From The Daily Capitalist
This is Part 3 of a four part article that deals with what I feel is the primary question investors must now answer: is our future to be inflation or deflation? The answer has vast implications to our investment planning and decisions for the near term, and possibly for our long term. It is a very complex question with a lot of moving parts involving economics and politics.
Like it or not, it is economic theory that is driving macroeconomic policies and political decisions that determine whether we will have inflation or deflation. Since not all of my readers are sophisticated traders I have tried to present the issues in a direct and hopefully understandable way. To those sophisticated readers, please bear with me.
What Factors Will Drive the Economy?
This is the point where we need to look at some long-term trends in the economy to see how they will impact a recovery.
If our economy is based on consumer spending (70% of GDP) then GDP will see a decline in the second half of 2010.
In my article, Economic Megatrends That Will Drive Our Future, I point our seven megatrends that will impact our economy for the long term:
- The culture of consumption is broken and won’t return to former levels. This is the key to everything.
- Consumers will continue to increase savings to prepare for retirement.
- Declining U.S. consumer demand will continue to negatively impact the world economy.
- Deflation (deleveraging) will continue for some time.
- Home ownership rates will decline to more historical levels of, say, around 66%, down from the high of 69% during the boom, which will keep a lid on home prices.
- Government stimulus and recovery programs only delay recovery and deepen the pain for workers.
- Massive federal deficits will double the national debt, result in higher taxes, and will act as a permanent drag on the economy.
I wrote this article in September, 2009, and it still stands. The significant things to note are No. 1 and No.2. Consumers are over-indebted and are doing their best to pay down debt. This article from the Wall Street Journal defines the issue:
After years of bingeing on debt, U.S. households are paring back. Those not doing so by choice are often being forced, because lending standards remain tight.
[T]he household sector's debt level, which includes both consumer credit and mortgage loans, remained at about 20% of total assets in the first quarter.
In the mid-1990s that ratio was around 15%, compared with a peak in the first quarter of 2009 of about 22.5%.
Just getting debt down to 18% would require households to shed an additional $1.4 trillion of debt.
The way to pay down debt is to decrease spending and increase savings, especially when unemployment is at 9.7% and when real wages (inflation adjusted) have been essentially flat:
J. M. Keynes referred to the phenomenon of increased savings and reduced spending as “hoarding” by consumers and believed it harmed the economy, which is why, he said, the government needs to spend in their stead. In fact, what consumers are doing is very rational economic behavior in light of uncertainty. Savings will actually lead the economy out of the recession by creating new capital to fund an economic expansion.
The main point here is that the consumption cycle for the majority of big spenders, the Baby Boomers, has changed, in my opinion, permanently. Boomers now realize that they need to save for retirement because Social Security won’t be enough, they don’t have enough financial assets, their home values will not regain their former highs, and they won’t inherit enough from their parents to help them in their old age.
This has significant impacts on the recovery and the inflation/deflation issue. That is because the politicians making policy decisions believe that Keynes is right. I’ll discuss this later.
Is Credit Unfreezing?
Recently lending has increased and excess reserves have decreased. Some have suggested that this is the beginning of the end of the credit freeze but I disagree.
This chart (TOTLL, YoY) reveals an increase in lending by commercial banks in Q1 2010:
This corresponds to a like decrease in excess reserves (EXCRESNS) during the same period:
This lending is evidenced by an increase in consumer loans in Q1 2010 (CONSUMER):
What happened was that consumers went on a mild spending spree. I believe that almost all of the increase in consumer spending had to do with government fiscal stimulus: Cash for Clunkers, Cash for Appliances, and the home buyer credit which has spurred sales in home improvement goods.
New car sales have been doing better as a result of dealer incentives. The data show that nonrevolving loans (NREVNCB), the measure for (mainly) auto loans (up 7.1% in April), went up dramatically in Q1 2010:
Retail sales increased during that period, but now it is declining, much to the concern of the Fed.
The latest Fed Flow of Funds report showed renewed declines in total credit as well as consumer credit. For Q1 overall household debt decreased for the seventh consecutive month (-2.4%). Consumer credit contracted 1.5%. Nonfinancial business debt was flat after four months of declines.
The Report said revolving credit, or credit-card use, fell a 19th straight time in April, down 12.0%. Further, personal savings are increasing again after the drawdown.
It appears that the temporary increase in consumer spending was not related entirely to money supply increases. Nonrevolving loans for autos increased, but a significant portion of general spending was fueled by personal savings of consumers. The following chart reveals that the rate of consumer savings (PSAVERT) declined in response to government incentives which favored certain industries (mid-2009 to Q1 2010). It appears that personal savings is starting to rise again, but we will need to watch the data to confirm such a trend.
The Fed’s Problem
The Fed has a dilemma.
On the one hand, if they believe we are in a strong recovery, then they are worried about inflation.
There was a lot of talk about recovery and the problem of what will happen when banks start lending again: banks will use their huge excess reserves which would cause money supply to explode, thus fueling “inflation” which they define as rising prices. This is what has been popularly referred to as the “draining the pond” or the “exit strategy” problem: how can the Fed sop up excess reserves before they hit the economy and cause rising prices? It is a very serious issue.
The Fed closely monitors CPI and, as shown before, prices are growing at the rate of 2% YoY. (I’ll discuss signs of a decreasing CPI rate below.) If they decide to decrease the money supply by raising the Fed Funds rate from nearly zero percent, they believe they run the risk of jeopardizing the nascent recovery.
For many months now most of the discussion by the Fed and most economists concerned exit strategy. Now the discussion has changed almost 180°: the buzz is now all about the possibility of deflation and economic decline. (See discussion below.)
For these reasons, I don’t think they are that concerned with inflation for the near term.
The Implications of a Double-Dip Decline
Temporary Effects of Stimulus
I think the economy is headed for a decline commencing at some point in the second half of 2010. I believe the Fed is concerned about this as well. Evidence of this is starting to show up in the numbers. The reasons for this are complex, but:
- Most of the economic gains have been the result of fiscal stimulus which is running out of steam.
- There has not been sufficient deleveraging in the economy by which banks have repaired their balance sheets.
- The remaining huge real estate debt hanging over banks, especially commercial real estate, has not been dealt with because of various government policies that postpone the inevitable write-downs (mark-to-make believe, extend and pretend, housing credits, and delay and pray) and will restrict lending.
- Monetary stimulus has failed to create viable economic growth.
- These facts inhibit the creation of credit and will act like an anchor on the economy.
- The long-term megatrends mentioned before will reduce economic activity and cause major shifts in the economy.
There is no question that consumer spending has been stimulated by government programs. Those programs are now coming to an end. Recent data showing a decline in retail sales surprised most economists.
The Wealth Effect
Another factor is that the stock markets have had a positive impact on families’ perceived wealth which has helped consumer spending. But, it appears that most of such spending has been from the wealthier segment of the economy. A recent Gallup poll showed that consumers earning more than $90,000 accounted for the bulk of that spending increase. A market stock decline will reduce this wealth effect.
I believe our manufacturing recovery has been a result of cyclical factors unrelated to stimulus programs. As nervous retailers and wholesalers cleared out inventories in the early stages of the recession, at some point they had to restock. While unemployment is high, the fact is that at least 80% of the work force have jobs and, even though they may feel insecure, they still spend on what is necessary. That boosted manufacturing. But manufacturing without renewed consumer demand and a revival of credit will not lead us out of the recession.
Also, manufacturing has been benefited by the cheap dollar which has boosted exports. Other countries, especially developing countries, have been buyers of US products. But I think this is changing because of:
- The dollar’s rise caused by Europe’s deep economic problems will reduce our cheap dollar advantage; and
- China’s economy is based on exports and declining US and EU economies will impact its growth. Further they are facing a serious housing bubble that will burst the hard way. China needs an American economic recovery to save them, not vice versa.
It is clear that the American economy headed for a double dip decline, which I believe will occur in the second half of 2010.
I have noticed in the mainstream media that with increasingly weak numbers coming out recently there is a lot of talk about deflation. This is important because it is a reflection of mainstream economic thinking, which includes the Fed. Ben Bernanke reads the same headlines as you and I do.
Here are some recent headlines and the issues they raise:
The consumer price index dropped 0.2% last month, the Labor Department said. The "core" rate of inflation--underlying consumer prices, which strip out volatile energy and food items and are closely watched by the Fed--rose 0.1% in May. …
This concerns shows up in Core CPI YoY (CPI less energy and food):
Deflation makes it harder for consumers, businesses and governments to pay off debts. Principal repayments on debt are fixed but deflation is marked by falling incomes, so as deflation sets in the burden of paying off old debts gets greater. …
That's an acute worry today. In addition to government debt, U.S. households are still trying to work off large debt burdens built up in the last two decades. A Federal Reserve report Thursday [Flow of Funds report] showed households cut their borrowings in the first quarter to $13.5 trillion, down from a peak of $13.9 trillion in 2008.
Advancing a theme he has emphasized in the last few months, Mr. Bernanke said that if Congress pursued more fiscal stimulus to sustain the recovery, it should be accompanied by a concrete plan to bring the deficit back into line in the long run. Without a fiscal "exit strategy," he said, the U.S. could, "in the worst case," see financial instability like in Greece.
The Congressional Budget Office projects the U.S. deficit will hit $1.4 trillion this year, or 9.4% of gross domestic product. Even as the economy recovers, it projects deficits in excess of $400 billion a year later this decade.
At a moment when many economists warn that the American economic recovery is likely to be imperiled by prolonged high unemployment and slow growth, President Obama is discovering that the tools available to him last year — a big economic stimulus and action by the Federal Reserve — are both now politically untenable.
But fiscal woes in Europe, stock-market declines at home and stubbornly high U.S. unemployment have alerted some officials to risks that the economy could lose momentum and that inflation, already running below the Fed's informal target of 1.5% to 2%, could fall further, raising a risk of price deflation.
There is no world economy big enough to offset renewed contraction in Europe and the US. Concerted fiscal tightening could, in current circumstances, fail: larger cyclical deficits, as economies weaken, could offset attempts at structural fiscal tightening. …
Policymakers must recognise that deflation is a risk, too, and that tighter fiscal policy requires effective monetary policy offsets, which may be hard to deliver today, above all in the eurozone.
Premature fiscal tightening is, warns experience, as big a danger as delayed tightening would be. There are no certainties here.
The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest increase on records going back to 1952. Cash made up about 7% of all company assets including factories and financial investments, the highest level since 1963.
You get the drift: the economy is not going as the Fed and most economists have predicted so naturally they talk about deflation. They are worried about the possibility of experiencing deflation similar to what occurred in the Great Depression.
Why Most Economists Have it Wrong
Most economists believe that more fiscal stimulus is needed now and that Bernanke’s cries for fiscal sanity must not be heeded or we will sink into a depression. This is a normal Keynesian reaction to the world. In fact the arch knee-jerk Keynesian of our time, Paul Krugman’s last three editorials have spoken to this issue. Across the pond Martin Wolf of the Financial Times has been beating the same drum.
I wish they would explain why all the fiscal and monetary stimulus the government has done since October, 2008 hasn’t worked yet. Krugman would just say government hasn’t spent enough. But then he always says that. Perhaps he should read some of Rogoff and Reinhart’s research on what government debt does to a country’s ability to recover. The fact is fiscal stimulus never works and never has. But it will leave us saddled with huge debt.
It would be a mistake to credit government spending on fiscal stimulus projects for any lasting economic gains. Since the government can ultimately only obtain money from taxpayers, it is only a shift of capital from individuals (i.e., the folks that make the economy function) to the government to fund projects it deems politically beneficial.
Government fiscal stimulus projects do not create any lasting economic benefit. While it is true that new roads and safe bridges benefit the economy, that is not the purpose of fiscal stimulus. The purpose of fiscal stimulus is to create “jobs” and stimulate consumer spending. Such stimulus is wasteful and never creates a viable economic enterprise which would continue after the money dries up.
One must ask what the private economy would do with the $62 billion already spent through the American Recovery and Reinvestment Act ($202 billion contracts, grants and loans awarded to date). I urge anyone who believes the spending through ARRA would stimulate the economy to check out the various contracts and grants that are being awarded. The main web site is Recovery.gov. You will see that most are repairs to federal facilities or grants for federal programs. I recommend you hold your nose while doing this. They are outrageous wastes of your tax money and they will damage the ability of the economy to recover and will place a great burden on future generations to pay them.
If government spending were the key to economic wealth then we should all be rich.
Tomorrow, Part 4. The Fed's response to a decline, money supply, and the likely outcome.
After Part 4, I will publish the entire article as one downloadable PDF.