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Saturday, March 7, 2009

Forecast: Recovery contingent on policy actions, Fed improvement

This Week

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Another context for the forecast is those economists who are predicting the ultimate depression. This is actually a hopeful sign. Why hopeful? These same economists predicted until the middle of last year that the U.S. and the world would avoid recession entirely, or that one or another decoupling scenario would prevent the decline from becoming worldwide. That is, the current crop of financial prognosticators, with a few exceptions, is always wrong.

Discouraging signs: Some of them, including the Fed's open market committee, are seeing recovery in 2010. The FOMC is even more wrong than the mainstream economists.

The Demand Side observation. The worse the better. Bad news in the short run will do wonders to stimulate the dramatic and bold action needed for recovery. Also, we are lucky to have the president we have.

Paul Kasriel, Northern Trust

Now let's stick our toe in the forecast water with Paul Kasriel at Northern Trust, one of the few very good forecasters. His assessment released last week, quote

The current economic environment is indeed bleak and there are precious few signs of a recovery. But we believe that if the massive fiscal stimulus package being worked up in Congress is financed largely by the banking system and the Federal Reserve, there is a good chance the economy will begin to grow by the fourth quarter of this year and continue to do so throughout 2010. And if we are correct on this, we also believe there is a good chance that the consumer price index will be advancing at a fast enough pace by the second half of 2010 to induce the Federal Reserve to become more aggressive in draining credit from the financial system. This could set the stage for another recession commencing in 2012, or perhaps some time in 2011. So, the shape of the path of economic activity we see over the next few years is not a “V”, a “U”, or an “L”, but a “W” – down, up, down, up, all within four or five years.

[W]hat is our rationale for a late-2009 economic recovery and a subsequent 2011 or 2012 slowdown/downturn? Massive federal spending funded by the Federal Reserve and the banking system. The Obama administration and Congress are in the process of developing a two-year fiscal stimulus package that at last, but likely not the final, count totals $825 billion. This fiscal stimulus program will include all things to all people – traditional and non-traditional infrastructure spending, aid to state and local governments, expansion of food stamp and unemployment insurance programs, and tax cuts for households and businesses. This massive federal spending and tax cut program will be financed by issuing additional federal debt. Who is likely to purchase this debt? The Federal Reserve and the banking system.

The implication of the banking system and the Federal Reserve monetizing large proportions of nonfinancial sector borrowing – government or private sector – is that the borrowers are able to increase their spending without any other entity cutting back on its spending. Thus, in terms of the GDP accounts, total spending in the economy increases. This is why we expect a recovery in real GDP by the fourth quarter of this year.

If monetizing nonfinancial debt were costless, economically speaking, the Zimbabwean economy would be the envy of the world. But, of course, there are economic costs. Monetizing debt means printing money. And printing money ultimately leads to accelerating prices – prices of goods, services and assets. ... If we are correct that a real GDP recovery commences by the fourth quarter of this year, then we believe the Federal Reserve will cautiously begin slowing its credit creation in the first half of 2010 – that is, the Fed will begin to slowly increase the federal funds rate. We then see inflationary pressures intensifying in the second half of 2010 and the Fed reacting to this with more aggressive hikes in the federal funds rate. This is what we believe will trigger the next official recession, or at least, growth recession.

In conclusion, over much of 2009, the year-over-year change in the CPI is likely to be negative. We advise investors not to extrapolate this “deflation” into 2010 and 2011. With the massive monetization of debt that is likely to occur, increases in the CPI are expected to resume.

Demand Side Forecast

The Demand Side forecast is unchanged from November not entirely because we are too lazy to update the web site demandside dot net, but also because it is as accurate as anything contemporaneous. It sees a U-shaped recession that is severe enough in the short term to stimulate the needed policy measures. We anticipate the Fed's fever about inflation will be sufficiently chastened by its ineptness in the current crisis to prevent the aggressive intervention predicted by Kasriel.

History of Accuracy

We would like to buttress our credentials by pointing out that Demand Side has a record of accuracy. Irrespective of orthodox approval, in earlier forms we correctly predicted the fall of the quote New Economy unquote of the Clinton years. The Three Amigos of the time (perhaps even of Time Magazine) were Alan Greenspan, Robert Rubin and Larry Summers. Fed Chair, Treasury and Assistant Treasury Secretary. Neglected in the congratulatory analysis of Rubinomics was acknowledgment of fifteen dollar oil.

Demand Side was one of a very small number, maybe two, who saw the New Economy falling under the old economy weight of higher interest rates and higher energy prices. Most have put the cause of the downturn in 2001 as the delayed effects of the dot.com crash. Others, primarily Bush's group have put it down as some sort of reaction to 9-11, which happened five months after the start of the recession.

This first Bush Recession did allow Republicans to move their tax cuts through Congress, neatly changing the message of surplus -- "After all, it's your money," to one adapted to the need for economic stimulus. At the time it was assumed all tax cuts have stimulative value. Meanwhile Alan Greenspan changed high interest rates to rates of one percent, to stave off a newly feared deflation. Never mind he had stalled the economy with his fears of inflation only twelve months earlier.

No matter how hard we jumped up and down, our miniscule soapbox did not allow us the elevation to get onto the radar.

Demand Side correctly anticipated that tax cuts for the wealthy would be ineffectual. What ensued was the jobless recovery. We also made an early call that Greenspan's one percent rates were not restarting the New Economy, as he may have hoped, but shoveling debt into residential construction, a remarkably passive and unproductive form of capital investment. We were slackjawed in amazement that Congress came back for a second helping of the Bush tax cut poison. Clearly jobs and incomes were lagging and a speculative fever was inflating a bubble.

This was made most clear in Dean Baker's historical trend analysis of rents versus ownership. A rapidly growing divergence demonstrated, as he had with similar analysis of the dot.com experience, that the housing boom was a bubble. We repeatedly highlighted the fact that housing had become not just a place to live, but a financial asset. It was the asset price explosion that was sucking debt into housing, housing which was clearly unaffordable absent the imagined jump in equity.

We called the collapse of the housing bubble eighteen months before its time. We missed that call, but learned. The bubble was extended from a basic herd event by the corruption of the housing market in its late stages with fraud and abuse, widely cloaked by the perceived inevitability of prices rising forever. That is, the fever of the buyers slash borrowers to participate was enabled by machinations of sellers slash lenders to provide ever more capital. Extra leverage, financially engineered triple A securities, liars loans, and even criminal conspiracies exploited the boom.

The corruption of the markets had occurred also in the S&L crisis and in the stock market bubble. We had actully done some work with Baker at the end of the dot.com bubble where he preferred the primacy of the insider trading dynamic and we preferred the rudimentary herd theory. Of course, both exist. The bubble creates conditions for fraud and corruption -- and delays the natural boom and bust.

By missing the corruption of the housing markets we also missed the devastating impacts on the financial sector of that corruption. The allocation of capital, the management of risk and the mobilization of savings -- the core functions of a working financial system -- were completely broken by the practices of the big banks, the mortgage companies, the investment houses, and the other members of the shadow banking system. We quickly picked up on the work of Nouriel Roubini and Joseph Stiglitz in 2007 to come in far ahead of the curve on the crash.

And you may remember our first editions of the podcast calling the beginning of the recession in the last week of October 2007, statistically for November. We witnessed months of denial by others, lasting well into May, 2008. Subsequently the National Bureau of Economic Research identified the recession as beginning in December, 2007. Their call came after the November elections, our call came contemporaneously, fully a year earlier.

Parenthetically, while the NBER garners plenty of respect for its probity in making this calculation, at Demand Side we do not see the value for policy of a determination made so long after the fact. It only adds to the confusion. Decisions that need to be made in real time cannot wait until the committee gets consensus, particularly when the committee is stacked with boneheads.

One event we did not miss at Demand Side that others have -- even the most notable -- was the commodities bubble. Following the work of analyst Charles Peabody we called the oil and commodities bubble as it emerged in November 2007. Our correct stagflation forecast for the first half of 2008 was based on the premise that liquidity was chasing the rising asset price -- commodities -- and rising asset prices were creating cost-push inflation and subtracting another fraction of effective demand. We tracked the commodities bubble upward and called its peak virtually the week it happened. We made lots of virtual money in our fantasy portfolio as oil, metals, grains and energy dropped like a stone. Oil from $147 to $40.

On the way up we cautioned about the euphoria in alternative energy. On the way down we warned about the devastating impacts on commodity producers and made mention of the collateral damage on the auto industry. Both the income shock of $4.50 per gallon gas and the micro shock to the companies, as they lacked the hybrid technology so much in demand. Hybrids and alternative energy have floated to the back of the collective consciousness today, as the collapse of the banks have replaced every other economic news.

We should make mention before we leave the commodity bubble story that the brevity of the bubble and the fact that oil did not reach $200 per barrel as called for by Goldman Sachs was in part due to prompt and aggressive oversight in Congress. Fraud and market manipulation in commodities no doubt occurred, but on a scale far below that of the other bubbles.


Let's be clear. Demand Side's forecasting success arose not because of statistical models or any real econometric expertise. Were were clear about our method at the time. We correctly observed the conditions of stagnating wages and incomes that underlay the housing bubble and that would be revealed when the tide went out. The huge increase in debt under Bush was papering over a very weak underlying economy. The current decrepit economy is the economy of 2001 minus ten trillion dollars of debt.

This recovery depends on policy choices and bold action. Any future recovery depends on their being instituted, and so our forecast depends not on the imagined quote natural economic forces unquote, but on the political will of the nation and its leaders. As soon as policies are changed, the economy will improve. Until they are made, the economy will be frustrated.

Here are six key actions:

  1. Reduce the principle in mortgage debt.
  2. Reconstruct the financial sector by dealing directly with insolvent zombie banks
  3. Stop the contraction of state and local governments with grants to replace collapsing revenues.
  4. Step up infrastructure, green energy and jobs spending.
  5. Institute improvements to the social insurance system by instituting national health care and improving social security retirement.
  6. Coordinate similar policies with other nations. Use the power of the dollar to create physical and human capital around the world. Inevitably this will create wealth and markets for the U.S. to sell its products into. More importantly it will mobilize cooperation that we need to meet the incredible challenges ahead, economic, environmental and social.

There are primary obstacles to recovery. Five on top are:

  1. The consumer economy.
  2. Reaganomics
  3. The obtuseness of orthodox economics
  4. The institutional power of the Fed
  5. The burden of debt
Next Week

Next week we'll look at the debt. Much has been made of the federal deficit, but a great deal more borrowing has been done by the private sector. Reducing this debt burden is essential to recovery. Part one of reducing this debt, rather than simply transferring it to the taxpayer, needs the Fed to act radically different than it now is.

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