Laughing Off 'Year Of Recovery' Pretense

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With the advance release of the fourth quarter's GDP figure estimated at just above 3%, it contrasts very sharply with the estimates of payroll growth, particularly in the latter weeks of that quarter. There has been a very heavy element of inventory carrying accounting for a great deal of the GDP estimate, but that does not fully explain the divergence. Of course, there should be no expectations for an extremely close correlation, particularly in any short time period, between estimates of GDP and estimates of labor utilization, but there has always been some historical anticipation that any such divergence would be minor and temporary.

We assume from economic accounts that they are, in general, decent proxies of economic health and behavior. Thus we should expect that GDP, like retail sales or any other economic figure, finds itself in concert far more often than not with a broad spectrum of coincident indications; like employment.

For some reason, however, the separation between GDP and employment has spanned quite some years now, falling completely under the aegis of the current "recovery." If we use the latest construction of GDP as the Bureau of Economic Analysis has updated its approach, which now includes intangibles and certain research "investments", the Great Recession cycle peak occurred in the third quarter of 2008 at $14.844 trillion. It would take nearly two years to regain that level, demonstrating the degree to which the economy fell into restructuring, but by the second quarter of 2010 GDP was $14.879 trillion. As of the latest figure, GDP is now about 15% above that level.

The Bureau of Labor Statistics and its Establishment Survey shows a cycle peak in January 2008 where an estimated 138 million Americans were employed. The Household Survey, under slightly different methodology, marks the same month. As of December 2013, the Establishment Survey is still more than a million employees below that cyclical peak - after now nearly six full years!

GDP is essentially a statistical survey process that attempts to measure the amount of goods and services traded within an economic system (limited only to "value added"). In rough terms, the BEA uses the dollar value of that trade to measure economic progress (or recession). That places a good deal of emphasis on anything that may potentially disrupt or disturb a clean reading of dollar values, particularly inflation.

The current convention regarding the difference between employment and GDP is reduced to the estimates of productivity, as some sort of remainder in a rather simplistic equation. The BEA derives the productivity figures after it has assigned a dollar value to the goods and services GDP part, then estimates "inflation" in consumer prices of the various segments - productivity is the plug line or balancing item. If the price/inflation estimate is perhaps too low, then productivity will look to be uncharacteristically strong. But that is the only way you can arrive at an economic system whereby 1% fewer workers produce 15% more goods and service. The only other way that equation balances is if 1% fewer workers produce the same (or less, or even only slightly more) goods and services but prices actually change by something close to 15%.

The former scenario is what we would expect to see in an economy that is booming in the truest sense of the word - where actual productivity is freeing up labor resources to pursue other ends and means of economic transformation. That would be the driving end of a wave of not just innovation, but revolutionary innovation. That was the industrial revolution as the adoption of innovative technology in agriculture freed labor to pursue opportunities in industrial production that did not exist previously. It was certainly disruptive in the sense that it upended the old order, but society and the economic system were visibly better for it. That hardly describes the last six years.

The contra example above, the latter, places a great deal of emphasis on the dollar itself. For as long as there has existed the dollar, there has existed the temptation to make it pliable enough to fit the fancy of its masters. In the context of the economic system as it has developed since the earliest stirrings of industrial transformation.

In the current age, there is no mistake about where the dollars strings attach. The Federal Reserve sets policy but does not really operate the "printing press", that is reserved for the global banking cabal including eurodollar participants. There are relatively persuasive arguments on both sides as to which end is in actual control, the banks or the Fed, but in my mind there is no degree of separation, at least not meaningfully in this setting. The banking system operates as the business end of policy. Banking interests have become fully aligned with policy directives as the banking system has been re-oriented in that direction by progression in the past six or so decades.

A full part of that changing systemic character has been the gradual reduction in the relevance of real money. Convention always marks 1971 as the end of the gold era, but it really began its demise far earlier. The Bretton Woods system was plagued almost from the start by this impulse toward dollar pliability, whether for US government purposes, US banking purposes or global trade. The formation of the London gold pool in November 1961 was a symptom of market forces attempting to re-assert authority over currency; and how far government control would be stretched to wrestle free of any competition over monetary monopoly.

Of course, the market lost as convertibility was removed from the dollar, amounting to a soft default on US government obligations. Throughout the rest of the 1970's, the floating gold price of the dollar was a visible reminder of just how bad monetary stewardship could be in an age where ultimate currency arbitration was centralized rather than in the dispersed hands of ordinary people.

By the 1990's, in contrast, the Federal Reserve had conjured enough credibility (mistaken on most accounts) to take that one step further, by utterly destroying gold; turning it away from money into just another investment. It has been said, and not by Fed apologists and orthodox practitioners, that the Federal Reserve followed some kind of a gold price targeting in the 1990's that allowed it to create the conditions for the "best" part of the Great "Moderation." To me that was always inconsistent with the data from that age, not the least of which was the obvious stock bubble that began protruding as early as 1995. That bubble was concurrent to financial imbalances in housing and mortgage finance (the housing bubble that generally refers to the mid-2000's was only the last stage of the process), as well as financial domination through the vast spread of eurodollars and accumulated "reserves."

To suggest that targeting gold prices had an effect on the overall banking system's "printing press" during that age is to not notice that gold had been delinked from any role in the monetary system. As such, and as the Fed itself has indicated on numerous occasions, gold prices operated solely as indicator of inflation expectations; expectations being the operative word and a tip toward psychology rather than actual monetary restraint. In order to fully incorporate such a gold price restraint into the current policy framework would have to include a belief that increasing interest rates is itself a restraint on money and credit creation. There is no evidence to believe as much, particularly since interest rate targeting is an implicit promise to fulfill any demand for wholesale money (starting in federal funds markets) at whatever target. The quantity is never restrained, nor is it even considered, only the cost.

There are numerous contrary episodes that show exactly what a hard money limit actually looks like, including the first crisis of the Second Bank of the United States. The historical contrast illustrates this principle well.

Created in 1817, the Second Bank was peculiar right at the start. We have to remember that the US system before 1849 was almost always "short" of hard money. The most popular form of money in the early 19th century was a Spanish silver dollar, so there was a market desire to fill a currency void through the issue of bank notes (paper money). The Second Bank, because of factors relating to the end of the War of 1812 and even the financing of the Louisiana Purchase, largely accepted bank notes as "money" in the place of gold.

That posed a problem as early as 1818, as suddenly specie (hard money) began to trade at premiums to bank notes, including notes issued by the Second Bank itself. To restore that imbalance required adherence to market principles, not just hollow acknowledgement toward "expectations", meaning bank notes were redeemed in sufficient quantity to reduce the price of gold and the discounts on paper currency. Unfortunately for that age, the expansion of bank notes engendered by the Second Bank's acceptance of them made this price discipline "contractionary."

Since the Second Bank had assumed the external liability of the debt on the Louisiana Purchase, which had to be paid in hard money, and the import drain of hard money abroad, there was no choice but to redeem bank notes in an attempt to both increase the level of gold and silver in the Second Bank's hands and restore price parity of hard money with its own notes. That gold price rule mechanism drained gold and silver reserves from the interior banks, forcing them to restrain note issuance and even contract paper money "supply."

It is estimated that a 6% premium price on Spanish silver dollars in late 1818 forced the Second Bank into enough note redemptions that the total supply of bank notes in the US fell sharply from $68 million in 1816 to $45 million by early 1820. Such contraction was concurrent with only a $5.5 million increase in specie reserves at the Second Bank, from just $2.5 million in 1818 to $8 million by 1822. It should be noted that this was involuntary on the part of the Second Bank, as it was largely expansionary in its practices (thus would have, under the modern vernacular, loved to have possessed the kind of "flexibility" that Chairman Bernanke and now Janet Yellen exercise routinely). The panic of 1819 that followed (with the first modern instance of unemployment in the US economy) was a market-based restraint on prior credit expansion because gold served a central role in the financial equation.

The financial system in the 1990's looked nothing like that. Upon entering 1990, gold prices were around $400 per ounce, having come down from the inflation high of 1980. The price of gold in dollars was very nearly the same by and throughout 1995, mostly trading in a range of $375 to $390. By the end of the decade, gold was trading around $275 per ounce. This is used as good evidence that the 1990's, even the latter half, were/was devoid of inflation, as gold surely would have signaled as much.

But we know that central banks had been particularly active in the 1990's, even more than the 1980's, in gold leasing. That would add a second, more hidden manipulative element to the monetary psychology of a policy regime that was growing more and more dependent on such effects of expectation management. Why that is believed consistent with more visible and tangible restraint, such as limitations on reserves, is beyond me. In other words, I am not arguing that Alan Greenspan's Fed did not take gold prices into account in setting policy targets, particularly changes in interest rates, only that such account has little bearing on the overall credit and money supply of the dollar system. It certainly acts nothing like a true gold system such as that existed in the Second Bank era.

As we saw in the decade after, gold prices played little role in affecting the path of credit imbalances - which suggests, and strongly so, that interest rate targeting offers nothing at all by way of restraint (particularly in the years where the interest rate target was raised and credit production failed to register even a minor disruption). That is true whether gold is factored or not since the financial system holds no real role for hard money at all.

Total credit liabilities to the nonfinancial sectors of the US economy grew by more than 70% during the 1990's, from a little more than $10 trillion to about $17.3 trillion. Total M3 money stock, which includes a rough estimate of repos and eurodollars, increased by $2 trillion to $6.5 trillion in just the five years after 1994 - exactly when gold prices were declining most and official measures of inflation were most benign. That it was concurrent to the stock bubble is simply ignored as mere coincidence.

What this entire narrative suggests, again at least to me, is that the modern concept of inflation is, at best, flawed, and, at worst, woefully inadequate. There is no current role for gold in this system, and that has been true for far more than just the 1990's and 2000's; and that was exactly what the central bank system wanted. Gold has been relegated to an indication, driven off the pedestal of monetary function and yanked out from under the base of the pyramid. And because of that fall from grace, abhorrent as it has been, gold no longer operates like money, and thus does not incorporate all the information (nor act) it once did when it was central to the system. Again, gold is no longer money but an investment class, with as much relevance to current monetary finance and information content as copper or palladium prices.

This aligns closely with the more obvious degradation in the standards by which economic performance is judged. The diminishing stability of the dollar is not only a primary impediment to the function of the US economy (and the global economy, as emerging markets continue to show); it has the potential to confound the measures by which convention uses. That has implications not only in observation and analysis but also in setting policy itself, particularly where the modern practitioner believes in a more acute sense of precision about such economic accounts and factors.

In the current case, which now spans an absolutely incredible six years, where does said precision lie? Is GDP accurate about the state of the economy? How does the lack of confirmation in the labor market square with that interpretation? The existing GDP construct, which fully incorporates current philosophy on "inflation", would only hold as valid if the rate of growth in money and credit assumed as simply matching "market demand." That would lead to the interpretation that bubbles have been (and are) indeed market-driven offshoots of a healthy growth trend.

Taking that a step further, given history here, that would mean that economic agents and investors are as dumb as the contempt for which they are held by authorities. I think that is demonstrably false, not the least of which because the bubbles have burst (with more to come). Can a highly functioning economy create such a misallocation of resources? I highly doubt it, and that gets back to the conundrum of the first part of this piece; namely that it is only economies operating in dysfunction that seem to coincide with bubbles and monetary imbalances, not the other way around. Like the lacking employment, asset bubbles are visible signs to the contrary, that there is monetary imbalance significant enough to be a full drag on ultimate performance. The divergence with GDP is simply that modern statistics are not calibrated toward such complexity as is presented by the global nature of the interconnected, and financially dominant, economy.

The current economy doesn't comport with the textbook definition of resounding growth (again, unless you reduce the standards in the textbook) because it is not operating as such, and an economy operating far below potential or peak efficiency is far more likely to be misallocating resources, especially monetary in nature. We have lost the ability to even see where and by how much monetary debasement even occurs; but we feel its effects all the same as this disconnect between "Main Street" and DC goes well beyond laughing off the annual ritual of "this is the year of recovery."


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

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