Guest Post: Central Planning's Christmas Problem
Submitted by Jeff Snider of Atlantic Capital Management
Central Planning's Christmas Problem
Most of human history conforms to established patterns, forming the basis of modern statistical analysis. Random walk extrapolation from any data series seems to hold up in the face of reality because the data series is extracted from the pattern itself, a sort of logical fallacy. Models constructed in this way “behave” rather well until the pattern and paradigm shifts.
At that point, models should be recalibrated to the new pattern in order to maintain any kind of usefulness (or simply scrapped). This is especially true if the model failed to see the paradigm shift coming, a predictive capacity that is almost built-in since inflection points are not really points at all; they are an eventual slide into the new pattern. During the inflection “period”, models conditioned by the old pattern will increasingly look out of sync and render confusing results to their practitioners. But, due to human nature intruding into this “scientific” process, all too often these human practitioners look to rationalize and fit the wider world into their models, rather than see the paradigm shift for what it is. Combining this willful blindness with the simplifications that models have to incorporate just to function, the fact that they rarely see inflections is not at all surprising.
That the world of 2010 & 2011 looks nothing like the world of 2005 & 2006 has yet to be included into the “science” of economics and its mathematical modeling. Sure, statistical analysis has incorporated the data series of the past few years into the larger subset (they have told us so: http://www.frbsf.org/publications/economics/papers/2011/wp11-01bk.pdf), but the larger assumptions about how all the major and minor economic variables interact with each other have remained largely untouched. The Fed still believes low interest rates stimulate both credit demand and supply, an economic “law” that only applied to the previous period dominated by the over-saturation of credit. We see this pretty much everywhere modern monetary thought penetrates – from monetary policy and predictive capacity to economic statistics.
Within the context of economic statistics, I think it is pretty much common knowledge that they are conditioned by adjustments, imputations and the like. All these various techniques for “shaping” the data into “meaningful” results for interpretation is done based on assumptions about the patterned validity of those very assumptions.
For example, seasonal adjustments are made on quarter-over-quarter data simply because there is still, in this modern age, seasonal variations to economic activity within a calendar year. Among all the more controversial data manipulations (like the imputation of owner occupied housing rent), the seasonal adjustments are probably the most widely accepted and unchallenged.
Christmas is one of those expected variations. American consumers, in particular, engage in the bulk of their marginal consumption in and around the Christmas holiday “season”. Therefore, economic models expect to see an increase in shopping activity within the holiday season as compared to the rest of the year. The seasonal assumptions also take into account the significant production and inventory accumulation leading up to the consumer binge.
I think it has become apparent that there is something rather amiss in the economic statistics of the past few years (to put it mildly in light of the massive downward revisions to economic estimates that come no sooner than six months after preliminary releases). We have now seen in both 2010 & 2011 the exact same pattern repeat: a weaker-than-expected summertime lull, stoking recessionary fears heading into that crucial holiday period; followed by better-than-expected results during the last stages of the run-up and early stages of the actual shopping period; followed by weaker-than-expected end of the current year and start to the next year.
The past two summers, both the “Summer of Recovery” in 2010 and the “Summer of Crisis” in 2011, have created the impression of an economy on the verge of contraction. Both autumns, the QE 2.0 insanity of 2010 and the Operation Twist impotence of 2011, have largely erased those recessionary fears through the release of improving statistical extrapolations of the underlying data. By the end of July 2011, the economic exuberance of QE 2.0 was proven to be nothing more than a statistical mirage, as nearly all of the follow-through consumer “strength” in Q1 2011 was written off (there were similar downward revisions in the middle of 2010 for the 2009 Christmas cycle, though not of quite the same shocking magnitude).
If we think of seasonal assumptions as statistical fudge factors that attempt to smooth out the volatility or amplitude in the rates of change, then the real story begins to emerge, especially as it relates to the economy in this new paradigm.
In the good old days of the asset bubble periods, the seasonal fluctuations between the holiday season and the rest of the year were not as pronounced. In other words, household consumption held relatively steady throughout the year (the savings rate was uniformly low or near-zero). So these old-pattern statistical assumptions of the BEA do not expect an overly large amplitude to the rates of change in activity moving between seasonal periods.
The Christmas season, in cold economic terms, is nothing more than binge shopping. So the seasonal assumptions of this binge season before 2008 were that the binges were relatively constant (on the margins) during the year, but just a bit bigger toward the end of the calendar. Since access to money of some type in the bubble period was readily available throughout the calendar year, binges could be more constant since they were functions of cash flows rather than seasons (if a home equity loan closed in April there was no need to wait until Black Friday to load up on flat screens and expensive towels).
After 2007, of course, with the collapse of household wealth and marginal access to credit (thanks to the collapse of the marginal supply of credit), binge buying of Christmas-like proportions during the year has largely ceased (with the notable iExceptions). The majority of the American population is forced into re-proportioning marginally away from discretionary spending, concentrating more on necessities (especially as the Fed intentionally creates inflationary expectations, which pushes the dollar lower and commodity prices higher) and requiring the anachronistic concept of saving before buying, including the return of layaway instead of 0% financing.
In terms of statistical variations then, the models, based on the low-amplitude expectations of pre-collapse pattern, expect to see only a little deceleration after the Christmas binge. But, as pointed out earlier on ZeroHedge (http://www.zerohedge.com/news/black-friday-shopping-hangover-coming-david-rosenberg-explains), the bills come due starting late December and January, cannibalizing discretionary spending in the winter season of the next year and making the early quarters look far worse than those modeled expectations. That weakness carries through mid-year, again confounding expectations, as consumers increase their level of savings absent consistent incremental external funding (such as credit, transfers or jobs). Models then see a massive upward and unexpected magnitude of change in demand and activity between the summertime lull and the holiday season. Because they have not really changed economic assumptions from the pre-collapse pattern, they are unable to account for this large increase in volatility and amplitude in the rate of change between seasons, so the data looks so very disappointing in the spring and summer, and so very good in the Christmas window.
This leads to all sorts of collateral consequences in both real and mathematical terms. Employment, for instance, has tended to be more seasonal and part-time in this recovery largely because of the intuitions of real participants, despite all the manufactured expectations that come with these overly rosy extrapolations of the Christmas season. So the BLS’s models cannot account for this new configuration either. The adjusted employment numbers end up following the same exact pattern as the BEA’s economic numbers: summer weakness, autumn surprise, following year writedowns. In real economic terms this means jobs will only follow the real pattern, performing far below the expectations of economists and model practitioners that endlessly proclaim “the consumer is back”.
Looking at the recovery from a non-seasonally adjusted basis by comparing year-over-year changes, the picture that emerges is far more clear (http://www.zerohedge.com/news/tis-season-seasonal-obfuscation) and much more dire. The economy is slowing, ratcheting itself lower with each seasonal cycle of disappointment as more people exhaust sources of income (reduced wages by becoming a “discouraged” worker or falling off the 99 week cliff into SNAP). The contractionary fears of the summer were valid in the real economy, only displaced by the temporal interpretations of confused models.
There are numerous implications to all of this, not the least of which is the validity of central planning as a useful tool of economic control. The Federal Reserve and its central bank brethren are forms of economic control, even if they “only” set the rate of interest, and therefore the cost of money and risk within the financial system. These levers of “stimulation” have led to the very real world consequences that we find ourselves in today. This “new normal” or paradigm shift is a direct result of the policies implemented by the flawed monetary science practiced within the central bank-dominated regimes of developed economic systems.
(For all those that believe the 2008 crash was perpetrated by the powers that be on purpose, I ask what is better: to transfer wealth quietly from the population who willingly hand over their “money”, all the while thinking they are concurrently “succeeding”, or quickly and violently taking wealth in full view of the now on guard population looking for retribution and somewhat aware of what is actually amiss? Forty years of harmony and the slow transfer of inflation and debt, or three years of misery and the building forces of bottom-up resentment and potential power shift? The perfect “crime” of wealth transfer is committing it without anyone ever knowing it is taking place. I think Wall Street is and has been the direct benefactor of flawed monetary thought, reaping the vast, quiet reward of being the Federal Reserve’s pet monetary tool as it sought to implement the economic utopia of objective monetary science, enthusiastically joining Alan Greenspan in defeating the business cycle by enlarging the financial economy. The 2008 crash was the necessary response to the dramatic build of inefficiencies from that dystopian drive, the neglect of the real economy in the paper chase of easy, inflated debt money. That Wall Street succeeded in both phases is simply the result of this symbiosis – maintaining central bank control means maintaining Wall Street – as is the regular movement of personnel between Washington and New York. The Fed gets the power and Wall Street gets the money that comes from it – literally. The crash caught both off-guard, desperately scrambling to find plausible explanations that preserve this dangerous dynamic.)
The relevance of all this goes well beyond diagnosing the lack of recovery, finally spilling over into questions of exactly what kind of system will emerge moving forward. The lack of actual improvement in any real sense has left these central authorities searching for both answers and scapegoats. One segment of the statist impulse has already pegged capitalism as the primary culprit, with free markets as the bastard child of market instability and economic insecurity. Not coincidentally, that has been the premise to all this central control and intervention in the first place – that free markets are inherently unstable and messy. So the objective precision of enlightened central planners has to lead to a less messy, more equitable economic arrangement, or it has no validity.
To force the economy into a real recovery, this segment believes, is to move toward less freedom and more planning. Andy Stern’s (the former head of the SEIU, one of the largest labor unions in the world) op-ed in last week’s Wall Street Journal openly called for central planning akin to China. In the process, he expressly advocates leaving the very capitalist system that he acknowledges created all this wealth in the first place.
On the other side of the conventional political spectrum, Ramesh Ponnuru (senior editor at the conservative magazine National Review) wrote last week in Bloomberg to give us what is supposed to be the capitalist response. He argues, with bipartisan concurrence of the idea from the likes of Paul Krugman and Christina Romer, for the Fed to abandon interest rate targeting in favor of Nominal GDP targeting. Here the central bank ensures the economy grows to a specific target every year (ostensibly leaving “the market” to sort out the mix of inflation and income growth to reach the target) through the familiar toolkit of credit and money creation channels.
The Fed actually discussed this idea at its last policy meeting (perhaps because it was loudly proclaimed by Goldman Sachs back in October?), ultimately deciding against it, not on the grounds of potential efficacy, but because transitioning to such a standard would leave too much uncertainty in the marketplace (the irony is probably lost on them). The fact that it was even a topic, and has gained notoriety, means that this is an idea that may end up being advanced further over time as it becomes even more clear that monetary policy as it is currently construed is overwhelmingly ineffective, and therefore in need of a cosmetic makeover that leaves the current system largely in place. There may come a time when the central economic authority needs to throw the stirring population a bone.
And so we are again left with only two mainstream political options for moving forward – direct central planning through mostly fiscal means or indirect central planning through monetary means (another damaging round of QE or some alternate form of monetary control like NGDP). Since the BEA and BLS have trouble even tabulating economic results, it is a little hard to believe either could be successful at even the most basic task of measuring their own results. This is especially true of the very real possibility that 4.5% NGDP targeting could lead to a mix of 4.5% inflation and 0% income growth (assuming that the economy would actually obey that 4.5% “speed limit” and not quickly progress into 15% nominal growth with 15% inflation and 0% income), considering the statistical, heuristic weakness of matching inflation data to real world conditions.
The lack of alternate choice of economic stewardship owes largely to the unchallenged idea that the economy has to be pushed into recovery, as if recoveries are artificially constructed in a classroom laboratory. To the economic manager, the free market always leads to failure, while the managed economy is a picture of harmony and universal satisfaction, applying the recovery antidote to the capitalist poison of recession.
Mr. Ponnuru unwittingly demonstrates this “logic” quite clearly:
“But we do have some experience with it. Josh Hendrickson, an assistant professor of economics at the University of Mississippi, has shown that from 1984 to 2007 the Fed acted, for the most part, as though it were trying to keep NGDP growing at a stable rate. Whether by design or accident, it did so -- and the result has come to be called “the great moderation” because of the gentleness of business cycles in that period.”
He might as well have said that we should emulate the monetary policies of the 1922 to 1929 period. He accurately describes the “great moderation” as under the careful influence of central authority, but fails to connect the obvious dots of that authority to the 2008 to 2011 period. The Panic of 2008 was not some isolated eruption of sudden free market capitalism within the sea of carefully measured, benevolent stewardship by the Federal Reserve’s objective science. The residue of over-consumption and asset inflation, especially as it relates to binge shopping even in 2011, is a monetary phenomena that the Fed willingly concedes (though it would never go so far as classify it as inflation). The only difference is that it believes it was/is all a success story. The rest of the world sits angrily impoverished in the afterglow of monetary central authority, doomed to pepper spraying each other for $1 WalMart towels on the one “thankful” day where binge shopping can still be practiced.
The binge consumption of housing ATM’s was not capitalism. It was the central control of monetarism and all its real distortions, especially the systemic price of risk and how that misallocates so many real resources, especially labor. Consumerism of the last few decades was done on the back of asset prices driving short-term considerations of net worth, not judgments of income expectations. In other words, households responded to asset inflation, turning temporary notions of net worth into debt because corporations followed established monetary incentives into repurchasing hundreds of billions in stock instead of making productive investments, all the while moving production offshore to chase the accounting boost to bottom lines that the intentionally weak dollar provided. Combining that with gain-on-sale accounting and flooding the world with money to enforce low interest rates, thereby changing and perverting the very nature of intermediation, and it is no wonder that prices rose well above what can fairly be called fundamental (I am not sure when inflation became synonymous with free market capitalism, but Alan Greenspan had a lot to do with it). That the asset prices of stocks, concurrent to the irrational exuberance of real estate, driving people to intentional impoverishment is called capitalism or free markets without qualification is intentionally obtuse. Mr. Ponnuru does not want the public to see 2008 as a direct consequence of the Great Moderation because it necessarily invalidates all that he advocates.
Unless conventional political wisdom is changed in light of all this junk science, it will blame the one process that could actually create economic potential and a valid pathway to real success (as opposed to imaginary statistical interpretations). Free markets are the only way to overcome this very real deficiency in precision and the inefficiencies that always and everywhere follow from it. So the first real challenge of 2012 is to make sure that the “Great Moderation” is seen for what it really was (a flavor of statism) and that the “Great Recession” is seen as the obligatory results of that intentional monetary control through Wall Street (with a huge assist from direct central planning within the GSE’s).
Andy Stern and his political compatriots may acknowledge that capitalism actually created the wealth upon which modern society rests, but they have completely missed the central diagnosis of the current malaise. It is not the pursuit of capitalistic wealth that has led us down the path to economic destruction, it was the paternalistic sense of modern economic planners on both the left and right to change the very notion of wealth from productive capacity to money, and thus a tool of control, that created this mess. Abandoning money as the yoke of central planning and embracing money as a limited tool that only facilitates the exchange productive endeavors is the real path to long-term economic health. Until such a systemic realization and reset occurs, one-off, miserable consumption binges will be the norm, meaning central planning by central banks will continue to ruin Christmas.