After QE; Piketty and neo-feudalism

There is a lot of nonsense going around about interest rates going up post-QE. Following John Hussman's lead, in a recent post I showed the empirical regularity governing the relationship between central bank balance sheet as a percent of GDP and long-term interest rates proxied by the 10 year T-bond.

Recently Base/GDP has been about 0.22, so we are way out on the right end tail. It would take a reduction of the ratio of about 15 percent of GDP to begin to raise long rates, or about $2.6 trillion at current rates of GDP. The St. Louis base is currently at $3.7 trillion, and has been growing at over 20 percent a year since the last recession.

Now, "tapering" is a reduction in the rate of increase of additions to the base, not a reduction of the base. The chart looks to me like a very strong empirical regularity indeed. So the chance that long rates will rise anytime soon is remote in the extreme, as the Fed has no announced plans whatsoever to actually reduce the base.
Long rates will remain low and the bad debt clogging the banking system will remain impacted, that much seems assured for years to come.
What is a somewhat lower probability outcome is that the dump-the-dollar movement internationally gains sufficient momentum that the Fed has to buy up more and more (perhaps virtually all) new Government debt. This might be called the MMT-by-force-majeure outcome, as there is little chance that such additions to the Fed's balance sheet will ever go away.

In this latter case rates will not go up because of the empirical regularity shown above, but as the dollar falls on the foreign exchange markets due to weak demand to hold or trade in dollars, there will be import inflation domestically in the US. This will cause a further collapse of effective demand--already afflicting the bottom 80 percent or so of Americans--as real purchasing power of consumers is decimated. The US will become an even less attractive place to invest, and capital flight will occur. The US's status as a banana republic will be cemented.

This is the essence of the dreaded global currency reset: the dollar falls on international markets, import inflation slams domestic real demand, but neither short-term nor long-term interest rates rise (short rates exhibit a similar empirical regularity to that shown above). A domestic stagflation occurs. The Fed, ever the servant of Capital, will fight the inflation with modest rises in short rates (this can be done administratively in the short run) sufficient to beat any thought of asking for higher wages out of the heads of workers even though labor cost-push inflation exists only as a curiosity in economic history textbooks.
In the final chapter plutocrats of various "nationalities" (with allegiance to none) will divvy up Plantation America, keeping the best parts of it private, for themselves and their would-be-royal progeny.

Enter the Anti-Mainstream Economist

Certainly Thomas Piketty is the most important economist of the past 80 years, since the last Fourth Turning (Keynes got it that time). I highly recommend The New Yorker's review of his big book (here). A Frenchman, Picketty came to the US at 22 as a young economics superstar and to his great credit, became immediately disenchanted (disgusted is a better word, probably) with the status-quo-supporting mathematical fictions he encountered at MIT. (Disgust afflicted your correspondent upon entering economics at the graduate level in search of "science" after an undergraduate career studying literature.) Son of a leftist French couple, Piketty imbibed the Marxist notion of capital increasingly displacing labor leading to the reserve army of the unemployed and set out to study the issue of the distribution empirically, probably sensing that only real world data could displace the mathematical fictions of the self-congratulating, narcissistic mathematical economist-priests ruling policy in the West.

Piketty's concerns over where the world is going are as dire as mine. He is the Anti-Mainstream economist on the white horse that I thought could never possibly arrive. The New Yorker disappointingly pooh-poohs Piketty's suggestions that we need to raise taxes on the incomes and wealth of the plutocrats as politically infeasible. (But of course The New Yorker’s readership inhabits the status quo, so what else could they say?)
Democracy will have to be reborn to prevent a return to out-and-out feudalism.
It couldn't happen here, of course (although Piketty now has a stateside ally in fellow French-born Berkeley economist Emanuel Saez). Piketty turned tail after a couple of years in the US and returned to Paris, where he has remained since.

[Editor: spelling of Piketty's name corrected 3/27/2014]

“Pushing on a string”—because the status quo

When I learned my macro, it was accepted that increasing reserves of the banking system when it was already in a substantial excess reserves position would have no effect on real output; hence it was called “pushing on a string,” an expression that I believe was coined in the Great Depression with respect to the excess reserves of the day.

In the Liquidity Trap, monetary policy was considered to be useless.

Now we have the trickle up theory of asset inflation, openly acknowledged by the Fed. Janet Yellen says the trickle down happens after the trickle up. But of course, the Fed does not acknowledge that asset inflation is inflation; it’s just wealth effect. John Hussman has pointed out that even the wealth effect is caused by an illusion, that the banking system is solvent, courtesy of FAS 157. Nevertheless, the Fed feels compelled to sweep the bad assets under the carpet before they can be audited. In the end we’ll have Good Bank, Bad Bank, with the Bad Bank being the Fed.

The non-economists readers of this blog need to be aware that current Fed policy, QE, goes against everything the entire mainstream macroeconomics canon says, but you won’t find an academic economist to admit it. If they’re conservative, like the Establishment Blowhard Gregory Mankiw, they like it because it lines the pockets of their clientele, the 1 percent (the “because capitalism (the banks want it) otherwise martial law” argument). If they’re liberal, like Paul Krugman, they like it because liberals always like accommodative monetary policy; it always serves their clientele, government, through monetization of the debt.

So mainstream academic economics has aligned itself with the status quo, and established its lack of intellectual integrity beyond any doubt.

The two political parties and their mainstream economist cheerleaders both support the status quo, while the structural rot continues. You just need to know they’ve abandoned everything the discipline has been saying for over thirty years in doing so.

Fourth turning update

The entertaining Jim Quinn has put up the third in his series of "Trying to Stay Sane in an Insane World." Quinn works at Wharton and his website is either one of the cleverest honeypots around, or Wharton — a bastion of, let's face it, Wall Street think — actually allows some free speech.

However, here's my response to the Austrians who say — who chant — "Government bad! Government bad!" — and, "Free markets good! Free markets good!"

Feudalism bad! The Middle Ages were based on a system of highly concentrated ownership of the means of production, which at that time was mostly land. You had your lords and your serfs. With the assistance of rapidly improving technology are getting closer and closer to a new age of feudalism.

The Crisis still looks to peak after 2020. Buckle up.

Corporations: virus or cancer?

Along with many others (see Finance Addict’s recent post Apple, Foxconn and the rise of the supranationals), I have  come to the conclusion (witness Europe, the banks, the pathetic sovereigns) that it is the corporation that is the dominant social institution on the face of the Earth today.

For a while, I thought corporations were like a virus, because their inanimate, inhuman virus-like structure made the metaphor appealing.

But upon reflection, I think that the modern supranational corporation is more like a cancer.  A cancer is a form of hypertrophied growth that spreads across and throughout the host organism, promoting its own essentially inanimate ends, while killing the host.

Isn’t that what the modern supranationals are doing?  Not that their looting managements are suffering, but many in the host countries are being left behind.

Of course, I am exaggerating.  Real living standards have been raised by supranationals in their host countries.  The problem today is that the looting by the management teams has become rabid, hollowing out the host societies’ democratic institutions, leaving a husk of historically extreme inequality that is possibly the most corrosive, ultimately destructive legacy possible, as it is a breeding ground for the most base forms of human society:  fascism, and revolutionary totalitarianism.

The message of the deeper thinkers and researchers in behavioral matters (not economists) is that social justice in the form of more equal distributions promotes many other very material goods.  See Wilkinson’s absolutely mind-blowing ted.org talk for the amazing empirical results.  “Economic growth” does not answer all human needs.

Can you legislate social justice?  Probably not.  It has to come from a widely held value system.  And, in America as elsewhere, the false god of Econ has inculcated some very bad values into this primate species, especially in the out-of-control ruling castes of the supranationals, who more and more bow to only the false god of Econ, aka Greed.

What Mankiw doesn’t teach: the costs of inequality

I posted on Wilkinson over a year ago, and I’m glad to see www.angybearblog.com [corrected] covering his work.  This is an oldie but goodie, definitely must-watch even if you’ve seen it before.

Thirty-some years ago, having completed an honors English degree from Yale, I decided to get a Ph.D. in Economics to study the dominant mythology of our age.  It can’t fall soon enough….

Links 4/4: Academic choice theory; madness in high places

Blacklisted Economics Professor Found Dead: NC Publishes His Last Letter - 04/04/2011 - Yves Smith

I was not aware of this man’s work, but it describes my own feelings as an apostate academic economist about academic economics and academic economists.  This is must read for regular readers of this blog.  A representative quote (the professor is responding to questions in a letter from a bright high school student):

[…]

What kinds of proposals could help to minimize value destruction by academic economists? You are quite right that from the point of view of the public this issue looms large. Even in most Western democracies, more than half of the total GDP is allocated according to principles promoted by agents subject to Academic Choice dynamics, i.e. economists. One simple remedy to the large negative externalities generated through their academic entrepreneurship could be to shrink the size of the sector of academic economists.
Another approach is indicated by the game theoretic insight that winning strategies in competitive games usually involve a random element. Following this principle, ever since antiquity trials have been decided by juries who are chosen by lot. We should therefore strongly consider periodically repopulating economics departments with people selected at random. […]

When working in industry one needs to harmonize one’s models with empirical reality as best one can, while cognitively harmonizing the systemic context of one’s efforts in the tradition of trying to do good within the system, being part of the solution, and so on.  And trying to give money to the poor until it hurts.

• Former CIA Analyst Tells Truth About Libya Intervention On CNN, Hilarity Ensues – zerohedge

Alfred McCoy, Taking Down America

A very thoughtful piece from www.tomdispatch.com on where the world may be going in several different scenarios.  It points out that if the international corporate elite indeed trumps the nation state in power and influence, that the next period may be international feudalism, with the pattern of extreme inequality seen in the U.S. under corporate hegemony spreading across the rest of the world.  Serfs of the world, unite!  One of the best reads I’ve come across for Big Picture.  And indirectly highlights the need to keep the Internet open—and speech free—as at least a possible countervailing force against the sheer dead weight of money.

Alfred McCoy, Taking Down America

Visual interpretation of the unemployment number

If there is any relation between mean duration of unemployment and the subsequent drop in the unemployment rate, we are in for a very slow decline (if any) in the unemployment rate:

The following charts show the relationship between mean duration of unemployment and unemployment rate a year later, showing that the relationship has changed in this recession:

Using the fitted equation for the period 2007:1 to August 2010, we have a forecasted unemployment rate of 7.5 percent in August 2011.  This depends on a big ceteris paribus (other things equal) assumption about civilian labor force participation rate and other factors behaving the same in the recovery as in the recession.  If we use the line fitted to the whole sample, the forecasted unemployment rate is 10.2 percent, with a looser fit.

So let us assume unemployment remains unchanged for the next year.  What does that do to “animal spirits”?  We are interested because the distinguishing characteristic of an NBER-defined slump or a business slump as understood by any practical person is the associated failure of confidence; which, as Keynes pointed out, is a palpable entity to the practical person that is adequately proxied by survey measures.  And visual examination of the record (below) shows that every recession has been accompanied one-to-one by a failure of confidence as measured by the venerable Michigan sentiment series, and our measure, A.  I have assumed

Regular readers will recall that our proxy for the determinants of confidence is the relation of the unemployment rate to an adaptation level:

A = - (U – UMEAN)/sigma(U)

where A is “animal spirits.”

We are still not close to a failure of confidence; which is not to say the economy isn’t in an over-indebtedness-induced “underemployment equilibrium” exacerbated by a highly unequal distribution of income and wealth.  The next failure of confidence will probably not occur until about 2013.  For this forecast I assume the unemployment rate will fall for a year, stabilize, and begin to rise again:

If we assume the unemployment rate remains constant for two years and then begins to rise after the next Presidential election, we have this picture:

In the case above confidence never recovers to “positive” levels, but adaptation level effects are evident in that, even as unemployment rises to new highs, the plunge in confidence is not worse than before.  Plus ça change, plus c'est la même chose….

With regard to Hussman’s views on the yield curve noted recently, the 1/10 yield curve is still 2.5+ percent positively sloped, so any logistic yield curve model will still show very low recession probability (ours, of course, also utilizes the A variable; and in any event the effect of ZIRP will not be a distortive on the 1/10 curve as on the 3-month; and changes in the slope are still highly indicative):

The shape of the current cycle resembles the 1970-1974 abortive recovery, only worse. 

At some point I will write up some insights on “America on the hedonic treadmill” and the adaptive necessity of resetting adaptation level “set points” to survive what’s coming, but everybody already knows that we’re going to have to get by with less.  The primary contribution today is to put the current cycle in context along the most important dimension, that of “animal spirits” or confidence.  The next collapse is still a ways off.

Quick comment on double dips

The only time there has been a “double dip” NBER recession in the postwar period was in the 1980-1982 episode, and it was fully signaled by a secondary inversion of the yield curve.  The 1/10 yield curve inverts an average of about a year before NBER recessions begin.  Here is a 12-month smoothed 1/10 yield curve slope over the postwar period:

The unsmoothed yield curve did go positive in between the 1980 and 1981-1982 recessions, but only briefly; as Volcker applied more tight money after an election year acceleration of inflation.  The smoothed yield curve remained fully inverted.  (The only time the curve inverted and a technical recession did not occur was in 1966—but a drop in the GDP growth rate from ~8 percent to near zero did occur; a “growth recession” it was termed).

Today the yield curve is steeply sloped, so no double dip is indicated.  Why should the yield curve send such great signals?  That is beyond the scope of this note.  I don’t argue with 60 years of empirical regularity.  The yield curve was also inverted steeply in 1928-1929.

The quickest drop off of the smoothed slope from a level such as we’re at now over 3 was from 2004:6 to 2007:6, as the Fed raised short rates and deflation began its assault on the US economy and long rates.  Thus, if we match that decline rate, the curve might invert in mid-2013 and the next recession begin in mid-2014.

The unemployment story that goes along with this might go something like this:

Unemployment rate rises slightly for a few months, and then a determined effort is made to report declining unemployment rates, which, however, must remain within the realm of credibility with a populace (or least the marginally well informed part of which) has come to rely on the larger U6 unemployment rate measure and the employment-population ratio for indicators of labor market health.  This will prime “animal spirits” for the election year, after which all hell breaks loose.

Here’s the picture:

Now a run on the dollar or a failed Treasury auction might cause an inversion to occur quicker, but why would the Chinese do that?  They’re having their own bubble-popping problems.  However, the imperial temptation to drive the world into dollars by starting another war, probably in the Middle East, lingers always.  We probably won’t see unemployment rates under 8 percent for many years.  The best summation of the current labor market is Calculated Risk’s chart here.  Job growth has stalled.

Where will the demand for labor come from?  Americans are an adaptable people, and as they adapt to the “new normal,” business will chug on.  People may exit the measured labor force.  We will continue to be in an underemployment equilibrium because the income distribution is unequal enough that balanced demand is not possible.  Wage concessions to benefit wider employment will be made by Americans on the receiving end of the ruling elite’s diktats, and in this way a new social cohesion among the disenfranchised majority may grow, possibly into a democratic movement with the potential to forge a new social contract through the broken-down apparatus of the American government, or possibly into a new class of post-industrial serfs.

Links 5/20/2010

1. Merkel to The Banks and Hedge Funds: Sprechen Sie Deutsche? Then Droppen Sie Dead - Jesse

Merkel says ban short sales and screw CDSs.

2. Should We Ban Naked CDSs?, by Brad DeLong

Brad says, “I say, narrowly, no--that if we can get proper clearing, transparency, and capital adequacy requirements in place banning naked CDOs would not do any good and would do a little bit of harm. But it is a close call….”  [Could you mince a little bit more, Professor?]

Could the lameness of the American economics mainstream be any more transparent?

++++++++++++++++++++

3. Shadow inventory sales for years to come – 1.6 million distress sales in 2010, 1.6 million in 2011, and 1.5 million in 2012. By summer of 2011 REO pipeline will rise to 536,000. – mybudget360.com

Remember that a huge wave of exotic mortgage rate resets hits in second half 2010 and first half 2011 (reference).  So even though the yield curve is not inverted and no “recession” is in sight over the next 12 months, growth can be expected to be very slow as the deflationary collapse gains momentum, the tipping point to come in about three years, by my best estimation, when there will be an epochal collapse of confidence in Western democratic systems.

Labor Day 2009 by the numbers

Via:  Economic Policy Institute  A statistical picture of a nation with a broken social contract. 

Labor Day by the numbers
By Anna Turner

September 7, 2009 | An EPI Fact Sheet

compiled by Anna Turner

Note that all numbers are current as of September 4, 2009.

TOTAL JOBS LOST DURING THE RECESSION: 6.9 MILLION

• New jobs needed per month to keep up with population growth: 127,000
• Jobs lost in August 2009: 216,000
• Jobs needed to regain pre-recession unemployment levels: 9.4 million
• Manufacturing jobs lost since the start of the recession: 2.0 million (14.6% of sector's jobs)
• Construction jobs lost in the recession: 1.4 million (19%, nearly one in five construction jobs)
• Mass layoffs (50 or more people by a single employer) in July 2009: 2,157; jobs lost: 206,791

UNEMPLOYMENT RATE: 9.7%

• Number unemployed: 14.9 million  (up from 7.5 million in December 2007)
• Underemployment rate: 16.8%; Share of workers un- or underemployed: roughly 1 in 6
• Under- and unemployed, marginally attached and involuntary part-time workers: 26.4 million
• Unemployment rate, ages 16 to 24: 18.2%
• Male unemployment: 10.9%; female unemployment: 8.2%
• White unemployment: 8.9%; black unemployment: 15.1%; Hispanic unemployment: 13%
• Unemployment rate, young college graduates: 5.9% (2nd worst on record); Worst recorded unemployment rate for young college graduates: 6.2% (1983)
• Traditional ratio of young college grads' unemployment to overall rate: 50%; Current ratio: 70%
• Portion of unemployed who have been jobless more than six months: one third
• Average weekly unemployment benefit in July (including additional $25 per week from the American Recovery and Reinvestment Act): $332

STATES WITH DOUBLE-DIGIT UNEMPLOYMENT IN JULY, 2009: 16; WHEN THIS LAST HAPPENED: 1983

• Highest unemployment rate: Michigan, 15.0%; lowest: North Dakota, 4.2%
• When California's Hispanic unemployment surpassed black unemployment: 2nd quarter, 2009
• Projected African American unemployment for Michigan, 2nd quarter of 2010: 24.9%

INCREASE IN AVERAGE U.S. WORKER'S PRODUCTIVITY, 2000-07: 19.2%

• Decrease in all prime-aged worker's real median weekly wages, 2000-2007: $1; Decrease for African Americans: $3
• Annual growth rate of private-sector workers' wages, last three months: 2.6%
• Annual growth of wages in managerial, professional, and related occupations, 2009, 2nd quarter: 0%
• Annual growth rate of real (inflation-adjusted), average, hourly wages since June 2000:  0.70%*
• Ratio of average CEO's pay to typical worker's pay in 1979: 27 to 1; Ratio in 2007: 275 to 1

EXPECTED NEW SPENDING (12-MONTHS) FROM THE NEW $7.25 MINIMUM WAGE: $5.5 BILLION

• Share of minimum wage workers with high school diploma in 1979: 57.5%: Share in 2008: 72%
• Workers getting a raise from latest minimum wage increase: 4.5 million
• Share of affected workers with annual family income below $35,000: 57.1%;  Share working at least 20 hours a week: 81.6%
• Extent to which the minimum wage's real value is lower than in 1968: 17%

AMERICANS UNINSURED IN 2007:  45 MILLION

• Drop in children covered through parents' employers, 2000 to 2007: 3.4 million
• Share of people under 65, with incomes in the top 20%, covered by employers in 2007: 86.4%; Share with incomes in the bottom 20%, covered by employers: 21.9%
• Share of Hispanic workers who are uninsured: 39.8%
• Percentage of under-65 Americans with employer-sponsored health insurance in 2000: 68.3%; In 2007: 62.9%
• Average monthly cost of COBRA with American Recovery and Reinvestment Act subsidy: $370; Without American Recovery and Reinvestment Act subsidy: $1,057
• Rise in out-of-pocket spending for the 1% of adults with the greatest medical expenses, 2004-2007: 42%
• Increase in health care premiums since 1999: 119%
• Amount by which U.S. private health insurance administrative costs exceeded all Canadian national health spending in 2007: $25 billion**
• Share of total U.S. health care costs paid by private insurers in 2007: 35%
• Share of total health care costs paid by U.S. government in 2007: 46%

SHARE OF PEOPLE NEAR RETIREMENT AGE WITH A 401(K) BALANCE UNDER $40,000 IN 2007: 50%

• Percentage of amount needed to maintain living standards that is held by average 401(k) participant approaching retirement: 20-40%
• Share of 401(k) assets estimated to be lost since 2007: 29%

WORKPLACES WITH NO CONTRACT MORE THAN THREE YEARS AFTER ELECTION IS WON: 25%

• Share of employers that interrogate workers in mandatory one-on-one meetings, 1999-2003: 63%; Share of employers that threaten workers in such meetings, 1999-2003: 54%
• Increase in likelihood that firm will fail if unionized: 0%
• U.S. manufacturing workers ranking on "value-added per employee," compared to 16 nations with higher compensation: 2

ANNUALIZED RATE OF ECONOMIC CONTRACTION, 2nd QUARTER, 2009: 1%

• Likely size of this contraction without the American Recovery and Reinvestment Act: 3-4%
• Jobs lost with the American Recovery and Reinvestment Act, 2nd quarter, 2009: 1.3 million
• Jobs that would have been lost without the American Recovery and Reinvestment Act, 2nd quarter, 2009: 1.8 million at least***

* EPI analysis of CPS and BLS data
**EPI analysis of HHS CMS, OECD, and World Bank data
***Mark Zandi, Moody's Economy.com

The bubble at the end of the age

Before commenting on the stock market, which everyone cares about, I must indulge a small obsession with the way that mainstream economists are able to ignore relevant research in psychology even when they are doing inherently psychological work themselves, and even when the relevant work in psychology was actually published by an economist—but in a journal with “psychology” in the title. 

I refer of course to the article by Robert Shiller in Sunday’s New York Times, “An Echo Chamber of Boom and Bust,” which apparently resulted from Shiller talking to himself in his office.  In their book on “animal spirits” Shiller and Akerlof ignore a seminal article in the Journal of Economic Psychology relating “animal spirits” to the first law of psychology, the Wundt Curve describing sensitivity to adaptation level. (see this and this).  The obscure economist who wrote these papers might reasonably be really pissed off at the arrogance of Shiller and Akerlof.  I have it on good authority that Shiller declined to respond to correspondence on the subject.

Paul Samuelson once said words to the effect that, "As economists, we don’t care what other people think of our work—we write for ourselves.”

I’m just a blogger, as Calculated Risk likes to say (and CR is someone who does respond to emails, BTW). 

As August has come to a close and a lot of folks are looking for a stock market pullback (and yours truly is slightly bloody from a small –2 beta position on the NDX), I thought it would be appropriate to update the Coppock Guide and my own “animal spirits” of the stock market oscillator that are both monthly models. 

The picture is pretty astoundingly bullish on a pure emotion basis.  Of course, it would require a veritable tsunami of liquidity to float the market on top of an economy that is in a depression.  But that’s what we have a Federal Reserve and Goldman Sachs for! 

Here’s the picture:

Click on graph to see bigger image in new window.

Now, I am as blown away as anyone to think that the U.S. stock market would have the unmitigated chutzpah to complete a gigantic head-and-shoulders pattern by climbing another ~50 percent from today’s levels, but this is what the emotional nature of the market wants, and it’s what Ben Bernanke would most like to deliver.  It might happen after the current pull back, as more economic indicators stabilize, and the dollar rallies on weakness in foreign economies.

It could be the bubble at the end of the age for America.  The way things are going the next collapse, due by my reckoning in 2013 or 2014, will be worse than this one.  The stock market will see new lows, in real terms if not in nominal terms.  If, as many expect, the government responds to fiscal bankruptcy by starting a big hot war and getting an inflation or hyper-inflation going, the stock market could continue to go up.

Next “animal spirits” update will be after the unemployment rate data is released on Friday.

It’s the debt, stupid (reprise)

Via:  Comstock Partners 

Check out the charts.  Only when viewed in the this context can one understand the scale of the criminality of the financial institution bailouts that put the bad debt (bad bets) of financial speculators on the backs of the American taxpayers.  This is all stuff regular readers have heard before, but Comstock does a really nice job on it.

I expect this house of cards to collapse within five or so years in unprecedented defaults that will of necessity be upon private debts.  This implies further asset price deflation in the U.S., probably of both real estate and stock prices. 

The monetary and fiscal authorities can be expected to “panic” again (really, they just realize that they have no choices, that all their moves are forced moves, forced by the financial-military-industrial complex and its ownership of the government).  It might well be agreed that, historically, the quickest way to get an inflation going to reduce the government’s debt is to have a hot war.  The chances of a U.S.-initiated war starting in the next decade are pretty good.  A rapid inflation could ignite.  So could a world war, over oil resources, perhaps. 

God save us from our leaders, and our greed.

Deleveraging the U.S. Economy
Total Credit Market Debt as a % of GDP
H/H Debt relative to Disposable Income
Savings Rate
Personal Consumption vs. GDP
H/H Debt vs. GDP
Credit Conditions
Capacity Utilization
Net Worth

We are in the process of deleveraging the most leveraged economy in history.  Many investors look at this deleveraging as a positive for the United States.  We, on the other hand, look at this deleveraging as a major negative that will weigh on the economy for years to come and we could wind up with a lost couple of decades just as Japan experienced over the past 20 years.  It is true that Japan didn't act as quickly as we did but our debt ratio presently is much worse than Japan's debt ratios throughout their deleveraging process. 

Presently, the stock market is exploding to the upside, which you could say argues against the case we are attempting to make in this special report.  However, if you step back and look at the larger picture, you can see that the stock market is still down over 35% from the highs reached in 2007 and also down over 33% from the highs reached in early 2000.  In fact, the market now is acting in the same manner as it did in early 2000 at the peak of the dot com bubble and again in 2006 & 2007 at the combined housing and stock market bubble. 

This seems to us to be a "mini bubble" of stocks reacting to an abundance of "money printing" by governments all over the world since stocks are rising worldwide.  Of course, if the U.S. doesn't recover there will be no worldwide recovery since the rest of the world is still dependent upon the U.S. consumers' appetite for their goods and services (despite the so called growth of domestic consumption in China and India).   We, however, don't believe that the U.S. massive stimulus programs and money printing can solve a problem of excess debt generation that resulted from greed and living way beyond our means.  If this were the answer Argentina would be one of the most prosperous countries in the world.  This excess debt actually resulted from the same money printing and easy money that we are now using to alleviate the pain.

Most investors believe the bailouts, stimulus plans, and quantitative easing will lead to inflation.  In fact, almost all of the bearish prognosticators are negative because of the fear that interest rates will rise once the inflation starts to work its way into the economy.  They point to the doubling of the monetary base which they believe will soon lead to rising prices as more dollars are created chasing the same amount of goods.  We, on the other hand, are not as concerned about the doubling of the monetary base because we believe the excess money will need the money multiplier and increases in velocity in order to increase aggregate demand and eventually inflation.  As long as velocity (turnover of money) is stagnant we expect the increases in the monetary base and all the quantitative easing will lead to a stagnant economy and deflation until the consumer goes into the same borrowing and spending patterns that was characteristic of the 1990s through 2007.  

Remember, over the past decade (when we believe the secular bear market started) the total debt in the U.S. doubled from $26 trillion in 2000 to just over $52 trillion presently (peaking a few months ago at $54 trillion).  This consists of $14 trillion of gross Federal, State and Local Government debt and $38 trillion of private debt.  We expect the private debt to continue declining in the future as the deleveraging of America unfolds, while the government debt will very likely explode to the upside as the government tries to slow down the private deleveraging by helping out the entities and individuals in the most trouble with debt (such as over-extended homeowners).    

We wrote a special report in January of this year titled "Substituting Debt for Savings and Productive Investment" in which we explained why the U.S. economy historically prospered because of hard working Americans saving a substantial amount of their income which was used for productive investment.  Unfortunately, all of this changed over the past few decades and got worse over the past decade.  In fact, we stated in the report that it took $1.50 of debt to generate $1 of GDP in the 1960s, $1.70 to generate $1 of GDP in the '70s, $2.90 in the '80s, $3.20 in the '90s, and an unbelievable $5.40 of debt to generate $1 of GDP in the latest decade.  Over the past two decades, while most investors thought this trend could continue indefinitely, we have been warning them of the catastrophic problems associated with this ballooning debt. 

The attached chart of total debt relative to GDP shows exactly how much debt grew in this country relative to GDP (it is now 375% of GDP).  The total debt grew to over $52 trillion relative to our current GDP of approximately $14 trillion.  This is worse than the debt to GDP relationship in the great depression (even when the GDP imploded) and greater than the debt to GDP that existed in Japan in 1989.  Even if you took the debt to GDP when the U.S. entered the secular bear market in early 2000 and compared that to 1929 and Japan in late 1989, our debt to GDP still exceeded both (by a substantial margin relative to 1929).  The approximate numbers at that time were about 275% in the U.S. in early 2000, 190% in 1929, and about 270% in Japan in 1989. 

In fact, the similarities between Japan's deleveraging and the U.S. presently are eerie.  Japan's total debt to GDP increased from 270% when their secular bear market started to just about 350% 7 years later (1998) before declining to 110% presently.  The U.S. increased their total debt to GDP from 275% of GDP when our secular bear market started (in our opinion) to 375% presently (10 years later), and we suspect the total debt to decline similar to Japan's even though the Japanese government debt tripled during their deleveraging.  The government debt relative to GDP was about 50% in both the U.S. and Japan when the secular bear market started.  We also suspect that our government debt will grow substantially just like it did in Japan as the private debt collapses.  Also, the Japanese stock market doubled during the three years preceding their secular bear market in 1987, 1988, and 1989 while the U.S. market also doubled during the three years preceding the beginning of our secular bear market in 1997, 1998, and 1999. 

There also a few significant differences between the U.S. and Japan.  The private debt in Japan was almost the reverse of the U.S. where most of our excess debt was in the household sector and most of the excess debt in Japan was in the corporate sector.  The debt to GDP figures in Japan were not easy to come by from the typical sources until the mid 1990s and had to be estimated, but should be pretty close to the numbers used above.  Our sources on the above Japanese debt figures came from Ned Davis Research and the Federal Reserve Bank of San Francisco. NDR's report, "Japan's Lost Decade-- Is the U.S. Next?" have great statistics and information and the Fed's report "U.S. Household Deleveraging and Future Consumption Growth" is well worth reading.

The Fed study charted the peak of the debt related bubble of the stock and real estate assets in Japan in 1991 (1989 for stocks and 1991 for real estate) and overlaid it with the peak of U.S. debt associated with the same assets in 2008.  They concluded that if we are able to liquidate our debt at the same rate as Japan we would have to increase our savings rate from the present 6% (artificially high due to the recent stimulus paid to households) today to around 10% in 2018.  If U.S. households were to undertake a similar deleveraging, the collective debt-to-income ratio which peaked in 2008 at 133% (H/H debt vs. Disposable Personal Income) would need to drop to around 100% by 2018, returning to the level that prevailed in 2002.

If the savings rate in the U.S. were to rise to the 10% level by 2018 (following the Japanese experience), the SF Fed economists calculate that it would subtract ¾ of 1% from annual consumption growth each year.  We did a weekly comment about this very subject on June 25 of this year and came to a similar conclusion.  In that same report we showed that from 1955 to 1985 that consumption accounted for around 62% of GDP.  Because of the debt driven consumption over the past few years at the end of March 2009 consumption accounted for over 70% of GDP.  If the percentage dropped to the normal low 60% area of GDP it would subtract about $1 trillion off of consumption (or from $10 trillion to $9 trillion).  We also showed in that same report that H/H debt averaged 55% of GDP over the past 55 years and was 64% as late as 1995.  It has since soared to over 100% of GDP giving a big boost to spending that will be reversed as the deleveraging takes place over the next few years.

Other problems we have in the U.S. that will exacerbate the deleveraging are excess capacity, unemployment rates skyrocketing (putting a damper on wages), credit availability contracting, and dramatic declines in net worth.  The attached chart of capacity utilization is self evident that excess capacity in the U.S. has just dropped to record lows with the manufacturing capacity dropping to under 65% and total capacity utilization is just a touch better at 68%.  It is very hard to imagine corporations adding fixed investment at this time.  With unemployment rates close to 10% and rising, it is unlikely that wages will grow anytime soon.  The charts on credit availability and net worth reductions are self explanatory and will also put a damper on consumer spending rising anytime soon.

We expect that the U.S. deleveraging will follow along the path of Japan for years as real estate continues to decline and the deleveraging extracts a significant toll from any growth the economy might experience.  We also expect that, just like Japan, the stock market will also be sluggish to down during the next few years as the most leveraged economy in history unwinds the debt.   

The collapse of effective demand

Everybody knows residential investment demand has fallen off a cliff post-housing bubble, but nonresidential investment demand is off 20 percent year-over-year because it is a “derived demand,” from the demand for consumption (which I looked at here—we are way above trend share of GDP going to consumption). 

Aggregate demand  = Consumption + Investment + Government spending + (Exports – Imports)) .  The table below shows the annualized rates of decline of GDP components.  The rates of decline of private investment spending are huge.  With capacity utilization at ~67 percent and further decreases in consumption likely, investment might at best stabilize in the near term.  The jet-assisted take-off of “multiplier-accelerator interaction” (where increasing consumption with production at capacity causes a disproportionate increase in derived investment demand) is not in the cards for the foreseeable future.  Ideally, in a Keynesian world, government would step in with government sponsored investment spending.  Unfortunately, much projected deficit spending has gone or will go to nonproductive wars, banking bailouts and health care (I support government making health insurance available to all Americans).  And after a postwar period in which “Keynesian” policies have created a mountain of public and private debt, recent Treasury auctions do not suggest a tremendous willingness of foreigners to fund our huge deficits, and we can hardly fund them ourselves unless by printing money, which will further erode foreign confidence in the dollar. 

America is a rich country.  There is enough to go around, but the realignment of national priorities required goes straight against the grain of entrenched interests, who would in fact have to give something back to the country that has given them so much.  That’s not easy for anyone to do.  But if we continue on this path the collapse of effective demand will probably continue, perhaps with a pause of a couple of years due to temporarily weakly rising “animal spirits,” ending in some form of social collapse and its consequences.

The middle way: reprise

Arianna Huffington got a naked capitalism citation for saying that a middle way reflecting neither all-Republican nor all-Democratic boilerplate positions is gaining ground in Washington (after >3 min I can’t find the link; sorry).

Here’s the problem I have with the libertarians: most of them don’t seem bothered by the financial catastrophe impending upon us (and yes, I will address that in the next “animal spirits” update).  From this I infer that they’re relatively well-off for the most part, traders and other rich folk who’d like to keep their taxes low and who don’t give much of a fig for the suffering of the unemployed.  Even Ron Paul has come out recently saying that it would be irresponsible not to provide health care for these folks.  He suggests paying for it by ending our wars.

Here’s the problem I have with the Keynesians like Paul Krugman:  they don’t look at the aggregate debt problem.  They’re advocating more debt to solve a problem of too much debt.  It will sink us.  It’s not just the ratio of federal debt to GDP; it’s the ratio of all nonfinancial debt to GDP that is at record levels of ~375 percent.  The Blue Dog Democrats share this concern.  My position is that we offer (1) health care and (2) a livable dole to the involuntarily unemployed.  These are the best stimulus dollars we can spend; they will be spent wisely.  Let the economy self-organize at the local level.  It’s going to take a long time to reconfigure the economy toward more saving and investment, away from consumption.  Also, helping people out will make them feel better about being Americans, rather than becoming radicalized.

Here’s the problem I have with the Monetarists:  see the above.  Ben Bernanke thinks that lowering interest rates, stimulating credit expansion, and adding to nonfinancial credit market debt is going to help!  When he and Alan (Not-Potty-Trained) Greenspan worried about deflation, didn’t they wonder why they were worrying about deflation?  Deflation happens when asset values get bid out of range by excessive credit creation, and people stop servicing the debt.  Banks reasonably tighten credit standards, and prices decline.  But no!  Greenspan and Bernanke think more credit creation is the answer.  Meanwhile, by keeping interest rates near zero (especially for well-connected borrowers like Goldman Sachs who not only get near-zero interest rates but FDIC guarantees on their debt) the Fed is creating a carry trade that will further distort asset prices and relative values.

Republicans exist to keep taxes low on rich people.  Democrats exist for much the same reason, because of the way elections are funded, but are willing to go a little higher on marginal tax rates on rich people.  It used to be that Democrats were the proven budget-busters, but after George W. Bush, that label no longer applies.  Most of Obama’s deficit is inherited.

The politicians need to come down off their ideological high horses and start taking care of the people. 

A simple outlines of my plan is here, in a letter I sent to my elected representatives:

Dear -----:

America already has more debt than it can handle.  The deficits will sink
the economy into a debt-deflation.

The stimulus, like the banking bailouts, is likely to go to the richest
Americans.  The government is broken.  The stimulus will not help the
people.  It is pork that will go to the well-connected.

America is a basket case.  Here's what we need:

1.  Health care for all, especially the unemployed, and a livable dole for
the unemployed to see them through the long crisis to come.  They will
spend the money taking care of their families and finding new jobs in time.

2.  Higher (much higher) marginal tax rates on the rich who have
manipulated the system to their advantage for so long.  I suggest 75%
rates on income over $1 million.  The rich need to learn to share, to give
back to the country that has treated them so well.

3.  An aggressive FDIC campaign to recognize and charge off bad debt in
the banking system.  Making rich investors whole on the taxpayers' backs
only exacerbates the debt-deflation, and risks turning America into a
neo-feudal society.  Reverse the banking bailouts.  Make Goldman Sachs pay
up—their profits were made with taxpayer money.

4.  Fiscal discipline.  The deficits need to be brought down under 5% of
GDP immediately, and to balance within 5 years.

America is a rich country.  The problem is not the amount of GDP, it's how
it's distributed.  America is now the greatest debtor country.  The
Keynesianism that worked in the thirties will sink us now. The government
is broken and can not be trusted to spend the public's money wisely.

These recommendations don't fit into either Republican or Democratic
molds.  As I used to tell my students, "make the adjustment."  A far worse
depression awaits us if we don't.

It's time for triage.  America is a basket case.

“Keep It Simple, Stupid” would seem to be a good way to go in the current environment.  So many mistakes were made during the Panic of 2008… and opportunistic Beltway insiders stand ready to spin every event to their own advantage.

Stop the bailouts.  Cut the pork.  Take care of the people.  Let the economy self-organize.

On the failure of macroeconomics

There’s a lot of discussion of The Economist’s recent articles on the failure of economics.  I have commented on this previously in Screw the stimulus, shoot the macroeconomists.  Let me try to adopt a more conciliatory tone.  Like many Americans, I am experiencing a lot of frustration watching our dysfunctional government with the perspective of a Boomer’s life experience. So many mistakes, repeated so many times….

The political system is incapable of applying good macroeconomic models even if they exist.  Take for example the slope of the yield curve as a recession indicator, which I used in my model along with my “animal spirits” variable.  Introductory managerial finance texts teach that an inversion of the yield curve is a reliable signal of a recession arriving within about a year.  The Fed knows this, most financially astute people know this. 

The yield curve inverted in 2000 and again in 2006.  What was the policy response?  To pump up the money supply, credit and lending and debt expansion!  Why?  Because Alan Greenspan and Ben Bernanke both saw the potential for deflation.  Was this the right thing to do?  No!  The reason deflation was realistically in the outlook was because we had too much debt already! 

By pumping up credit, our exalted Fed chairmen thought they could save the economy, or perhaps at least not have it collapse on their watch.  Bernanke was publicly quoted many times in 2007 saying the economy was in good shape.

We live in a political economy.

So what should we do?  Take care of the people!  Make policy on moral grounds with minimal reliance on models.  When people become unemployed, help them.  My basic requirements for the stimulus as noted in the reference above are a poverty level dole for the unemployed, and universal health care.  It is truly barbaric that you lose your health care when you lose your job (or it becomes so expensive you can’t afford it).  The government can’t be trusted to spend our money wisely much beyond that.  Too much of the stimulus will be on wasteful projects.

I know this is way too reasonable for the professional economists to buy into.  I am a Ph.D. economist.  The academics are all riding their particular hobby horses, charging their favorite windmills. 

We are living with political economy they’ve helped to create, a mish-mash of broken theories that come in and out of vogue with the amount of money backing their political spokes-clowns.  Remember “supply-side economics”?  How about “real business cycle theory”?  Or “efficient markets theory”?  All these impressively mathematical theories were marshaled to support policies that had major distributional consequences.

Please!  Let’s try looking directly at who gets what out of these policies, and whether a majority of Americans think they’re fair.  It’s our money.

That’s my modest proposal.

Via:  Ritholtz.com  The Jalopy Economy.  What central banking and modern macroeconomics (Keynesian or monetarist) have brought us.

All the fuss about “financial innovation” is largely about the illusory gains due to increasing indebtedness.  The rise in debt has fueled Wall Street’s compensation, asset bubbles, and has brought the U.S. to the brink of bankruptcy (and this doesn’t include the hidden indebtedness arising from social program promises).