Economics: The 'Science' of Hubristic Hope

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Last week's payroll report had me thinking of Alexander Pope's 1733 "Essay on Man", particularly the well-known line of "Hope springs eternal in the human breast." Pope's book was a critique of science, particularly the hubris that was seeping into it as it unlocked knowledge of the governing dynamics of the world and universe (those bristling days of Enlightenment). For the "science" of modern economics, and its unshakable belief in its ability to manage the unmistakably unscientific system that is the real economy, last Friday was the latest spring of eternal hope.

In the context of a recovery from a steep recession, one that saw an economic dislocation of dizzying proportions, that payroll report showed just how far the bar has fallen in terms of what may constitute hope (or a recovery for that matter). Two hundred thousand plus jobs should be the norm, not the cause for celebration, particularly given that there are only slightly more jobs in this country in January 2012 than January 2005. And I could beat the dead horse of the labor force participation rate, but I don't think the statistical machinations of how employment is calculated and then perceived is really what is driving this latest incarnation of hope.

Economics, always deriving itself from math, is essentially the study of second derivatives - not just rates of growth, but changes in those rates, especially accelerations (not so much decelerations). One month does not make a trend, but it can lead to hope that such an accelerating trend is unfolding. Perhaps in isolation this might be a worthwhile assumption, but the hard truth is that this is actually the third "spring" of second derivative hope in as many Januarys.

It seems like ancient history, unfortunately, but the discussions of January 2010 were centered on the letter "V", as in V-shaped recovery. Again, second derivative statistics provided much of the spring of hope back then, though the single quarter sample size proved inadequate for a trend. The initial estimate for Q4 2009 GDP was nearly 6% growth. It "confirmed" that the recovery had arrived, and was about to zoom ahead, solving all manner of lingering, unsolved financial problems. The internals of that calculation did not seem to matter, particularly since 80% of that GDP growth was from inventory not-shrinking-as-fast as previous quarters. Inventory was still shrinking, ironically, but in the world of second derivatives the slowing decline was enough to calculate a healthy GDP number.

At the same time, Census hiring was providing additional job-based "stimulus", as was a promise that the tax-credit-driven housing rebound would eliminate the negative trend in housing (it was believed to be the best housing season in years). Monetary policy saved the financial system from certain ruin, and stimulus was everywhere, making it appear that the science of economics had gotten it all right. Treasury Secretary Geithner proclaimed it the "Summer of Recovery".

Except that all of that hope was a mirage. By the time of Secretary Geithner's op-ed proclamation, the bloom was off the second derivative rose. That nearly 6% Q4 growth? Revised downward all the way to 3.9% (not a bad quarter, but not V-shaped). Census hiring faded, FAS 166 & 167 hit consumer credit hard (credit card master trusts that were off-balance sheet prior were forcibly repatriated, tightening the equity-capital noose of credit issuers), and the fiscal stimulus failed to deliver any positive lasting effects.

On top of all that, the financial system was not even close to "normalized". A tiny country in the Aegean that mattered little to the mighty euro became household knowledge, as did the word "contagion". And the stock market nearly crashed again, reflecting the volatility and menacing correlation that was erupting in every marketplace.

By the end of the Summer of Recovery, recession fears had returned, the spring of hope withered in the sun of economic and financial reality. So Chairman Bernanke gave us QE 2.0.

Hope returned and blossomed. All the dark days of that summer faded into the awe of monetary muscle, all $600 billion of it. Economic statistics improved, as second derivatives suddenly shifted from deceleration back to acceleration. By December 2010, fiscal stimulus in the form of the "Bush" tax cut extension and payroll tax reduction was added to the monetary stimulus making its way through highly correlated marketplaces. By January 2011, this second well of hope had convinced economists that the recovery was on, though they were noticeably more subdued this time (no talk of the "V", though there was some cursory discussion of a "U"). Estimates at that time for Q1 GDP 2011 averaged about 4.25%. Economic science and its models can only see exuberance when so much stimulus is added.

It did not last long, as first Q1 2011 GDP came in well below those expectations. By the end of July 2011, final revisions admitted that Q1 2011 GDP actually came in at 0.4% . Worse than that, the Bureau of Economic Analysis had reconstituted its statistical understanding of all its data to conclude that both Q3 & Q4 2010 GDP were well overstated too. It essentially meant that all the QE-inspired hope was entirely unjustified. Scientific estimates of acceleration were not just wrong in terms of degree, but in terms of direction - the economy was decelerating noticeably (but there was supposedly no statistical evidence of inflation).

Once again, by the summer of 2011, talk had returned to recession. The financial crisis, centered on Greece in 2010, had now enflamed all of the PIIGS (with four of them having been bailed out at some point), causing utter havoc in the global banking system. Both QE's were supposed to ensure ample liquidity for any circumstance, but the global wholesale money markets were dangerous liquidity deserts on par with some of the worst days of 2008. Volatility and correlation had, somehow, risen even further.

By September 2011, markets had expected QE 3.0, but collateral shortages forced the Fed to the sidelines, rolling out only Operation Twist. Yet the second derivative economic data changed again, as recession chatter subsided with "better than expected" headline results. The consumer was proclaimed (also for the third time) to be back. Holiday traffic was up, as was sentiment. Manufacturing surveys showed noticeable rebounds. And employment saw, seemingly, two good months in a row.

There is a distinct pattern here that should be obvious to nearly every observer. End of year optimism carries into the new year as inventories rise, buoying manufacturing, even manufacturing employment, only to falter by spring or summer of the next year. Businesses that built inventory find themselves unable to shed it, primarily because consumers were just binging at Christmas. The bills start coming due, or savings have to be rebuilt (no thanks to zero interest rates on savings balances and investments), and activity falls off dramatically. Sentiment shifts decidedly negative, only to be reversed by autumn as the binge cycle reappears - as businesses that lay dormant during the lean spring/summer lull suddenly start preparing for the Christmas season. Activity returns, though the actual amount is debatable, but sentiment turns decidedly positive. It all crashes again once the holiday bills come due the following year. Rinse. Repeat.

I think that is where we are today. The Christmas "high" is still in effect, and the bills have yet to be fully digested. This week's release of consumer credit is particularly troubling to that end. The enormous jump in the use of consumer credit in December should not be so re-assuring to economists, especially since Q4 2011 GDP was relatively weak from the consumer perspective (once again, most of the growth was inventory). After exhausting savings, consumers appear to be re-leveraging just to maintain spending rates, not advance or grow further. There is no acceleration despite the impoverishment.

The gyration of consumers around the Christmas season can be seen in the savings rate. In Q4 2009, the savings rate remained between 4% and 4.5%. While economists were busy pondering the upward slope of the V, the savings rate rose rather steadily all the way to 5.8% by June 2010. It remained near that level through August 2010 (5.6%), coinciding with the renewed fears of recession in 2010. It was as if the economy was one giant Christmas club savings plan.

The savings rate then fell again, remaining near 5.1% for all of Q4 2010, optimism returned and it seemed as if there might be a recovery after all. From there it remained close to 5% for the first six months of 2011. Since there was no significant decline in the savings rate, there was no real strength in the economy and recession fears returned. After a 5% rate in June 2011, savings again dropped dramatically, all the way to 3.5% for most of Q4 2011, dousing recession fears as the Christmas-focused savings were released, and re-imposing economic hope.

There are seasonal adjustments made to all this data, some of them more infamous and potentially confusing than others. But in the context of the roller coaster savings rate, it is not really surprising that mainstream statistical analysis cannot see these fluctuations and account for them. Part of this blindness stems from the very nature of statistical analysis itself, wedded to the data series upon which everything is based. In our current case, the statistical agencies are using procedures and extrapolations of pre-crisis data, even though pre-crisis patterns in the data are no longer valid. The math is blind to the paradigm shift that has occurred since 2008, yet its dependence on a statistically diverse dataset guarantees that it has to use data from the previous paradigm whether it is valid or not.

Despite the elevated employment report, there is really nothing that has fundamentally shifted the economic background. Consumers are not back, and whatever growth in consumption these past two years is a function of that unevenly declining savings rate, gyrating around the Christmas spending season. This is not the basis of a full, self-sustaining recovery. Instead, it speaks more to desperation or recession fatigue than anything of strength. If consumers have to dip into savings so far just to maintain a weak growth rate, and are now borrowing at a heavy clip just to keep a positive growth rate, then exactly how does that transition into a robust recovery? Are businesses supposed to suddenly add workers and start resource-heavy capital projects on weak consumer growth?

This third iteration of this pattern strikes me more as the last legs of the recovery, rather than the foundation of a new growth phase. The savings rate can fall only so far, there is only so much room for spending absent full employment and robust wages.

Real disposable personal income reached a high of $10.5 trillion in May 2008. As of December 2011, real disposable personal income was $10.16 trillion (seasonally adjusted annual rate). Now that is up from the depths of the Great Recession, $9.8 trillion in October 2009, though a lot of that improvement is just a large dropoff in tax payments and people not paying mortgages, but it still shows just how weak the circulation of money has been, and why a falling savings rate is needed just to register a weak growth rate in consumer spending.

Without some exogenous force shifting total income higher, there is no room for true economic expansion.

Traditional, self-sustaining recoveries feature dramatically rising household income. The Federal Reserve has guaranteed that household income from assets will be declining at least through 2014 (and likely beyond because, as Japan has amply demonstrated, the zero lower bound of interest rates is like a roach motel, once you check in you can never check out), so that is not an avenue.

That leaves real wages as the only possible channel, but the weak dollar and elevated commodity prices leave little incentive for businesses to expand domestically (while giving them a powerful incentive to channel internal resources overseas or into non-productive stock repurchases). What resources that have been deployed and spent for business capacity have been focused on capital equipment (especially computers), meaning the one segment that has actually been a positive economic force is focused on increasing labor productivity, meaning businesses are focused on making due with even less labor involvement.

Backstopping all of this is, of course, a European recession in full swing and a possible Greek default (followed closely by Portugal and Ireland, especially if Greece benefits from it). Though many commentators dismiss the economic collateral damage to the U.S. economy, there is no doubt that the interconnected system of global finance ensures that any transmission of euro-centric banking difficulties are spread into U.S. markets through these high price correlations (see October 2008, January & February 2009, May 2010, August 2011). These are not the seeds of economic recovery.

We don't have to look far back in history to find another "jobless" recovery, one that struggled to find its footing before taking off. Our last recovery (2002-03) parallels much of the travails of our current predicament (minus the persistent, ongoing banking panic), particularly the inability to create jobs and produce sustainable wage growth. Indeed, it was not until mid-2003, nearly two years after the mild recession ended, that the full recovery finally appeared. But it was not wages that led the way, it was a debt bubble ($7 trillion).

There is no such bubble to rescue this recovery. The consumer economy is dying, though it is not yet dead. The Christmas-time binge is nothing more than a throwback, a last gasp to experience the thrill of the good old days of the artificial economy, fueled by the fractional expansion of digitally printed wholesale money. Back then, though, money freely circulated through real estate and equity prices (asset inflation). Despite monetary expansion in the U.S. and Europe these past few years, there is just no way to circulate all that new money. That is the essence of the financial crisis since 2008. The methodology of transmitting monetary stimulation through debt has completely broken down - central banks cannot re-create the economic miracle of 2003 no matter how hard they try.

The new economic pattern has been established, economic potential without artificial stimulation is far less than the science of economics wants to admit. Hope springs eternal, but only before the Christmas bills come due in spring.

 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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