Can We Avoid Another Lost Decade?

Leo Kolivakis's picture

Via Pension Pulse.

Michael Darda, chief economist, chief market strategist and director of MKM Partners, wrote an op-ed in the WSJ asking, Are We Headed for a Lost Economic Decade?:

Despite
record doses of monetary and fiscal support, the U.S. recovery appears
to be stumbling. First-time claims for jobless benefits are on the
rise and economic growth estimates for the April-June quarter have
fallen to just over 1%. Many are now asking if we are on our way to a
double-dip recession or even a Japanese-style "lost decade."

 

These
concerns are not without merit. Although the Federal Reserve expanded
its balance sheet massively in 2008-2009, most of the high-powered
money (currency plus bank reserves) that it's provided has piled up as
excess bank reserves on deposit at the Fed.

 

Growth in commercial
bank credit and broad money (which consists of currency plus bank
reserves plus deposits in the banking system) is decidedly weak. That's
a reminder that interest-rate cuts and money printing don't have the
same traction when households are debt- and savings-constrained, and
financial institutions are uncertain about the value of the collateral
underpinning their loans.


 

But
there are key differences between where we are now and where Japan was
50 months after the 1990 peak in its real-estate market. These
differences make it less likely that we'll succumb to a deflationary
double-dip recession or a lost decade.

 

For example, industrial
commodity prices are about 75% above comparable levels in Japan just
over four years from the peak of its real-estate bubble, suggesting a
lower risk of a deflationary slump here. Corporate profits in the U.S.
are more than 50% above where earnings were at this point of the cycle
in Japan, despite the fact that the S&P 500 is actually lower than
the Nikkei 225 was at this point in Japan.


 

Although
broad money is currently expanding slowly in the U.S., the level of
the broad money stock is 20% higher here than it was in Japan 50 months
from the peak in its real estate market. This gap owes to the more
aggressive early efforts of the Fed as compared with the Bank of Japan.

 

Those
concerned about a Japanese-style lost decade occurring here will point
out that the Treasury yield-curve spread (the gap between long-term
interest rates and short-term interest rates) is actually narrower in
the U.S. now than it was in Japan 50 months from its real estate peak.
This gap not only gives us a picture of monetary policy, it also tells
us about the behavior of inflation expectations. The yield-curve spread
actually widened after the Fed announced the planned purchases of $1.75
trillion in agency, mortgage and Treasury debt in early 2009, as
deflation expectations were replaced with expectations for modest
inflation.

 

But the yield-curve spread
peaked in February 2010—the same month the level of the monetary base
peaked—and has since narrowed sharply. Treasury Inflation Protected
Security (TIPS) spreads have compressed during this period. These
indicators suggest the need for the Fed to remain accommodative, as the
Fed statement on Tuesday suggested would be the case.

 

The
current economic situation looks like the first few years of economic
recovery following the 1990-91 U.S. recession, which were also
characterized by weak broad-money growth and a contraction in bank
lending. The M2 money supply (a measure of broad money) expanded by
only 1.4% per annum through 1994 from 1992, but the velocity of money
(the frequency with which a unit of money circulates) turned higher,
allowing real GDP growth to average 3.7% per year nonetheless.

 

Putting fiscal policy on a sustainable, pro-growth track may help reduce uncertainty and improve velocity now.

 

One
problem that dogged Japan during its lost decade was a stop-and-go
fiscal policy in which stimulus packages were administered in an "on
again, off again" fashion and taxes were lowered and then raised. There
is a risk that the U.S. could fall into this trap in an effort to
strike a balance between short-term fiscal support and long-term budget

integrity.

 

This strongly suggests that congressional leaders of
both parties should embrace a pro-growth fiscal reform that would help
to create long-run fiscal stability and foster certainty about future
tax rates. With the 2001-2003 tax cuts set to expire at the end of
2010, the time is now to move ahead with broad-based reform.

 

A
good starting point would be the bipartisan Wyden-Gregg tax reform bill.
This bill is not incredibly bold, but is probably the best we could do
in the current environment and is much better than the current tax
code.

 

Wyden-Gregg would be
revenue-neutral; it would simplify the tax code by reducing the number
of personal income tax brackets to three from six and would do so
without raising marginal income tax rates. The bill also would cut the
top corporate tax rate to 24% from 35% in exchange for eliminating
corporate tax loopholes.

 

This would surely be preferable to
raising marginal tax rates at a time of high economic anxiety. Raising
tax rates on capital, which will occur if the 2003 tax cuts expire at
the end of this year, generally has not been an effective source of
revenue for the Treasury and could do damage to the recent strong
productivity trends the U.S. has enjoyed.

 

The
most likely course for the U.S. economy from here is for a choppy
recovery cycle to continue until households have increased their
savings and reduced their financial obligations to sufficient levels
and financial institutions have more confidence that loan losses have
peaked.

 

Avoiding policy mistakes during this period will be
critical. While the Fed is the ultimate source of liquidity and thus
"demand," congressional leaders could help reduce uncertainty and
increase confidence by embracing a bipartisan tax reform that focuses
on broadening the tax base and preserving incentives for growth.

Stéfane
Marion, chief economist at the National Bank of Canada, discusses
another factor which people should bear in mind before drawing too many
parallels with Japan's lost decade:

A growing
number of market watchers are beginning to draw parallels between the
hardships that the Japanese experienced in the aftermath of their
real-estate induced recession in the early 1990s and upcoming problems
for Americans. Is the U.S. about to experience a Japanese-style lost
decade? Three years after the onset of the recession, it is reassuring
to see that the timing and size of policy response in the U.S. has so
far enabled its economy to fare much better than Japan did at the same
point in the cycle on a number of fronts (production, money supply and
inflation).

Even if we do not
deny that the Americans still face a period of deleveraging, we doubt
that it will be as painful as that suffered by the Japanese. That’s
because of a key difference between the two countries: demographic
trends.
It is important to keep
in mind that Japan’s deflationary problems have been exacerbated by a
decline in the population of prime-age house buyers (defined as the
number of people in the 20-to-44 age group).

Unlike
Japan, the U.S. is at a positive inflection point for that specific age
cohort. According to the U.S. Bureau of Census, the population of people
aged 20-44 is expected to increase through the next twenty years (13
million people). Japan, for its part, has already experienced a decline
of 6% for that cohort (or 3.2 million people).

But while the US is not Japan, some see major problems ahead as interest
rates are kept at historic lows. The Associated Press reports, Fed official sees bigger risks in future, not now:

When it comes to the economy, Thomas Hoenig seems more worried about the future than the present.

Hoenig,
president of the Federal Reserve Bank of Kansas City, has been sending
up flares all year that the Federal Reserve's easy-money stance could
hurt the economy down the road. His big concerns: keeping rates low
will unleash inflation and spur new speculative bubbles.

And,
he's sticking to that stance even as the recovery has lost a lot of
momentum. Concerns are growing among private economists that the
economy could stall out, or worse, slide back into recession.

Hoenig,
in a speech delivered Friday, suggested that those fears are
overblown. As he sees it, the economy is growing modestly and has the
"wherewithal to recover." During recoveries, economic barometers often
bounce up and down, he said.

While
some private economists looking at recent economic data are seeing the
glass as half empty, Hoenig views it more as half full. He points out
that private companies have created 630,000 jobs so far this year.
While that's less than hoped for, it's "positive nonetheless," he said.
He notes gains in manufacturing and Americans' incomes over the last
12 months.

"While we are not where we want to be, the
economy is recovering" and it should continue to grow over the next
several quarters, he predicted.

For now, the economy still needs
the support of ultra-low rates, he said. Interest rates have been at
record lows near zero for nearly two years.

But
he worries that keeping rates too low for too long could create
problems later on. For instance, low rates could spur bubbles in the
prices of commodities, bonds or other asset prices. Or, they could
encourage people and businesses to take on too much debt again and
overly leverage themselves, he suggested.

"If we again
leave rates too low, too long out of our uneasiness over the strength
of the recovery and our intense desire to avoid recession at all costs,
we are risking a repeat of past errors and the consequences they
bring," Hoenig said in a speech in Lincoln, Neb.

Critics like
Hoenig blame the Fed for keeping rates low for too long a period after
the 2001 recession. Those low rates fed a housing bubble that
eventually burst and plunged the economy into a severe recession in
late 2007, they say.

"I believe that zero rates during a period of modest growth are a dangerous gamble," Hoenig said.

That's
why Hoenig has dissented at all five Fed meetings this year. The
latest one came Tuesday, when he broke from the Fed's decision to take
an unconventional step to strengthen the recovery by buying government
bonds.

One of the many challenges of being a Fed official is
having to make decisions on interest rates and other policies actions
now - based on your best thinking of what the future will hold.

When
James Bullard, president of the Federal Reserve Bank of St. Louis,
looks ahead he worries that the weak recovery could push the United
States into a deflationary period, like the "lost decade" Japan suffered
through in the 1990s. Low rates help combat deflation, a widespread
and prolonged drop in prices of goods and services, values of stocks
and homes, and in wages.

Hoenig, however, said he sees "no evidence that deflation is the most serious threat to the recovery today."

These
differences of opinion within the Fed provide a glimpse of the
challenge Fed Chairman Ben Bernanke tries to straddle as he tries to
steer the economy into a sustained recovery.

Hoenig does acknowledge that the economy is going through "trying times" - especially with unemployment now at 9.5 percent.

Low interest rates cannot solve every problem faced by the United States, he argued.

"In
trying to use policy as a cure-all, we will repeat the cycle of severe
recession and unemployment in a few short years by keeping rates too
low for too long," Hoenig, said. "I wish free money was really free and
that there was a painless way to move from severe recession and high
leverage to robust and sustainable economic growth, but there is no
short cut."

I happen to agree with
Hoenig that the US economic recovery is well underway, and that things
aren't half as bad as doomsayers will have you believe. But I disagree
with him is that the Fed should raise rates anytime soon.

Unlike the UK, inflation expectations remain low in the US, and some reputable fund managers are positioning their portfolios, fearing the danger of US deflation:

A
year ago, Pimco, the world’s second biggest bond fund manager,
assembled its financial wizards and instructed them to put a number on
the chances of deflation in the US. They came up with 10 per cent. Today, Mohamed El-Erian, who presides over Pimco’s $1,117bn in assets, puts it at 25 per cent.

 

“We
are still attaching the highest probability to outcome ‘C’ – what we
call the new normal, which involves muted growth, high unemployment and
choppy markets,” says Mr El-Erian. “But we are moving toward the
‘C-minus’ camp now.” The repercussions of the sharp global recession
that followed the 2008 financial crisis are still unclear, with economic
conditions far removed from those that most people have experienced.
The Federal Reserve showed its concern this week
when it downgraded its outlook for US economic growth. It took a first
step towards further monetary easing despite near-zero official
interest rates.

 

Investors are divided over what will happen next:
can the US economy be stopped from sliding into another recession –
the feared “double-dip”? Can the Fed prevent Japanese-style deflation,
a period of falling prices associated with economic stagnation, from
taking hold? Or might the easing lead to rampant inflation later?

 

Mr
El-Erian says Washington’s influence over the outcome makes
predictions tricky: “If the mindset in Washington doesn’t move from a
cyclical approach to a more structural approach to grapple with
fundamental problems, the probability of deflation increases.”

 

Pimco favours government bonds, with five- to 10-year US Treasuries likely to fare the best.

 

The
split among investors is acute in the hedge fund industry. John
Paulson – founder of the $33bn Paulson & Co, which profited
spectacularly from the collapse of the US subprime mortgage market –
has been consistently bullish on the US economy.

 

As well as
having launched a fund to take advantage of a US upswing, Mr Paulson
has denominated over a third of his entire funds under management in a
gold-linked share class, constructed specifically as an inflation
hedge.

 

But other leading fund
managers, including Peter Thiel of Clarium Capital, Seth Klarman of
Baupost and Ray Dallio of Bridgewater, are taking a different stance
and have positioned their portfolios with deflation, not inflation, in mind. Buying US government bonds and placing bets on volatility are central to their strategies.

 

Market
participants seem to be heeding their concerns. Expectations of
inflation – measurable in the so-called “breakeven” rate on 5-year US
Treasury bonds versus their inflation-linked equivalents – have been
falling sharply since a peak on April 30, hedge fund managers say.
Current prices imply an expected rate of inflation of just 1.3 per cent,
the lowest since October last year.

 

“Inflation proponents are
capitulating at the moment,” says Jamil Samaha, portfolio manager at
CQS, which manages $7.5bn. “It’s not necessarily that they have changed
their minds, but that the market has gone against them for longer than
they can afford it.”

 

Managers say markets are poised at a
critical juncture. “For several years I have believed that we will go
through a period where the markets will alternate between fearing
inflation and deflation – though unless policymakers make a huge
mistake, I don’t think either is necessarily poised to be realised,”
says Sushil Wadhwani, a former member of the Bank of England’s monetary
policy committee and founder of quantitative hedge fund Wadhwani Asset
Management.

 

With the economic
situation so fragile, though, the unexpected could have big
repercussions. “Markets are particularly vulnerable to event risk at
the moment; that could push the economy into brief deflation,” Mr
Wadhwani says. “The sort of events that could materialise in Europe
would make Lehman look like a garden party.”

 

“We’re clearly in a
deflationary episode, but so far there has been a belief that the Fed
can fight it,” says Ben Funnell, a portfolio manager at GLG Partners,
which manages $23bn. “If longer-term inflation expectations go
negative, though, equity earnings will be crushed, corporates will
scale back investment.”

 

David Kelly,
chief market strategist at JP Morgan Funds, which manages $400bn in the
US, does not believe there will be another US recession, even if
growth is slowing. He questions the wisdom of US investors who have
placed more money into bond funds than equity funds for 31 months in a
row.

 

“Anybody who’s investing in mutual funds or stocks should
not be looking at the next six months,” he says. “People’s
psychological time horizon shrinks when they are worried. But they
should be thinking: when do they need the money? If it’s five or 10
years down the road they should be buying stocks.”

 

Neil Woodford,
head of investment at the UK’s Invesco Perpetual, says: “We’re in the
early phases of a long period of adjustment ... government bond markets
are clearly concerned about deflation.” But some equity valuations are compelling, he says.

 

Jim
Rogers, the veteran investor, does not expect deflation but is not
favouring stocks. “There is a physical shortage of many commodities. If
anything goes wrong we will see higher prices,” he says.

 

“I
would rather own commodities than stocks. If the economy gets better,
more will be bought and, if it gets worse, then they are going to print
money, which is good for silver and gold.”

 

“I am going to sell
bonds short,” he adds. “But I’m not going to short them now because the
central banks have more money than I do.”

So
there you have it, even the experts are divided as to where we're
heading. One thing is for sure, markets will remain choppy until we get
some clear signs that the threat of deflation has been averted. Until
then, expect more volatility, and watch for a few potential bubbles
which are forming as all this sorts itself out.