My friend Rob Parenteau says "most professional investors are high frequency macro data and short run asset price driven." He basically means they have no real macro analytical framework to use when making investment decisions. Rob says "it is just a video game for them, where they trace and extrapolate the recent momentum." Rob is talking about recency bias. And I agree 100%. Recency bias was also on display on the way down I might add.
So given the spate of underwhelming macro data coming out of the U.S., you should be asking yourself why is the economy so weak? Answers like "Businesses are losing confidence in the President" or "the tax picture is unclear" will get you gonged. Even the somewhat better "aggregate demand is weak" will get you a "…and the survey says 0." You have to have a macro framework. And that means you have to avoid extrapolating the last batch of macro data and take a 30,000 foot view based on a consistent methodology.
What’s my answer? It’s the debt, silly. Households in the U.S. are up to their eyeballs in debt and this is significant as consumption represents over 70% of U.S. GDP. The U.S. economy is weak because people deep in debt don’t increase spending unless they feel comfortable they can meet their debt repayment schedule through money from income or wealth. So if incomes or asset prices are increasing, people feel safe to take on more debt. But if on aggregate both are stagnant or falling, you get a balance sheet recession. And goosing aggregate demand through stimulus quick fixes is not going to change this "“ at least, not until the balance sheets have recovered.
The framework I use to discern what this means over the short-to-medium term as well as the long-term is a modified Austrian framework. I’ve shown you this before. The first time was March 2008. The last time was in June when I wrote Why Stimulus Is No Panacea. The point I make connects interest rates to credit growth, debt and bubbles. Mainstream economists like Paul Krugman don’t believe "excessively low policy rates were a key reason for the housing bubble." But he misses the connection between credit growth and changes in monetary policy. When the Federal reserve holds interest rates low for long periods of time, it encourages the accumulation of debt by acting as a tax on savers and a subsidy to debtors. It also lowers risk premia as investors need to reach for yield. This is a boon for high risk projects and is what allowed bad actors like Enron and WorldCom to run amok. But it necessarily means that uneconomic projects are subsidized artificially and specific economic sectors relying on cheap funding are overbuilt.
In the late 1990s I worked in the high yield bond area and saw what low interest rates did to goose interest in telecom infrastructure plays. During the Russian crisis, bonds gapped down and bid/ask spreads widened to where no trades happened in ‘hundred-year flood’ fashion. But after the Fed orchestrated a bailout of LTCM and lowered rates, all was well. Telecom bonds from the likes of NTL, Telewest, Turkcell, and Jazztel dominated the marketplace. When the TMT bubble collapsed in a heap, so did these bonds. Many of these companies needed to be restructured "“ or, like Iridium, had to be liquidated. These are classic examples of uneconomic ventures and overbuilding due to cheap access to capital.
In the next decade, the Fed continued to goose the asset side of the balance sheet artificially as a solution to the balance sheet problem. Specifically, it targeted asset prices in lowering interest rates. Stock markets were weak well after recession ended in November 2001. So the Fed kept the foot on the accelerator. The result was a major credit bubble with housing at its center.
Raghuram Rajan makes the same point in a recent post:
Ultra-low rates encourage people to borrow to acquire assets, and are partly responsible for both the over-building in housing, the over-indebtedness of households, as well as the over-leveraging of the financial sector. More generally, a subsidy to capital will imply greater capital intensity (and waste) of capital, greater short term leverage, and excessive growth of sectors that rely on either fixed asset investment or credit. Is this the appropriate way to go (especially if we want more labor intensive sectors to grow to provide the jobs that are needed), and is it sustainable?
That’s the key question "“ sustainability. The household sector debt levels are simply not sustainable. So government pump-priming without reference to debt is a losing long-term proposition. Here’s my thesis for three approaches to this problem from last November:
The only question we have to ask ourselves is whether we want to reduce debt by:
As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:
I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path "“ especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.
The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.
You should recognize the first solution as the one the Greeks, Irish and the British are trying – an Austerian one (a term invented by my friend Rob Parenteau, who I referenced at the outset, by the way). The second solution is the one I have advocated for the US. The third solution is my least preferred outcome and is the path we are presently on (President Obama has now reversed himself and has backed away from his anti-deficit approach). The approach is heavily biased toward the status quo but is also politically unsustainable as I pointed out at the end of my "not a recession but a depression" piece.
With this macro background, where does that leave us today?
Consumers are dead in the water. Fiscal policy is also dead unless Obama opts to extend the Bush tax cuts. The monetary authority always acts last, plus the Fed is out of bullets on rates and so it’s not going to get funky here by conducting fiscal policy until recession actually hits. Residential investment is going to be weak with so much existing home inventory. So that leaves a pick up in non-residential business investment or exports over imports to lead us out of this recession.
I have said previously I expected 1-2% growth at best in the second half of this year. Given the data I am seeing now, I would revise that to 0-1% at best. And since we’re hanging our hat on trade (where things are deteriorating) and on business investment, the risk is clearly to the downside.
That’s why the U.S. economy is weak and why it will be weak for some time to come.
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Great synopsis and diagnosis, Edward. Much appreciated.
What do you think of this analogy: the US economy is addicted to heroin (low interest rates – would Greenspan be Avon Barksdale or Stringer Bell?), and more heroin is needed for the time being, in order to get to rehab with a fighting chance for survival.
Higher interest rates would lead to 5, 10, 20% of American homeowners entering foreclosure? Which would lead to how many of the big banks becoming (obviously) insolvent? I just don’t see how this scenario is beneficial regardless of the current economic malaise.
In order for the liquidation path to be a potential one, I think there needs to be a serious analysis about what this path entails – for example tell me what percentage of Americans and banks go belly up. If you’ve done this analysis or referred us to it, I’m sorry I missed it. Point me to it, and I’ll get reading.
We are in a policy cul-de-sac right now. The Doom Loop of ever lower rates and ever rising household sector debt burdens and ever rising financial service leverage is at an end. See here: http://www.creditwritedowns.com/2010/04/the-origins-of-the-next-crisis.html
That necessarily means the options are limited going forward. What should the government do then? The approach at present is predicated on goosing aggregate demand and leaving incumbents who have been poor stewards of capital in play. That won’t work as crisis will return in due course.
The liquidiation scenario is scary frankly. As I said: “The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.” So I’m not advocating this. Would higher rates lead us in that direction? At this juncture, perhaps. The time for higher rates would have been in early 2010. But the key for banks and debtors is the yield curve. Steep now with low nominal yields, that is the best of both worlds for debtors and banks. Right now the curve is flattening in a way that is bad for banks and good for debtors. Raising rates would flatten it even more and that would certainly spell trouble.
This is why I have proposed the third option.
Edward,
Thanks for your thoughts. I have a question. How is it that private sector savings increases in the Glide scenario, but not in the Hoover scenario? Is it because of the US macrosectoral balance identity? That an decrease in public sector deficit in the Hoover scenario must be offset by a decrease in private surplus (less saving) and/or a smaller current account deficit, whereas an increase in public sector deficit in the Glide scenario must be offset by an increase private sector surplus (more saving) and/or a larger current account deficit.
The Hoover scenario – as I wrote it at the time – is one in which double dip was mixed with a status quo bias. During the depression, debt distress meant savings rates turned negative. That’s would one would expect under austerity and a double dip. Eventually, however, the Obama Administration saw a weakening economy and backed away from the deficit/austerity language. They still have a status quo bias – i.e. pumping up incumbent economic actors and they are back at trying to increase aggregate demand – which doesn’t promote savings.
The goal should be deleveraging and private sector saving without economic collapse and you don’t get that through austerity or through pure aggregate demand/asset-based policies.
Great summation as usual Edward,
The ‘corporate cash’ on the sidelines meme is an interesting quandary as well. Hussman and did Mish did nice sumations of it, but in more practical speak, it’s like this;
Companies borrowed short-term debt to build reserves of cash and assets as a buffer, in case things went bad. They’ll hold a big reserve until they either think things are getting significantly better, or until they need to repay it or roll it over, if they still can. It’s short-term debt, they have to pay it back soon, with interest, so you can’t spend it or waste it on any giant splurges. No smart company is going to do that. If it were invested it would have to be done carefully. Get it wrong and you’re toast.
Hence this ‘cash’ remains a standing emergency buffer on the sidelines.
But things ARE getting worse, the recovery Summer is turning into the Autumn of our political discontent. So the buffering purpose of that ‘cash’ is now more relevant than ever. Spending it on a punt is out of the question. There won’t be any delirious gush of corporate spending and hiring to save the day. Indeed, the reverse becomes more likely. That debt will suddenly be seen as just debt that must be repaid soon, even during a negative growth phase, where earnings will fall lower, as will capacity to repay, and recovery will be slower with lower demand. And who knows what new taxes and level of unemployment will be suppressing the economy in QTR1 2012?
So a cashed-up company in Aug 2010 knows it has to be extra careful, so is more likely to cut earlier and hold fewer staff, spend less and make sure it can survive to repay or roll over (if it still can). In that uncertainty this cash is not a boost, as the need to repay dampens willingness to spend more than is absolutely necessary.
But let’s suppose the economy does drop into negative growth, and the money is used to successfully buffer and preserve the company. What if this is really a Depression? This is what everyone in business will be wondering.
Let’s suppose it isn’t a depression; we all still know that if this were a double-dip of the GFC it would still be way-worse than the early 1980′s. 1982 did not have a synchronous -27% multi-month decline in global trade volumes. Will there be increased final-demand on the other side of a second negative growth phase in 2011? In your company’s sector? Even a once cashed-up business survivor from that double-dip situation would have big debts to repay and few reserves left, with a skeletal staff, in a low demand environment, reduced credit, combined with synchronous global-trade carnage in export markets and sovereign debt balloons ready to pop.
This is incomparable to 1982-84 (which was fairly tame).
So I’d definitely want a fat cash buffer right now, but I sure wouldn’t borrow to get it, even at cheap rates. I’d pare costs down and sell assets and inventory to pay down debts, hibernate and hope this would be enough to see me still operating in a recovery in 2012 (my family’s needs require I play this safe). I would not want to go into a double-dip with a big short-term debt as cash as that would just wipe me out on the other side. That is not for me thanks.
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“…Brett Arends of MarketWatch puts present levels of corporate cash in perspective: “According to the Federal Reserve, nonfinancial firms borrowed another $289 billion in the first quarter, taking their total domestic debts to $7.2 trillion, the highest level ever. That’s up by $1.1 trillion since the first quarter of 2007; it’s twice the level seen in the late 1990s. Central bank and Commerce Department data reveal that gross domestic debts of nonfinancial corporations now amount to 50% of GDP.” – Hussman, August 9, 2010
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Corporate and SME wipeout is now in play. Small business is already a wipeout. I wish we were able to do something but it’s already happened. We only see historic data from the momentum dynamic that’s already way ahead of us, playing-out relentlessly. So all I have been able to think about is how do we get out of this? I see no way out. Among other things, fiscal stimulus is a problem of scale and time. Sustaining a billion-dollar bandaide over a multi-trillion-dollar sharkbite, for five years.
Guess what? You still bleed out.
We’re watching an underlying momentum of contraction. Picture a falling tree in a slow accelerating fall arc, gathering speed and kinetic energy as it goes down. The stimulus didn’t alter its trajectory much in 2009, because by the time massive stimulus was applied, the ‘tree’ already needed 3 to 4 times more equal but opposite kinetic energy (and some) to reverse the fall and prop it up vertical, than was actually available. You got a deflected shove upwards, better than nothing, but the tree did not rebalance, it remained very out of balance, and the tendency to fall immediately resumed. i.e. previously unimaginable levels of stimulus were nowhere near enough.
Ordinarily, you would never give up, because you really can succeed in very bleak or ‘hopeless’ situations more often than you might expect. But when you’re dealing with a non-linear change, you literally can’t impact it much, because by the time you respond, what is then required is more than you thought you would need. We are looking at (mass x velocity) squared. So a tree builds up energy faster than you can counter it, unless you catch it very early. The economy simply wants to go into negative growth and it can do this longer and faster than either currency or politics can combat it. The economic giant-redwood is way out of balance, and you can’t do enough quickly enough to rebalance it, because its been toppling un-noticed for about 6 years. During late-2009 we entered the phase where all that’s left is to get out of the way.
According to CMI data the economy was coming down fast precisely when it should have been going up fast. The formal QTR4 2009 GDP figure was already way behind events. This told me it is not going to stop, it’s already coming down, the contraction momentum is far too much for the US to stop it and it’s way ahead of policy makers. They won’t sufficiently fiscal stimulate even if politically they could, because you now can’t do enough fast enough to make any difference. It was possible to catch the tree in 2006 and maybe still in 2007, but in 2010? – NO.
The contraction momentum had already won in H2 2009. In real world practical terms we are about 4 years too late to catch it (to avoid creating a huge bubble).
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