What Is a Real Economic Recovery?

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The economy begins to suddenly and "unexpectedly" weaken just as monetary stimulus ends. The flames of Greece radiate throughout Europe, pressuring banks in Germany and, especially, France. The euro comes under pressure as LIBOR rates trip warnings, and eurodollar exposures are re-evaluated with a keener eye toward counterparty risk.

Good thing that that was 2010.

Fortunately for 2011, the Federal Reserve has created $600 billion to indirectly monetize U.S. government debt or the world would be in serious trouble. That is the message we will begin hearing in the next few weeks as the second program in the series of quantitative easing (QE) is evaluated; "it could have been worse."

Ultimately, I believe that is the salient point. Little thought is currently given to whether it actually should get worse before it gets better. Perhaps that is where the debate should shift. Setting aside recriminations - those can be saved for after the economy actually saves itself - the focus needs to be on longer-term growth prospects and how best to achieve them.

There has always been an implicit danger in trying to reflate an economy during the process of debt devolution. After several years of false starts and rolling crises, it should be becoming clear to all but the most ideological adherents that all the QE's and fiscal stimulus programs have been trying to make the economy go in a direction it is simply not able to go.

Monetary stimulus can only be effective if consumers and businesses borrow more money to spend. There is never any thought as to whether that is actually a good idea. It is taken on faith that debt is always and everywhere economically positive. That certainly sums up the fiscal end of the stimulus spectrum. As long as the federal government was filling the aggregate demand hole, the amount of borrowing was really a secondary or tertiary consideration of its advocates. There was no contemplation as to whether households and businesses actually care how and why they are receiving money flows.

The housing bubble itself is a microcosm of the larger economy that was built on fiat money and constantly leveraging credit production. Incomes were at best stagnant during that period, but asset prices kept rising and the economy kept growing. As is well known, both were predicated solely on the creation of credit. Without new money to fill the income gap, it all fell apart.

Economic activity based on the price of assets is a disaster waiting to happen, a massive ponzi scheme. In the aftermath of that disaster, it is certainly tempting to try to rebuild exactly as before - it seems like the path of least resistance. There is also a tendency to view the economy just before the collapse as the standard for economic potential and a target for the recovery. Policymakers are intent on getting the economy back to where it was in 2006 and 2007 because they mistakenly believe that economic potential is some historical data series.

It is a fool's errand. The economy of the pre-crisis period had gotten too far ahead of sustainability because of improper price signals and misaligned credit creation. Maintaining improper price signals and misaligned credit creation hardly seems to make sense now (two economic wrongs don't make a recovery).

If we take the view that the Great Recession was an attempt at re-allocating away from those price-based activities, then the idea that economic potential is far less than the pre-crisis era is much less imposing. Instead of being far below potential today, perhaps the economy during the housing bubble was actually far above its potential for too long. Any economy running ahead of itself requires a painful dislocation to reset back toward real potential based on natural flows, not credit.

The better part of dislocation is the re-allocation of resources. Mistakenly originated economic projects are erased and losses are assigned to those who made the mistakes. It is a brutal reminder that not every economic idea is a good one, and that individuals, businesses or intermediaries that make more than their fair share of mistakes will likely continue to do so if not put out of their misery. It is a self-controlling system of self-improvement. This is the essence of market discipline.

Market discipline drives investment. Allowing it to be enforced during a crisis breeds new confidence in the recovery. Investors see that businesses (and even governments) are reminded of the ultimate cost of failure, reassuring all participants that these lessons are taken to heart in the rebuilding process. If the profligate and wasteful are culled from the herd, the efficient are left. With the price of failure absolute, there are less systemic doubts about commitments to efficiency and profitability.

In order for market discipline to be fully applied, credit cannot be plentiful and cheap. Enforcing market discipline means taking credit away from those that cannot sustain themselves. It means putting a stop to throwing good money after bad. Maintaining a steady flow of funding to Greece, for example, only ensures that the Greeks never re-allocate to an economically efficient and sustainable basis. They will resist and put off sustainability measures as long as funding is in place. Change only occurs when funding stops.

The lack of market discipline engendered by never ending monetary stimulus fosters doubts throughout the investment arena. Unsure of obligor commitments to efficiency and sustainability, cash owners seek safety. Risk is reduced to a comparison of "safe" interest rates. It becomes the sole province of financial instruments and never moves beyond them. Small businesses suffer because liquidity is prized above all else, and they do not offer even a hint of it. In an unsure world unattached to discipline, there are no incentives for adding true risk.

This financial miscalculation, fostered by the maintenance of artificial interest rates, bleeds beyond financial investments into business operations. The focus on liquidity makes profitable businesses ignore economically helpful projects. These kinds of expansions are, by their nature, risky and illiquid. Instead, cash is preferred. So are financial maneuvers - stock buybacks over factory expansion or a new research focus; paying a premium for a smaller competitor rather than acquiring a new unproven technology that might take longer to develop. Above all else, immediate returns are demanded at the expense of long-term investment.

As long as liquidity is the primary consideration, profitability is itself a trap. Rather than fostering the sustainable flow of money within an economic system, unilateral profitability is a dead end. Money flows to the bottom line of companies and stays there. Without a real, non-financial outlet for accumulated net income we are all poorer for it. The opportunity cost of dead-end profitability is lost wealth. In the end, wealth-creating activities create a recovery, not financial trading.

In a healthy economy, profitability should breed expansion and additional labor usage. Risky, illiquid ventures allow increasing profits to be shared by workers. As much as record profit levels are championed as evidence of a strong economy and the attendant cash piles as a means to future strength, neither will be economically beneficial without that natural flow from business to labor and back again. An economy is really a cyclical flow and impediments to that flow are its Achilles heel. The record level of corporate profits and the persistently weak job market is the most visible sign that something is very wrong.

Absent growth in wages and jobs, households are left dependent on the government and savings. The former is not a long-term answer, while the latter is a direct casualty of monetary policy. Low interest rates are another tax on income, a transfer back into the black hole of the banking system. Economically productive money that would be used by consumers to spend is instead transferred to the capital accounts of banks (through profitability) that are still behind in their capital levels from all the loans they issued years ago.

Counterproductive does not even begin to describe such a policy, but it exemplifies the narrative of economic potential as well as anything. The banking system is still short of capital and balance sheet capacity for all the activity credit production created during the bubble. The Fed is fighting the last war. Only in a world full of intervention would it be thought sane to withdraw money from economically productive means (income to savers) in order to gross up capital to absorb the housing bubble after it occurred.

Unfortunately, the capital reconstruction efforts require both new capital (the tax on savers) and an end to asset repricing - what the Fed calls deflation. Setting aside whether or not collapsing credit is actually deflation (deflation is not really about falling prices, it is the hoarding of currency), the banking system absolutely needs to reinflate asset prices. Without reflation, the capital-based efforts are easily overwhelmed by new losses (such as continued weakness in real estate prices).

So the reflation of prices brings the disconnect between true risk and the manipulated price of risk to the forefront. It is an obvious dichotomy, feeding into the consistent desire for liquidity above all else. It also interrupts the natural progression of prices to reflect economic reality, the same succession that sparks re-allocation. But that progression cannot be fully contained and ends up leaking out in different places: gold prices, depressed municipal bond issuance, or extremely volatile currencies. Until aggregate prices equalize to true economic potential no business will commit to risk, and flows will be continuously interrupted. The self-sustaining recovery never truly forms.

Current monetary policy is more than misaligned, it is counterproductive. Until prices normalize with economic reality, liquidity will be the only consistently valuable characteristic of investment. There will be transitory opportunities to commit money to profitable financial instruments, but they will always prove to be fleeting. Fiscal and monetary policy are desperately trying to buy time, filling holes until the economy grows itself into a recovery. It is a nice theory, but the very efforts to employ "extend and pretend" guarantee that the organic recovery never arrives. It is self-defeating from the beginning.

As I said above, the reflation game is a dangerous game to play. Without an anchored structure of risk pricing, asset prices will rise and fall in synchronization with monetization, sorely missing the sound, fundamental support of a healthy recovery. The economy writhes from contraction to inflation and back, with participants worse off after every exasperating cycle.

It should be no surprise that 2010 is being repeated as nothing has fundamentally changed. The only difference is the crescendo of side effects to these reflation efforts. An artificial economy cannot last long and its end will always be painful (1937, 2007). In the long run, though, it may be far better to let the artificial, unsustainable economy fall rather than to continually prop it up by adapting the Japanese model. The foundation of a new economy that is predicated on market discipline, sustainability and, above all, scarce credit is the answer to long-term growth. Often times the best medicine is the hardest to swallow.

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

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