible, the annual selling rate in August may climb past the 12 million we expect for July.  While the sales pace will slip back in the following months, manufacturers likely won’t have to trim inventories at all in 4Q.  Beyond the spillover from the vehicle rebound, improving global growth, the growing impact of fiscal stimulus and looser financial conditions may also limit the slippage in 4Q, by sustaining exports, factory output, infrastructure and housing.

So, to recap, we have the Fed on hold at zero percent rates, a huge uptick in autos, government stimulus coming online, and a robust inventory cycle coming into place.  This does sound very bullish regarding Q3.  But, there are some major problems to contend with longer-term.

Four headwinds still indicate a moderate recovery, in our view.  First, financial conditions are still restrictive, reflecting the gradual improvement in bank balance sheets and securitization markets.  The combination of reduced access to credit and falling home prices will keep consumers cautious and promote further deleveraging and increased saving out of current income.  Second, absent a sustained pick-up in vehicle sales, the inventory-related production bounce in motor vehicles won’t last.  More broadly, inventories elsewhere in the economy aren’t yet lean in relation to sales.  Third, despite the infrastructure pick-up, stressed state and local governments are cutting current services and furloughing workers.  Fourth, ‘core’ consumer incomes (real, after-tax wages and salaries) are now falling again, following several one-time boosts to real after-tax income earlier this year (e.g., declines in energy prices, stepped-up tax refunds, a cut in withholding rates on April 1, and one-time checks to Social Security and SSI beneficiaries in May and June).  Measured by the employment cost index, private industry wages and salaries rose just 1.5% in the year ended June, a record low.  With continued pressure on wages and payrolls, and the bulk of the ARRA tax cuts likely to hit incomes only in spring 2010, real spendable income should be flat to down in 2H09.

Exactly right. Don’t forget the fact that jobs are still being cut and personal income is at 2007 levels as a result.  Not exactly the stuff of sustainable recoveries.  Berner goes on to suggest that declining inflation will keep the Fed on hold for some time to come and ends his analysis there. 

I would add the comment that this sounds bullish over the short-term but not necessarily sustainable. Auto demand is being pulled forward artificially and the inventory cycle and government stimulus are both temporary.  The only variable which is supportive of this V-shaped scenario over the longer-term is interest rates – and that is only because of the threat of deflation.  I see this as further confirmation that a W-shaped recession is a very real possibility.

Source

Roaring Out of Recession in 3Q – Richard Berner, Morgan Stanley

Related posts:

• The mother of all inventory corrections is not the same as re-stocking
• What does a double dip recession look like?
• Third quarter auto production to be significant boost to U.S. GDP
• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Economic recovery and the perverse math of GDP reporting

The US is not the only place where a double dip downturn is to be feared.  China has its own economic imbalances to deal with.  Too much money is being thrown at the problem creating malinvestment and a bubble economy, shares having doubled this year alone.

Stephen Roach thinks much of the stimulus money in China has been wasted, potentially requiring a second stimulus package.

‘The impact of the investment-led stimulus will fade and the Chinese growth rate will start to slip again some time towards the middle of 2010,’ Roach said, suggesting that slowing growth could lead to increased layoffs and thus social instability.

‘That means, the Chinese authorities will be forced to contemplate another proactive fiscal stimulus.’

In May, Roach had said China may face a ‘W’-shaped economic recovery and had previously said that China’s current stimulus is directed too much at the pace of growth rather than the quality of the growth.

The former global chief economist for the U.S. investment bank also reiterated his concerns about excessive investments in infrastructure, rather than on stimulating private consumption or bolstering health care or social safety nets for Chinese.

‘Bottom line is they are creating a very unbalanced macroeconomic structure,’ Roach said in the interview, estimating that investment spending in the first half of the year as a share of gross domestic product had exceeded 45 percent of the economy.

‘This is a ratio unheard of in the annals of a modern, large developing economy,’ he said.

These are much the same complaints that can be levelled against US policy makers.  However, the scale of the endeavour in China is truly breathtaking.  And while the growth potential in China is still very strong, the economy has a number of significant problems with which to deal, unemployment being one.  Another mentioned by Roach is the need for the Chinese to save huge sums in order to meet health care costs and to insure against economic misfortune because of the porous social safety net.

Were the government to put more emphasis on increasing economic security, many Chinese would feel more comfortable spending and the economy would be able to wean itself from its reliance on exports.  However, to date, infrastructure has been the name of the game in China’s fiscal stimulus.  Come this time next year, we will have a much better handle on whether this growth dynamic is sustainable or whether the government needs to top up its stimulus with yet more money.

Source

China may need 2nd fiscal stimulus next yr-Roach – Forbes

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
• Stephen Roach is talking double dip again
• China: Growth on track but at what cost?
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Late last year, I anticipated that the global slowdown would bring China’s GDP growth down to 2%, a level that would make most nations envious but which would have been catastrophic for China.  In the end, robust government stimulus has saved the day, as spending for infrastructure, commodities, and property has soared.  The 8% growth target seems likely to be met.

However, the malinvestment from excess lending has made China’s growth dynamic appear incredibly unbalanced as even China bull Stephen Roach opined yesterday.  An asset bubble is forming there. And even though shares tumbled 5% earlier this week, the correction was rather brief as the market came roaring back the very next day.

Perhaps this unbalanced growth and asset bubble is just the price China must pay in order to wean itself from dependence on export to the West.  After all, the country is still growing 8% whereas the United States has been in a mild depression over the past nine months.

That may make for nice copy, but is it really true?  Is China making the transition?  Are they actually growing 8%?  Marc Faber doubts it.

China’s economy is growing at 2 percent, not the 7.8 percent its government claims, says economist Marc Faber, publisher of the Gloom, Boom and Doom report.

“The Chinese government is one of the few governments in the world that knows its GDP numbers three years in advance,” Faber told CNBC.

“I’d be a bit careful about China.”

A growing number of investors turned bullish on China after its markets began to rise last March, Faber notes, adding that it’s possible Chinese markets will continue to rise for a while.

“If you throw money at the system, lots of things go up in value — but maybe they go up for the wrong reasons. What disturbs me today … is that the lows in March and late last year, sentiment was incredibly bearish about everything.”

Now, Faber observes, “there’s this incredibly bullish sentiment when insiders are actually selling and the technical picture of the market doesn’t look that great.”

Faber believes the market faces headwinds because there’s a huge supply of available shares and a record number of new issues, which dampens share-price increases.

“My sense is that, near term, we could still have disappointments because now the mood is very optimistic. I don’t think we’ll make new market lows in Asia, but I do think we’ll have a meaningful correction.”

On Monday, China’s first initial public offering in nearly a year rose so high and so fast that regulators were forced to halt trading twice, The Washington Post reports. The Hang Seng index rose to double its low point last fall.

There is a lot to like about China. But, this all sounds very toppy to me. Caution is definitely warranted.

Source

Faber: China Really Growing At 2 Percent – Money News

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The data being reported out of Asia is in marked contrast to what we are seeing in Europe and North America.  Last week, I noted that Singapore had put up big numbers.  China is also expanding robustly. Compare that with the data coming out of Europe like the UK growth numbers released today and you can see that Asia is de-coupling.  Now comes South Korea.  The BBC reports.

South Korea’s economy expanded in the second quarter by its fastest rate in five-and-a-half years.

Gross domestic product rose 2.3% from the previous three months. It fell 2.5% from the same quarter a year earlier, a smaller-than-expected fall.

Increased government spending, help for car buyers and record low interest rates helped boost the economy, the country’s central bank said…

The growth in the April-to-June period.. compares with 0.1% growth from January to March and a 5.1% drop in the October-to-December period.

Its exports rose 14.7% in the second quarter compared with the previous three months, helped by a weak won.

“The domestic demand growth was aided by tax benefits for car purchasers and fiscal spending. It’s hard to say the economy is set for self-driven recovery, given the dim jobs market outlook,” Kim Myung-kee at the Bank of Korea.

While economists welcomed the data, they voiced some caution.

South Korea’s growth was “driven a good mix of strong fiscal stimulus, a weak won and monetary easing”. But it is unclear if, as fiscal stimulus wanes and credit expansion slows, this growth will continue, Mr Kim added…

The fly in the ointment here is the fact that much of the increase in Asia is due to government stimulus and a comparison to already low numbers.  If you recall, Asia was crushed by the slowdown in the West, with export volumes falling 30-50% across the board. It’s kind of easy to show huge growth when you are doing so from a low base.  Going from 100 to 90 to 93 is not as indicative of a true recovery as going from 100 to 97 and back to 100.

So caution is certainly warranted here.  As I mentioned on Wednesday, Stephen Roach, a well-known economist based in Asia, says he doesn’t see good underlying demand fundamentals anywhere – and that presumably includes Asia (At about 4 minutes into the video linked above, he says: “The ultimate question here: where is the demand? And as I go around the world, especially in Asia, you know, I don’t see any follow through on the demand front”).

My conclusion: these are very good numbers and they do point to a faster rebound in Asia than elsewhere.  However, it is not entirely clear that the underlying demand without government stimulus is indeed robust.  Once fiscal policy is normalized in places like China and South Korea the true fundamentals will be clear.

Related posts:

• Is South Korea de-coupling?
• Japan does not demonstrate the failure of stimulus
• Denmark out of recession
• Does Japan’s economic implosion mean anything?
• Will Asia’s downturn be worse than America’s?

In reaction to recent comments about more stimulus by Laura Tyson, an advisor to President Obama, we have seen a host of commentators make their opinion known.  Here are two more  well regarded pundits: James Galbraith and Warren Buffett.  They are both indicating more stimulus is necessary.

James Galbraith makes his point on Bloomberg.  His recommendation is that stimulus address specific problems and be designed to add stimulus more quickly than with the first package.  The video is below.

Similarly, Buffett made noises about the need for more stimulus this morning on ABC. He said the first stimulus was filled with pork and was not as effective as it could have been.  His comments are available at the link at the bottom of this post via a four-minute video on ABC’s website.

Source

Warren Buffett Backs Second Stimulus – ABC News

Related posts:

• Jamie Galbraith: Stimulus not enough
• Warren Buffett: Don’t expect miracles from Obama
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