True Recovery Pushed Further Into the Future
The Greeks are going to dominate the weekend as they decide to elect someone to do something about austerity and the huge current account hole. In anticipation of a "bad" election result, Greeks and foreign investors are pulling their money out, just in case. I have little doubt that the broad public attention will be on the Aegean nation, however, I believe the biggest news of the week is right here. This is not to downplay the potential for Greece-induced chaos, but in the grand scheme of the global economy in mid-2012, there is sort of an anti-climax here with the ongoing Greek tragedy. The country already suffered the indignity of default, in the process helping to stifle all the good feelings left from the LTRO's. While financial danger has moved on to Spain and Italy, in the form of retail deposit flight to Switzerland, real economy danger lurks right here in the United States.
Embedded within the initial unemployment claims data this week, which was a bit worse than expected (continuing that trend), was a very large uptick in the number of people falling off the 99-week cliff. This past week 135,000 Americans reached their benefit limit and rolled off into...nothing. The week before, 105,000 exhausted their benefits, right into a job market that, even in its best months, can only seem to create part time or temporary work. The 99-week cliff is a real problem for the U.S. economy, more so than the Greek election.
As bad as the May payroll report was, at least in relation to overly optimistic and badly calibrated expectations, it was simply a continuation of the trend in this post-crisis period for personal and household income. Looking at disposable personal income growth, average growth is currently the weakest it has been since income was still contracting in late 2009 (through April 2012). On an inflation-adjusted, per capita basis, however, disposable income has, on average, been contracting since April 2011 (though the contraction has abated somewhat in 2012). Since disposable income includes not only wages but government transfer payments, this 99-week problem presents another structural challenge for the real economy.
In fact, what we see in a broad slice of U.S. economic data is that the peak of the "recovery" actually passed in the middle of 2010! Growth in real disposable income and real per capita disposable income has been decelerating since May 2010. That data is confirmed by year-over-year GDP growth rates: peaking at 3.3% and 3.5% in the second and third quarters of 2010, respectively, year-over-year growth (which strips out seasonal adjustments) has slowed markedly to between 1.5% to 1.6% for the final three quarters of 2011. In the first quarter of 2012, year-over-year growth is currently estimated at 2%, but that slight increase in the growth rate, in my opinion, will likely not survive revisions, eventually conforming to the previous three quarters.
The marginal factors of economic growth in this recovery period have largely been limited to inventories and corporate spending on equipment. In those peak "recovery" quarters in the middle of 2010, inventory building and business investments in equipment accounted for more than half of GDP growth (with business investment equally spread between computers and information technology, industrial equipment and transportation equipment). The pace of investment in these areas, however, has also been decelerating noticeably since that recovery peak, matching the slowdown in personal income.
As far as inventories and business capital investment, this slowing trend makes sense in the context of what happened in 2008 and 2009. The constraint on credit availability within the banking system spilled over into the real economy through business financing of working capital and capital projects (inventories and business investment). In the third quarter of 2008, before the real panic set in, the decline in GDP was equally paced by household spending and business investment/inventory de-stocking. After the panic, in the utter economic chaos of Q4 2008 (amounting to an almost incomprehensible 8.9% drop, quarter-over-quarter), more than half was due to these segments. Of the 6.7% decline in quarter-over-quarter GDP in the first quarter of 2009, nearly all of that decline was due to inventories and business investment.
The base of the recovery, then, was simply a catch-up in inventory levels and restarting or resuming some capital investments, all dependent on financing availability. For large corporations that meant an end run around banks directly to the bond market. It also meant that cash earnings that made it onto their balance sheets would be, in general, used as a financing cushion - large businesses have simply been self-financing in lieu of predictable bank credit. This is also why small businesses have not been able to participate equally in this recovery period. All the hand-wringing about the cash hoarding of US corporations misses this important point. These companies are sitting on cash waiting for the banking system to get its act together.
In the process of recovery, however, the resumption of inventory and capital investment might have been enough to pull the economy into a self-sustaining mode had this been a simple, cyclical economic progression. The same logic went into the "stimulus" bill and each dose of monetary intervention, that a burst of economic activity would "ignite" animal spirits and get the sustainable circulation of money flowing through the economy again. But in the context of economic activity as it was constituted during the asset bubbles, household incomes augmented by both asset inflation and easy credit will not simply be restored by temporary and limited boosts to economic activity. That "wealth effect" is gone, not to return anytime soon.
So all these temporary lifts to activity created a relatively shallow, uninspiring recovery that largely ended in the middle of 2010. Since then, we may have seen slight growth that has been continually eroded by commodity price pressures. As the temporary effects of inventory building and capital investment resumption wind down (outside of an enlarged inventory boost in Q4 2011), the marginal source of economic activity has shifted to household spending. But that spending, as noted above, has not been based on a healthy growth in disposable income, but rather a noticeable and unhealthy decline in the savings rate.
It is not coincidence that the household savings rate peaked at exactly the same time as the recovery's peak - mid-2010. In a true cyclical recovery, we would expect to see a rising savings rate concurrent to an increase in nominal spending levels. In other words, household income grows fast enough to allow for some increase in both saving and spending. We did see that, but only briefly. After reaching 5.6% in the middle quarters of 2010, the savings rate has steadily declined, slowly at first - to 5.0% by the first quarter of 2011, then hastening down to 3.6% in the first quarter of 2012. Whatever promise of a real recovery really ended in the middle of 2010.
The implications of this speak to the optimistic view that the U.S. economy will simply "muddle through" on a trajectory of slow, stable growth. Conventional economic thought turns on the idea that a dislocation or economic contraction is the product of some kind of shock. There is no question or thought given to the default assumption that an economy's basic state is growth, it is just naturally assumed that a growing population plus some increase in productivity produces a natural growth trajectory.
At the margins, we know that so much of the economic activity that defined the asset bubble periods was based on asset inflation and the offshoot drive to "cash in" asset wealth through debt accumulation. Post-2008, household wealth continues to suffer, and credit is scarce. In the real economy, the marginal path of monetary circulation continues to be heavily dependent on government transfers and extraordinary items (such as the "beneficial" effects on disposable income of not paying mortgage loan installments), rather than the more stable and growth-friendly wages
Given the structural constraints that remain in place, unfortunately augmented by the misguided attempt at inflation-expectation engineering, I continue to believe that the natural path of the global economy is further contraction. In other words, the artificial activity that formed the backbone of economic growth for more than two decades was in such high proportion that absent extraordinary measures there is no way to achieve anything better than temporary pockets of uneven growth. If there exists a tendency of reversion to the mean in economic terms, this is it. The artificial credit/asset inflation growth kept the economic trajectory far too high for far too long. This is particularly true given the massive imbalance of the financial economy which hid the very real effects and shifts of productive capacity in this country (off-shoring). Both monetary and fiscal policy have responded by trying to replay the financial/artificial economy playbook, rather than examine the very real productive deficit - the current account deficit is the scorecard of productive capacity that no longer exists domestically.
That is where the real economic bind comes from, since productivity in the post-2008 period has been limited to the capacity of business to squeeze production inputs (in both manufacturing and service businesses). There has been little productivity that can be counted as true innovation, certainly nothing approaching the level of innovation from the computer and internet revolutions. That kind of productive advancement forms the true backbone of the positive natural growth trajectory - innovation and development that spawns entire new industries and raises products and services to the level of non-discretionary; the kind of process evolution that drives the real (read: non-monetary) standard of living higher, that often results in modest and beneficial price deflation (which central banks resist at all costs). That kind of innovation has been noticeably and maddeningly absent during the artificial/bubble periods.
Perhaps it is a coincidence that the monetary bubbles took place during this ebb in innovation, but given the amount of resources and energy devoted to asset prices and credit production, I think there is enough evidence and logic here to at least consider a causal link. I have beat the drum against stock repurchases for a long time as I consider them to be a tremendous waste of resources (especially on the scale that occurred not only in the bubble periods, but in the three years since the nadir of the Great Recession), a malignant malinvestment that actually hastens the decline of productive capacity (through opportunity cost). The natural growth tendency of an economic system is dependent on the advancement of that productive capacity expressed through rising standards of living and the offshoot, concurrent rising levels of employment and labor specialization to efficiently circulate goods and services. Getting money to circulate through financial means cannot, under any circumstances, replace this process of true wealth creation. Not all economic activity is equal (the notion of aggregate demand is one of the biggest mistakes of modern economics).
Had the economy not been artificially boosted by monetary means, it is plausible that this more difficult path to the natural growth trajectory would have forced businesses to "value" financial resources far differently. If the only way to achieve monetary success is through actual and successful productive capacity, rather than pure asset price inflation, then it is certainly plausible that an increased devotion to productive capacity might have continued the trend in revolutionary innovation. If nothing else, financial resources that were squandered on stock repurchases might have been put to better use in the real economy as true productive potential, the very element that is missing right now.
In a mean reversion scenario, given all the excess, artificial growth of the monetary period, I think it is a mistake to simply expect economic growth as the base case. Looking back just at the economic results of the past four years shows an unmistakable and underwhelming response to so much "stimulus". In my opinion, the best case for these massive stimulus episodes was simply a masking of the true natural progression into further dislocation and contraction. Unfortunately, given the continued manifestation of monetary interventions and financial dysfunction, it should be expected that the ongoing dislocation will be far from uniform. We should expect that a natural negative trend might, in light of a financial system still burdened by price and asset artifacts of the artificial era, accelerate periodically - without much need for additional economic shocks.
Again, as the per capita data shows, the negative trend might already be in place. Given the deceleration of economic data of the past two years, it would only take a relatively small restatement of inflation to revise GDP accounts into the negative (without getting into an argument what the inflation rate really is, I think it is relatively non-controversial that true inflation has been understated through various means; to what degree remains unresolved), which would only match some concurrent data points. There is also the unresolved question as to what is the true measure of an economy. Is it simply measuring the dollar value of goods and services exchanged?
I believe a successful economic system is one where labor specialization is easily fostered and incorporated, regardless of the dollar value of anything that is exchanged. That is the real essence of innovation and real productivity - freeing up human resources to accomplish other productive tasks. Money is simply a tool to help achieve that goal; it is certainly not the predicate condition for exchange, nor should the system strive solely to circulate money. The successful cycle of money in the economic system, like the real, productive demand for money, is only a derivative measure of true economic success.
Economists that continue to proclaim a recovery are consistently disappointed and confounded by persistent weakness because they fail to see past the modern goal of simply cycling money. There is far more to the economic system than just money, the means and motives for its exchange are far more important. Not all economic activity is equal; there is no perfect substitute for true productive activity. Yet, in the age of aggregate demand, there is nothing to distinguish between generic activity and true productive activity. It is just assumed that economic activity due to growing consumption dependent on the "wealth effect" is as good as true consumption limited to successful growth in wages and employment. In the asset bubble periods, the proportion of the former was too high, but it was given equal treatment in terms of measuring monetary policy success, but more importantly in crafting how economists think an economic system should behave (and be influenced by central planners).
They call this the output gap, and it has been estimated to be quite large by some models. But those models simply assume that the actual economic output of the bubble periods was representative of potential - asset inflation, credit accumulation and all - because they only account for consumer inflation as the deciding, independent variable. Re-orienting expectations of potential with this in mind leads to this idea that true economic potential, given the dire state of the productive economy, is still below current levels of output (in my opinion this is where the savings rate is decisively demonstrative).
There really is no surprise as to why "unexpected" economic headlines apply only to weak data points. In light of the attention given to Greece, a return, or really a re-appearance in the data, of recession in the US is far more important and potentially market moving. Perhaps there is some value in looking for the next Lehman Brothers or the next shock that pushes us into recession, but, again, I believe a shock is not really necessary. I think it is pretty clear from the big economic picture of what has transpired under the activist central bank paradigm that there are still more negative adjustments to be made in the real economy; not just in the U.S., but globally. The massive financial imbalance that permeates not just the methodology of circulating money and allocating scarce resources will not be simply expunged by time and patience.
There has been far too much collateral and structural damage (such as investor expectations) for this rebalancing process to be over with after one attempt (2008). This would be true even if the imbalance of financial "investment" and innovation over true productive investment and innovation had not been so disproportionate in the last decade. But given the unilateral trade regimes that have grown and hardened in the past three decades because of the inserted financial substitution for true productive activity, the lost opportunity to replace that productive capacity by real innovation is really just now being felt in the form of confused economists and increasingly resentful polities. No amount of financial intervention can make up for that lost opportunity. Even if we somehow fixed this imbalance today, it would still mean a lag between development and economic payoff. With that in mind, coupled with the idea of a negative natural growth trajectory and mean reversion, it really behooves us to act sooner rather than later to help foster real economic solutions, including allowing the financial system to devolve itself back into a more suitable balance. The more resources that are wasted on financial and artificial remedies simply pushes our true recovery further into the future. That is truly bad news for everyone, including the Greeks.
