Dollar Bets On Secular and Cyclical Destruction

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In her press conference remarks earlier in March, Janet Yellen admitted that the economy may not be performing as previously thought. She dryly noted that, "participants are now seeing more slack in the economy than they previously did." It was only a few months ago when third quarter GDP purportedly "confirmed" that 5% growth was now the rule rather than the exception, and that the Federal Reserve would have no choice but to move quickly to undercut any "inflationary" pressures about it. That is the entire point of "slack" in orthodox economic treatment and the reason it is so emphasized about policy inflection.

Judging by the unemployment rate alone one would consider such a turning point at risk of being far past. Indeed, that is the emphasis of the so-called hawks who believe "inflation" owing to less slack as highly non-linear. In the point of view of Richard Fisher, for example, as he explained on March 9, "slack responds to monetary policy with a lag, and wage growth responds with a lag to slack, so current wage growth is a very backward-looking measure of policy's stance." His point, as was Yellen's more subtle references before March, is that the apparent pickup in hiring via the Establishment Survey or at least the structural view of employment limitations via the unemployment rate suggests an economy finally at full recovery.

That is the broad interpretation, after all, in this consistent noise about whether or not the Fed might end ZIRP after about six and a half years. All the signs have pointed to an increased emphasis on "slack" inside and outside the FOMC discussions, which has been interpreted consistently as meaning the recovery is nearly complete - and so must be the "accommodation." The FOMC members, for their part, have done little to dissuade that point of view, for both obvious reasons not to potentially disrupt the "right" direction by saying the "wrong" thing and for personal reasons to do nothing short of finally declaring victory in the economy.

This isn't to say there aren't admissions about deficiencies that clearly remain, as Janet Yellen is just as often quick to remind. That has been a constant feature of the Fed Chair going back to the great mistakes in 2008. Policymakers feel very good about what they have done even when they acknowledge what they have done hasn't brought about what was fully intended and expected.

The entire idea of "slack" goes right to that central dichotomy. If the economy has indeed recovered and tightened with respect to "slack", then that marriage of actual performance with "potential" signals an end to the Great Recession cycle. To that point, the CBO's latest estimates on "potential" suggest that very outcome, as the recent gains in GDP last year have closed the gap to almost zero.

In an academic sense, the CBO's outlook conforms very well to what the FOMC is looking to do about eventually raising rates. While not a fully incorporated member of the policy team, the CBO's calculations carry great weight both inside and outside of the lawmaking branch of government. As it is, the FOMC's own estimates about "potential" are running consistently in the same direction. By majority accounts, monetary policy was thinking about finally putting this excruciatingly long and painful cycle to rest until oil prices and the "dollar" rudely intruded.

The point Janet Yellen was making in the latest press charade was only that last year's certainty about the economy's booming qualities were not so easily ported across the turn of the calendar page. That is especially troubling as an actual recovery trend is not so fragile as this one seems to be. While last year's negative GDP in Q1 was unflinchingly called an anomaly, this year, with estimates already heading below zero with only some of February's data in hand to this point, won't be so easy to cast aside. You can claim that another negative first quarter is not recessionary, but the lack of any durable trend to one side or the other highlights perhaps the most important and relevant element of the entire recovery "cycle": deep instability.

In that respect, the closing of the "output gap", the academic calculation of "slack", is highly misleading. Again, far be it for the FOMC to point out and emphasize the true reason for that outcome as it would at least muddy the preferred recovery narrative if not end it entirely. Larry Summers perhaps put it best earlier this year when he stated, with appropriate frankness,

"The United States is now about 10 percent below potential, as it was estimated in 2007. In so far as the output gap has closed, it is not because we have gotten closer to what we thought potential was. It is because we have revised downwards our assessment of the economy's potential. That 10 percent potential represents about $20,000 per American family."

To be even more blunt, the reason that there may be less slack now is not because the economy has finally found its recovery but rather because it may never do so at all. You can quibble with the mathematic construction of the measure or its theoretical basis, but what is important here is that the very people that believe in these sorts of things are now forsaken by their very creations. If there is actually a reduced level of slack in the economy right now, it is only because the US economy has permanently shrunk via the Great Recession.

Thus explains the great "mystery" about why the numbers so differ with what people feel and say about the matter. This cannot be overstated by hyperbole, as it essentially confirms what many of us have been saying for years and years; that the Great Recession was no cycle but rather a permanent rift in economic function that will alter our history and social standing for a long, long time (depending on how it is ultimately dealt with). Again, I make no claims about the figures or even the concept of "slack" except to point out that orthodox economists have now endorsed an idea that disproves a great deal of their own theoretical foundation.

First and foremost, economic cycles are thought to be temporary disruptions of natural economic progression. The idea of recession is an artificial "shock" to some economic function large enough to create dislocation across a broad front, including financial purposes. The attempt of any central bank at management is not even thus to realign but rather simply to remove that impediment or obstacle. In terms of the current "cycle", the FOMC used ZIRP and QE's to restore what they consider normal financial function so that the economy could then of its own accord run back toward its 2006 existence.

The repeated failure of the economy to do so was explained as aberration due to the size and scope of the financial retrenching, including the somehow persistently quoted idea of personal deleveraging that never actually happened. It was always believed that at some point dissatisfactory economic results would on their own dissipate and the prior trend would reassert; slack would disappear. That was the only way in which to preserve the idea of monetary neutrality especially in view of the collapse of the housing bubble - it is a bedrock assumption of modern general equilibrium theory that monetary policy bears no long run imprint upon economic function. For that to be maintained almost demands a perfect "cycle" of recession to recovery; meaning any delay to the formed recovery could not be anything but temporary.

There is a lot of intuitive sense in at least the idea of symmetry in economic cycles, which was why it so convinced Milton Friedman of its soundness. Not only was it easily observed in all post-war cycles to that point in 1993 when he published his "plucking model", the idea that the size and speed of any recovery is determined by the recession preceding it feels quite natural in basic economic sensitivity. For policymakers in 2008 and 2009, the scary depths of the Great Recession were, once passed, to open up tremendous possibilities in the recovery that was fully expected to follow.

This is not to say that everyone expected perfect symmetry, far from it, as even Janet Yellen herself expressed at the August 2009 FOMC meeting:

"Even if we are lucky enough to get sustained, robust GDP growth of, say, 4 to 5 percent for the next two years, we are still likely to fall short of our full employment goal, given the size of the output gap and the pace at which potential output appears to be growing...

"These inflation fears notwithstanding, the main threat to the attainment of our price stability goal over the next several years stems from the disinflationary forces that have been unleashed by the enormous slack in the economy."

In a speech in Los Angeles a few months later, in March 2010, she predicted the long track back to recovery, but no less a recovery:

"We define potential as the level where GDP would be if the economy were operating at full employment, meaning the highest level of employment we could sustain without triggering a rise in inflation. Obviously, with the unemployment rate so high, we are very far from that full employment level. In fact, the output gap was around negative 6 percent in the fourth quarter of 2009, based on estimates from the nonpartisan Congressional Budget Office, or CBO. That's an enormous number and it means the U.S. economy was producing 6 percent fewer goods and services than it could have had we been at full employment. In view of my forecast of moderate growth and high unemployment, I don't expect the output gap to completely disappear until sometime in 2013."

It's now 2015 and we are still discussing slack. Worse, according to Larry Summers' view and the math of the CBO, the amount of "slack" in 2015 is up to around 10% of GDP which means the economy has gone in the wrong direction since 2009. And that is true, even by counterfactual, as prior estimates of GDP "potential" were for growth rates closer to the long run averages. With GDP in this recovery failing to even live up to that mark, the economy is losing ground over time through reduced compounding (the most powerful force in the universe according to Albert Einstein) compared to where it "should" be.

So what has happened recently is not a full recovery but rather an admission that the economy is much, much smaller now and that is the way it will have to be. Removing ZIRP is an acknowledgement that monetary policy cannot in any way possibly answer that direct charge. The preferred explanation from orthodox views is "secular stagnation", in that the economy is itself to blame for violating symmetry and the "plucking model" expectations. No one can blame monetary policy under orthodox rules because it is "neutral", which means that economists can have either a recovery or their current rules, but not both.

Since these insufficiencies have given rise to more fundamental questions, the idea of symmetry itself should probably fall under examination. I don't mean that in the respect of how the economy may actually operate, as even I find a great deal of sense of function in the primal sort of symmetry about natural cycles. The question here is whether Friedman's idea about it is consistent, and more importantly how that is applied to making policy decisions.

The plucking approach says that the economy moves along on its own track of potential, to be moved offward only by intrusiveness (which could actually be above or below). In the case of recession, recessions themselves are violations of economic parameters, not the attempts to counteract them. As I said above, the Fed sees itself in just such a role defending the economy against disturbances by creating even larger and more massive intrusions. To remove obstacles and allow natural progression to return means, under current understanding, intentionally changing the character of economic flow in financial redistribution.

At that point, already, we have left intuitive sense far behind and entered the realm of pure academic theory. The only way that makes sense and can work is if the central focus of a narrow group of policymakers can make better sense than the "market." In terms of economic cycles, what that means is there is no role whatsoever for recession. A recession is always and forever classified as a negative outcome, but more than that it is now a matter of settled policy that recession is purely an unnecessary construct to be overcome by any means.

In terms of the plucking model, that makes sense but only if the plucking model itself is correct about potential and performing at or near it. That view related to recession, of course, immediately brings to mind Joseph Schumpeter's "creative destruction." In his book Capitalism, Socialism and Democracy, he said:

"The opening up of new markets, foreign or domestic, and the organizational development from the craft shop to such concerns as U.S. Steel illustrate the same process of industrial mutation-if I may use that biological term-that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism."

Creative destruction, such that it exists, is not absent from the plucking model only in how it is theorized to induce "industrial mutation." The idea of upward sloping potential does, in fact, take account of creative destruction, but assumes that it is or should be a smooth process. What reason is there to believe that creative destruction cannot be lumpy? Or even that it may work best in close proximity to other negative factors?

We know without fail that creative destruction is the mode by which economic advance leads to social gain, but there is very little in actually how that takes place - there is nothing but cursory assumptions in how we get (got) from A to B. It is estimated that in 1800 there were 1.4 million American workers engaged in agricultural production; of which 530,000 were slaves. Out of a total estimate labor force of just 1.9 million, that was a huge proportional dedication to feeding, clothing and bare subsistence.

By 1910, there were upwards of perhaps 12 million agricultural workers but out of a total labor force of 37.5 million. Those additional workers were not destitute for want of agricultural placement, but rather gainfully engaged in trades that did not exist the century before. Of course, in the 21st century agricultural labor is barely a fraction of the total yet hardly anyone goes hungry - to the point that we now have to worry, supposedly, that even the poor are overly obese.

Those farm workers displaced by innovation and, yes, capital formation were not happy about it, and there is no covering the fact that the transformation was often messy and unseemly. But that does not change the ultimate outcome that we are all better for having it occur. It is not enough to say that those changes were made by dictations of changing profit circumstances, as they clearly were, as there is more to it than just such a bland assertion.

A great many of those who might have been working on farms during the 19th century transformation found themselves in the employ of the railroads - the tech movement of that age. While there were barely 5,000 railroad workers before 1840, there were over 1 million by 1900. Over the next two decades, railroad expansion formed the bedrock of total economic advance, with another 1.2 million workers added by 1920. Today, railroad employment is negligible, though "plucking model" would have you assume that it was a smooth transformation along the way.

In fact, while we can't see exactly the means by which railroad activity was subjected to creative destruction, the role of bankruptcy in the process is clear. The clusters of major bankruptcies in the 20th century all align closely with economic recession. That includes not just the 1930's as you might expect, but also the 1970's where there were three major railway bankruptcies in 1970 (recession of 1969-70) and then about fifteen in July 1973 just as the next recession was forming (oil crisis, "dollars" and so much that is familiar to today).

It just may be, to borrow a Warren Buffet adage, that recession is the mechanism by which a great deal of transformation takes place; where the lowered tide of economic activity reveals which businesses are productively naked. It is entirely possible that the process of recession is itself a heightened state of creative destruction that allows the quickest and most sensitive transitions - being dumped as a railroad worker in the 1970's, especially if young, would have been a favorable outcome given the employment trends that followed even if especially painful at the point of transition.

That is what is usually lost in the attempt at counteracting the process. The pain is immediate and obvious - and furthermore political as a great increase in unemployment is decidedly a danger to reelection. The gains from this, even recession, are not visible in the short run or even the intermediate, and thus may never get connected by convention with the actual progression at its inception.

In 1970 there were about 160,000 computer programmers and scientists; there are now (depending on definitions) almost 4 million. There were no webmasters in even 1990, now there are about 1 million. There is no reason to expect those gains were made steadily over time and interrupted by recession, rather it stands to reason by way of even financial resource allocation during that period that the removal of older and less productive businesses in recession fosters these new opportunities. Recessions have a way of sharpening even sensitivities of paper trading, as nonproductive businesses get out of the way and harm through paper losses but also force (of discipline) traders to look for the next big things.

And monetary theory and thus its policies are dedicated to stamping that out entirely, as if there is nothing to gain via loss. The whole point of monetary policy under interest rate targeting is to attempt to banish recession in the first place, to "smooth out the business cycle" as if the business cycle has no natural place in the economic order. The economists of the time, looking directly upon that tech growth in the 1980's, were quick to assert that they could "fill in the troughs without shaving off the peaks" as if there were nothing lost by doing so - and now stand in amazement as they recalculate the shriveling of those very peaks.

There is no way to prove or disprove the methodology of creative destruction but there is very strong intuition in its obvious absence. If the US economy, and actually the world economy, is suffering from severely curtailed "potential" and creative destruction is a major part in assigning and determining potential, then what follows is the possibility that creative destruction processes may just have been what was actually upset by the attempt at controlling economic variation. Alan Greenspan was lauded in the 1990's for banishing the business cycle, when two decades later it is becoming clear that economic dynamism and actual function may have actually been his target. We spent almost thirty years without much by way of recessions, only very mild versions, until arriving at the most serious break since the Great Depression. That could just be coincidence, or it could be great evidence of the uninterrupted accumulation of errors not addressed by creative destruction in a more natural cyclical setting.

The whole point of monetary policy is stasis, not stability in any economic sense. True stability, the one constant in actual progress, is change. That divergence is perhaps most clearly visible in the Panic of 2008 itself, where creative destruction appeared poised to upset and completely rearrange the financial order itself; blowing out those who made tremendous errors fostering great economic inefficiency for a long time. To which the FOMC responded, pace Friedman's plucking understanding of potential, by counteracting it with every effort they could think of - from ZIRP and QE's to too big to fail. The Fed sought to actually circumvent major markets themselves as if actual price discovery was too offensive to recovery.

The facts of our current economic case are that the recovery isn't here, and it is in fact never going to arrive under current constraints. By any serious and reasonable definition (which leaves GDP out) the economy in 2015 is much smaller than it was at the "cycle" peak in 2007; and likely even smaller than it was at the cycle peak before that. The problem now is that that dynamic isn't changing, and that the US economy is being left further and further behind; compounding is terrific in your favor but a total disaster when left apart from it. That is how the FOMC can even talk of recovery when labor utilization is at four-decade lows.

Economist Brad Delong coined the term "Lesser Depression" to describe this. Depending on how this "more slack than we anticipated" plays out in 2015, that may actually end up being the best case. We already know which way the "dollar" is betting, not for secular stagnation but for both secular and cyclical destruction.


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

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