Is This Recovery?

This article originally appeared on The Daily Capitalist.

There is a lot of good news to buoy the markets and give cheer to the public. We hear that new jobless claims are down another 15,000 to 358,000, the ninth week of declines out of the last ten, finally breaking below the 400,000 mark. A reduction in unemployment is a very positive sign and is politically significant. Also Gallup released its latest economic confidence poll and it is up to -20, the highest in 12 months, a very solid gain from the -54 score in August and September.  We heard as well that Greece may qualify for another round of funding to stay default (we are very skeptical of that). And, the S&P is very close to its 52-week high.

There is more. The official CPI was up 2.4% last year, a very modest and tolerable amount according to the Fed. Markit reports that the combined U.S. ISM manufacturing and non-manufacturing indices were up from 56.4 in December to 58.9 in January, hitting its highest level since March of last year. New orders in both surveys were up significantly. These data were backed up by reports of durable goods orders and factory orders. Data from many of the regional Feds confirm this.

Personal income increased 4.7% in 2011 versus an increase of 3.7% in 2010. Real disposable personal income (DPI) increased 0.9% compared with an increase of 1.8% in 2010. Real personal consumption expenditures (PCE) increased 2.2%, compared with an increase of 2.0% in 2010. State tax revenues increased 6.1% YoY according to the latest report.

What could possibly go wrong?

Are we in a recovery or not? This article will deal with this issue. I will briefly recap how we got here and the problems we need to overcome before we can call it a recovery. I will look at the reasons behind our current positive data. And then I will compare the current data to see where we are. 

What is holding back recovery?

Economic recovery is quite simple when you think about it: bad investments and their supporting debt need to be liquidated. These bad deals are called "malinvestment" and our recent housing boom left huge piles of them for us to clean up. Think of it as the detritus of bad economic policies that led to bad business decisions. Massive amounts of capital (consisting of real and fiat "paper" capital) were lost during the resulting bust and there is nothing anyone can do about it. Keeping bad deals alive only serves to trap valuable capital into unproductive assets and delays recovery. New capital must be created through real "organic" production to get the economy going again.

The biggest piles of detritus to clean up before the U.S. economy can recover are:

  • The asset and capital structure of our local and regional banks, mostly as related to real estate loans;
  • The debt of small business owners, especially in relation to commercial real estate holdings;
  • The debt of households in relation to home mortgages, student loans, and consumption-related debt.

All of the above have been important contributors to the stagnation of our economy. And all of the above, except student loans, have to do with real estate.

There certainly are other major issues this country needs to deal with that will also affect economic recovery. Those issues are political in nature and will depend in large part on the outcome of the 2012 elections. They are our budget deficit and huge national debt, tax policies, social welfare entitlement programs, and regulations which negatively impact capital formation and business expansion. These issues are not within the scope of this article but we have discussed them frequently here at The Daily Capitalist.

There is one further policy matter that is political in nature and that will impact the economy, and that is Fed policy which I will discuss.

Will consumer spending drive the economy? 

Most economists and analysts point to the lack of consumer demand as being the economy's greatest hurdle, but that is a symptom of a serious underlying problem rather than the cause. The cause is what Austrian theory economists call a lack of "real savings" (real capital). That lack occurs because, as noted above, the boom-bust business cycle, which we are still in the midst of, destroyed huge amounts of real capital/savings. (Household wealth declined by $10 trillion, for example.) We need real capital in order to have new production; without it, the economy stagnates.

To get production going manufacturers need to buy capital goods and commodities in order to make things. If they haven't been produced and you have a fistful of fiat dollars, then there is nothing to buy and nothing to produce. If we could print real savings we would already be in recovery which tells us that fiat money, the stuff that the Fed creates out of thin air, is not real wealth. Real savings can only come from the production of things that consumers, or the manufacturers of consumer goods, want. Profits saved from such production or from saved wages of workers employed to make such goods, is real capital/savings.

The bottom line is that if we had enough real capital/savings, we would have already recovered. The fact that we haven't recovered means that we don't have enough real capital/savings. Flogging the consumer to spend will only impoverish the consumer and destroy more capital. Consumers need to save, not spend.

Will manufacturing drive the economy?

Manufacturing is an important part of our economy, but not as important as it was. The production of goods represents only 24% of the economy (services are 47%). There is no question that recently manufacturing has been improving. It is being driven mainly by manufacturing exports and auto sales.

What is causing this?

There are two parallel functions occurring that are giving rise to the current good economic news. One is the natural forces that cause an economy to recover. The other is the Fed's policies to devalue the dollar and keep interest rates artificially low.

When I refer to "natural forces" causing a recovery, I am talking about market forces such as the liquidation of debt related to malinvestments, the devaluation of those malinvestments, and the formation of new real capital/savings. It is occurring naturally, often despite government policies, and is clearing the way for new production. But I believe it has been a very slow process and has not been sufficient to cause most of the positive economic news. I will discuss this in some detail in another article coming soon.

Much of the recent good economic news comes as a result of the Fed's cheap dollar policy. It does two things to stimulate manufacturing:

First, fiat money devalues a currency. This is obvious to us as we look at a constant positive inflation rate and the decline of the dollar in relation to most other currencies. That devaluation makes U.S. goods appear to be relatively cheaper on foreign markets and stimulates demand for them.  Thus a cheap dollar policy stimulates exports. 

Second, the Fed's zero interest rate policy (ZIRP) which has driven down interest rates, stimulates demand for certain big ticket goods such as autos. 


 Exports represent about 14% of GDP and of that manufacturing exports is about 5% of GDP: a substantial factor. So when the dollar declines it stimulates exports and this is going a long way to revive manufacturing in the U.S. 

The following chart shows the decline of the dollar (blue), the level of exports (red). I have inserted the two incidents of quantitative easing as shown in the salmon and light green bars. It is easy to see the mirror image inverse relationship of rising exports and a declining dollar. 

  The recent strengthening of the dollar, a result of the eurozone crisis driving the dollar up, and declining world economies do not point to continued strong export growth. This is already starting to show up in the numbers as this chart shows more clearly (gray bars):

The below chart of leading indicators, just out from the OECD, shows that the world is not cooperating with exporters—these are their major markets:



Auto production is about 2.5% of GDP, a substantial part of manufacturing. Recent sales improvement is being driven by cheap credit (ZIRP). This chart shows new car sales (blue), expanding nonrevolving credit (red), and auto loan interest rates (black):

The first thing you should notice is the high level of sales pre-Crash and its rapid decline in 2008 (blue). Note the spike in 2009 which was the ill-conceived Cash for Clunkers program. Nonrevolving credit is used mainly for financing autos and this chart shows the post-Crash rise of such credit growing in lock-step with auto sales. It also shows a significant spike in sales beginning in 2010 as auto loan interest rates decline (black) to historic lows. While recent sales growth is also a function of pent-up demand as consumers replace worn out vehicles, in an economy where consumer debt is still very high and where consumer income has been flat, most of these auto sales are being spurred on by low ZIRP-driven financing costs, not just organic demand.

Industrial production

The other thing is that industrial production is not growing strongly as the headlines would have you believe. If it was strong, it would be a good indicator of positive growth and the presence of real capital/saving driving growth. While factory orders and industrial production have improved, they have been essentially flat-to-declining for the past 12 months:


Improvements in manufacturing and industrial output are largely being driven by Fed policy, QE and ZIRP. I don't believe it will last because it appears that monetary growth and the rate of change of such growth, are declining as the effects of QE wear off. 

The role of money supply

If much of our positive economic data, especially manufacturing, employment, and price inflation is tied to monetary policy, then that begs the questions of where is money supply (MS) now, where is it heading, and what will the Fed do?

The Fed has been trying to stimulate the economy by making credit available to banks, by keeping interest rates (Fed Funds) at near zero (ZIRP), and by direct injections of money into the economy (QE, quantitative easing). Those policies as anticipated by the Fed have largely failed. In a truly recovering economy, credit would be expanding because businesses would be borrowing in order to expand and hire. Interest rates would be so attractive to borrowers, they couldn't resist expanding through borrowing. The problem is that it hasn't worked.

What is happening instead is that economic gains are coming largely from quantitative easing, a once-in-a-lifetime policy of last resort. While Chairman Bernanke denies it, creating money out of thin air (QE) has the same effect as printing new currency and throwing it out of the Chairman's proverbial helicopter.

Look at how QE has expanded the Fed's balance sheet from securities purchased on the open market, which  is how the Fed creates new money:

As you can see, its balance sheet exploded during the Crash (QE1) and has continued to grow (QE2). The Fed has injected about $2 trillion into the economy since 2008.  One can't deny that such injections have impacted the economy. It has rewarded the financial markets (S&P500: 3/6/09=666; 2/14/12=1,350), it has rewarded the multinationals and exporters, and it has caused a positive CPI despite massive deflationary forces.

MS itself has been on a rocky track, but it has expanded in response to QE. Bank credit expansion (loans) is the easiest way to cause MS to grow. While the Fed has made massive amounts of credit available to banks, without loan demand lenders are satisfied to keep it locked up at the Fed (excess reserves). Without landing activity, in order to make MS grow, the Fed has found it must inject new money directly into the economy via QE . 

To measure MS, I use the Austrian concepts of money supply, what is called "Austrian" or "True" money supply. Specifically I use what I consider to be the most accurate "Austrian" data which is from Michael Pollaro's The Contrarian Take (with his kind permission), which looks like this:

As you can see the percentage YoY change of TMS2 (bright blue line), the data which I think is most accurate, is actually declining. What does this mean?

Let me try to explain this with a more detailed, and unfortunately, a more complicated chart. This is the same chart as above with an addition of the QE events (vertical salmon and blue bars), the addition of GDP data (black line), and the addition of the NBER's dates for the Great Recession as a vertical gray bar. The scale on the inside of the chart on the left shows quarterly changes in GDP from 2006 to Q4 2011, and it is shown on the black line. I have exaggerated GDP by showing percentage changes of GDP on a quarterly basis to make it fit to Pollaro's chart and to make my point clearer. Another chart below shows GDP alone.

 What I believe this chart shows is that, after a delay, quantitative easing has caused much of the "recovery" by increasing MS which in turn has increased GDP .

In terms of measuring money supply, I use the bright blue line (TMS2) which shows annualized changes. If you are a believer in M2, Pollaro shows that as well (dark blue line). QE1, starting in November 2007 and ending in March 2008, brought a huge infusion of new money into the economy, about $1.3 trillion in only 3 months. The Fed, as you recall, went on a massive buying campaign which including a lot of "bad" assets (GSE debt, etc.). GDP is a lagging indicator, but as you can see it was well on its way down by Q1 2007 as real estate values collapsed and Lehman went under. By Q4 2009 GDP started to pick up which was a 6-month lag from the end of QE1. 

As the effects of QE1 wore off, as one would expect it to do in the face of massive deflationary forces, GDP began to stall out and unemployment continued to climb. By October, 2009 unemployment reached 10%, and people were talking about a jobless recovery. GDP peaked in Q4 2009 and started declining again in Q1 2010. The Fed took action starting in November 2009 through June, 2010, and QE2 brought another $600 billion of new fiat money into the economy over a four month period. GDP bottomed out in Q1 2011 and since then it has been expanding but at a snail's pace. On a YoY basis GDP is stagnating, but not declining. Again, there was about a 6-month lag between the end of QE2 and GDP turnaround.

Here is a chart that makes it easier to see real GDP:

To those out there who see this as an exercise in curve fitting, faulty logic (post hoc ergo propter hoc), or Monetarist theory, these data are consistent with Austrian Business Cycle Theory (ABCT) and one would expect to see these results after flooding the economy with fiat money. I believe that the gains, such as they are, are not "real" in the sense that they are not based on real savings, but on fiat money which always redirects capital into projects that eventually will become malinvestments.

When money is injected in the QE fashion, it takes longer for the money to get into the farther reaches of the economy. When you think about it, the cash initially goes to the Fed's Prime Dealers and they use it to make investments, which indirectly leads to productive activities, but takes time to expand beyond, say, New York City. Bank credit expansion through loans is a more direct transmission into productive activities rather than investment activities (businesses borrow to expand business, consumers borrow to buy homes and cars).

The thing about GDP is that it is not necessarily a very good measure of economic activity in the sense that it measures what we spend. If you inject more fiat money into the economy it means there will be more spending and a higher GDP. More spending doesn't always mean that those activities will be productive and lasting. That is especially the case with QE. But, for whatever it's worth, the world pays attention to GDP and so will we; it's just very tricky footing for forecasters.

It appears that TMS2 MS growth is declining. One look at the above chart will confirm this. This has to do with a lot of factors, but mainly it is occurring because QE2 is wearing off. This is occurring despite the fact that we are finally seeing modest increases in bank lending activity:

The above chart shows total loan activity (blue line) and the components that are business loans (red line) and consumer loans (green line). Ignore the straight line increase in Q2 2010; that is a recalculation based on a change of the government's methodology. While it shows recent modest improvement, loans have not grown since April, 2010. The latest Fed data (H8) shows that consumer loans actually declined 0.7% YoY in 2011 and business loans only grew 1.7% YoY. The commercial and industrial (C&I) portion of business loans were up a very positive 9.6%. The problem is that there are fewer potential borrowers, and the value of C&I business loans has actually declined (blue line):

Another MS factor to consider is what is happening in Europe. The European Central Bank and the Bank of England are inflating: the ECB with purchases of sovereign bonds and LTRO (Long-term Refinancing Operations), and from QE with the Bank of England. According to Michael Pollaro, some of this money is finding its way back to U.S. Treasurys.

That being the case, declining MS growth is likely a stronger trend than is apparent.

Where are we?

QE has finally given the economy a bit of a ride, but it appears that it is running its course, otherwise, we would see healthier bank credit expansion, and an increasing MS without Fed money steroids, and that isn't happening yet. 

Exports are the other thing to be watched as the EU, China, and the rest of the world slow down. Whatever one thinks of the role of U.S. exports, this is a serious negative factor. Recall that exports are about 10% of our economy and are seen by most analysts as an important driver of our economy.

Based on these data, it is likely that the U.S. will start to see more weakness in the economy during Q2-Q3 2012. The timing is based on the fact that this "recovery" is fragile in the sense that it has been supported more by fiat money stimulus rather than real capital/savings. The data show that as MS declines, the economy, at least as represented by GDP, reacts rather quickly and negatively.

The issue really comes down to whether or not bank credit will take off again. If we consider the present state of deleveraging and liquidation of malinvestments, we are about half-way to the end zone. (This will be the subject of my next article.) Also, while C&I loans are growing, modestly, real estate loans and consumer loans are still weak. The NFIB reports that small business credit demand is still tepid, relatively unchanged for 2011. Small businesses represent about one-half of the U.S. economy. Thus it is unlikely that MS will expand from an orgy of borrowing.

That leaves the Fed with only one effective tool in their proverbial toolbox. That is, of course, QE3. 

What other tools do they have? They could pay no interest on excess reserves, or even charge interest on reserves, but I don't think it will force banks to lend because there isn't enough demand to drain reserves. As Michael Pollaro pointed out, it is more likely that banks will run into loan limits because of capital ratio constraints before they tap into excess reserves. As well, while there is some easing of credit terms, it is unlikely that consumers will go on a spending/borrowing binge for the reasons mentioned above. More Operation Twist? Unlikely. Low interest rates aren't the problem, ZIRP has seen to that.


Quantitative easing has only been used once before in U.S. history, and that was during the Great Depression. You might wish to ponder that bit of information. What that is telling us is that we cannot compare what is occurring now to our experience in prior recessions.

With all due respect to Rogoff and Reinhart, this time is different for the U.S., at least in terms of our modern experience. Fed policies employed in previous recessions which were then thought to work, have failed in our current cycle. Those policies were mainly forms of lowering the Fed Funds rate, reducing bank reserve requirements, and discount window operations. We now have ZIRP and that has done nothing to stimulate the economy as the Fed had hoped it would. 

This time we have persistent high unemployment, economic stagnation, a "liquidity trap", high civilian and government debt, low savings, flat to declining wages, and substantial asset devaluation. This has been going on since 2008, a full four years. If it all sounds familiar, these same things happened in the 1930s

This time is far worse than any other modern recession. What we are seeing now is a depression, despite what the NBER would have you believe. If you are still looking for the "Big One" to happen, you are too late. It happened here and it is still happening here and in Europe. They, like us, have tried to paper over most of the effects of the boom-bust business cycle malinvestment, and they have failed and the piper is at their door.

Within that context, let me sum up my thinking:

1. The economic "good news" is largely based on fiat money steroids and will not last without continuous injections of new fiat money into the economy.

2. The last injection of fiat money (QE2) is already wearing out and money supply is most likely declining.

3. A declining MS will result in further economic weakness (stagnation) and flattening-to-increasing unemployment.

4. This is likely to occur in Q2-Q3 2012.

5. As soon as unemployment goes up again, the Fed will announce QE3.

6. The dollar will continue to be weak.

7. It is likely that price inflation will continue to be "modest" (as the Fed sees it) in light of ongoing real estate related asset devaluation. This depends on the amount of QE.


Thanks to DoctoRx and Michael Pollaro for their help with this article.