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Wednesday, October 6, 2010

Transcript: 407 Forecast

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The Forecast Returns,

Karl Popper's line oft quoted by George Soros and replicated on one of the Demand Side blog sites, is,

"Predictions and explanations are symmetrical and reversible." Which is the opposite of the disclaimer which accompanies most private and public forecasts. That disclaimer goes something like, "Of course, economic forecasts are subject to extreme uncertainty."

It is the demand side view that if your explanation is valid, then your prediction will be at least approximately correct. And on the other hand, if your prediction proves to be bogus, then your explanation has to be revisited and revised. It is just not appropriate to blame unforeseeable events. But appropriate or not, this is precisely what the Fed and the fine fellows in the Neoclassical and Monetarist camps routinely do. Most famously, when Ben Bernanke spoke to the assembled at Davos with the words, "Nobody saw it coming," while in the front row were four or five economists, including Joseph Stiglitz, who had been warning of it for years.

As John Maynard Keynes said,

Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be.

No, that is,

I do not know which makes a man more conservative - to know nothing but the present, or nothing but the past.

Well, that's not it either. He said those things, but the one I'm looking for is... Well, I can't find it. Paraphrased, it is "An economists professional standing does not suffer as much from his being wrong as it does from his being outside the consensus view." That is, it is better for one's career to be wrong and close to the norm, than it is to be right.

The hysteria over the next data point evinced in the financial media is generated by the expectation that the next data point will make a difference. Stagnation is in place. This hysteria reveals that forecasters and analysts are not making predictions about the future, they are making predictions about the present. Later in the podcast we will hear from Meredith Whitney on two keys to our outlook -- the downsizing of state and local governments and the fragility of the banking system. Here we will simply note that no recovery occurs without cleaning the financial system of bad loans and recognizing true values of assets. This has not been done, nor is it in prospect.

The Demand Side forecast has been and continues to be bouncing along the bottom, a bottom sloped downward, with increasing fragility in financial markets portending new financial crises. We are adding to our forecast today a bubble watch on commodities. We'll explain that in a moment.

Our chart of GDP continues to be fairly accurate, and even includes the bounce at the beginning of the year. It is drawn at a real rate of one percent. Nominal GDP will be about the same, as inflation continues to be flat. This inflation dimension will be confused by any commodities bubble.

Before we get to that, we have to admit that we overestimated unemployment. We stated that 12 percent unemployment was "baked in," with 20 percent in the all-in U6 measure. So far we've gotten to 10 percent and 17 percent. Some of our error is explained by the shrinking of he work force, and the employment to population ratio continues to describe a very weak economy.

Should Republicans win in the fall, and even if they don't, but are still able to obstruct even modest stimulus or begin an erosion of social insurance, we suspect our 12 and 20 are not unrealistic, at all. Combined with an even greater control of the economy by the casino corporate sector, we will be getting into truly dangerous waters.

Now, the inflation dilemma. New strength in oil markets and a break-out of the CRB Raw Industrials Sub-Index to the upside indicates the cheap chips for the financial sector may be moving into commodity speculation. Over the past ten to twelve years, we have had three major financial bubbles -- the dot.com boom, the housing boom, and the short, sharp boom in commodities ending on July 4, 2008. Each of these bubbles was born out of the efforts to mitigate the damage of the bursting of the previous bubble.

An explicit strategy of Alan Greenspan was to create housing wealth to offset the wealth destroyed in the dot.com bust. At least that was his expressed strategy in 2002. We suspect that after triggering the bust with the historically highest real interest rates in 1999 and 2000, and then attempting to reverse course by dropping them to historic lows, Greenspan observed that the cheap money was flowing into real estate and said, "I meant to do that." A Maestro Magoo, "Ah, Magoo, You've done it again."

Now the reverse has happened, with the bust in housing, interest rates were brought to zero with the idea of stemming the collapse. But that cheap money has flowed into liquid assets, not real estate. True, housing has ended its free fall. Some of this, we suspect, is due to the trillion point two five in Fed purchases of mortgage backed securities and the wholesale takeover of the housing market by the GSE's.

But the point is that the Fed's direct subsidies to the financial sector have not shown up in credit growth, or in housing, but in bonds and stocks. Cheap chips, zero-cost positions, have allowed leverage to dominate these markets. Now it may again be moving into commodities. Note this is a watch, not a warning. Dollar weakness is also a reason for oil price strength. With currencies racing to the bottom, and none getting a lead on the others, it is hard to call which one will win. Be that as it may, the real test will come when the stock market falters. This is when you would expect the chips to get placed on the green, the commodities, to the detriment of all who might eat or use raw materials.

The impact on our forecast is in price rises that may be confused as general inflation. While commodity speculation is a financial phenomenon, it has direct results in gauges of inflation like the CPI, impacts that speculation in housing and stocks and bonds do not. This impact on inflation measures is alarming to the Fed and the inflation fanatics. They have been subdued to some degree by years of price stability, but you can be sure that at the sign of any movement in CPI, they will throw off their restraints and begin the clamor that the long-awaited inflation explosion is at hand, and the sky is finally falling.  Unfortunately inflation as a general phenomenon is far away.

General inflation would mean an increase in nominal wages and salaries, which would reduce the relative burden of debts, whose nominal payments would remain the same.  But earned income is stagnant, except at the highest levels, and fails even to reflect productivity increases.  Thus the increase in prices of commodities is a tax on people that general inflation is not.  Yet the financial authorities are likely to respond with what they view as restriction, because the only response they know to inflation is to restrict demand.

In this case, we may be fortunate, because the Fed's raising interest rates could help.  Pension funds and others who depend on interest income have been starved by the eagerness to coddle the banks with zero interst rates. 

While one might hope for a raise in interest rates, we suspect banking control of Fed policy will not allow this. The response to inflation will likely be seen in the time-honored strategy of shooting ourselves in the foot, with reductions in government spending and investment. Bond vigilantes and inflation chicken littles will demand austerity. Thus, the U.S. will join Europe in starving the ox. Demand will be crippled. The fields that need to be tilled and planted will be neglected, and the Depression will become worse.

Meanwhile the "financial sector first" strategy will continue to gin up demand for financial assets without producing investment.  More and more money seeking fewer and fewer productive uses for money means higher prices for existing assets.  The financial sector, in which we include the Fed, is masturbating and expecting somebody to get pregnant.  It is not going to happen.


That is the Demand Side forecast. Now to the comparisons.


To hear the talk from the professional offices, the current stagnation is nothing but what was forecast by the consensus over the past twelve months. In fact, as we said several weeks ago, since August it has been a sea of people in cardigans and cuorduroy sports coats moonwalking back their predictions. A year ago, ten months ago, eight months ago, six months ago, the number of people predicting something other than recovery was David Rosenberg, Steve Keen, Joseph Stiglitz, and a handful of the usual suspects. For a while it felt like it was David Rosenberg and me. The consensus is coming closer by the week.

The common view and tone is reflected in a piece from Comstock Partners which we will relay in a moment. The irony, the great irony, is that the rehabilitation of Rosenberg and the other heretics comes just at the time the official word came out that they were wrong. The NBER declared the 2007 recession over as of June 2009 and the recovery underway. The response to this announcement epitomizes the situation with forecasters today. Had the NBER made the same statement six months ago, Wall Street and the AEA would have broken out in a mass chorus of "I told you so's." But they didn't, and the response from the same professionals is muted derision, or an embarrassed, "Of course, it doesn't feel like a recovery."

But here, from Comstock Partners, issued August 19, what might be characterized as the lower end of what has come to be the consensus view.

By Comstock Partners

As we have long expected, the economy is tracing out a trajectory typical of a balance sheet induced recession rather than the garden-variety inventory recessions typical of the period since the end of World Wart ll. In a balance sheet recession the dire effects of debt deleveraging overwhelm the efforts of the government to stimulate the economy as is happening now, and the economy undergoes a lengthy period of deflation, sub-par recoveries and frequent slowdowns as the U.S. experienced during the 1930s and Japan over the last 20 years.

While the massive stimulative measures undertaken by the Fed, Congress and the White House have succeeded in averting a financial collapse, they are being more than offset by the deleveraging now taking place. The effects of inventory replenishment are winding down without any other major drivers to sustain growth. Typically a new economic expansion is led by inventories, consumer spending, employment, housing and readily available credit. This time only inventories have performed their usual function, meaning that the economy has been acting on only one of five cylinders.

The Fed has already used all of its conventional weapons and will undoubtedly resort to untried unconventional measures with unknown outcomes and the possibility of unintended consequences. The most likely measures will probably be further large purchases of Treasury securities and mortgage bonds together with a ceiling on Treasury bond yields as outlined in Chairman Bernanke’s famous 2002 speech that earned him the nickname "Helicopter Ben". This is commonly referred to quantitative easing or QE2. We doubt, however, that this will have any more effect than QE1 as it would be more than offset by debt deleveraging.

We also believe that the market is currently too complacent about the global economy. China is attempting to prevent a bubble by engineering a soft landing that will at best result in a substantial slowing of imports, and at worst a full-fledged recession as often happens when governments aim for soft landings. Japan, too, is undergoing renewed economic weakness following two decades of deflation and minimal growth. Europe is going through a short period of temporary calm after the EU and the IMF threw a lifeline to the struggling southern tier. However, the authorities have failed to deal with the underlying structural debt problems that will continue to be a major problem while the austerity measures that that are being implemented will be a major drag on the various economies.

For example the German magazine, Der Spiegel points out that the austerity measures applauded by the EU are already having dire effects on the Greek economy. The Greek government has reduced its budget deficit by an astounding 39.7% and spending by 10%. This has had a drastic effect on income, consumption, employment and bankruptcies, leading to a "mixture of fear, hopelessness and anger". According to the article another wave of layoffs is likely in the fall and this could have" extreme social consequences." Such an outcome could come as a severe shock to a U.S. market that has factored in a quieter Europe.

In sum we believe that the market is still discounting a continued U.S. recovery as well as a supportive global economy. In the current climate such hopes are likely to be disappointed and corporate earnings estimates for 2010 and 2011 will probably be revised down sharply. The market peaked in late April and is now trending down amid a lot of volatility.

That from Comstock Partners

Just in passing,

As we said, our forecast predicts increasing chances of financial crises emanating from the fragility of banks and their exposure to sovereign debt restructuring in Europe and the commercial real estate collapse in the United States. We have also said we are bouncing along the bottom and the bottom is sloped downward. The reason for the downward slope is the decay of the fiscal positions of state and local governments.

Our audio today is from Meredith Whitney, who called the financial sector's collapse to much outrage, only to be proven right. Here are some comments to CNBC recently, relating to both the banks and to the condition of state finances.


Meredith Whitney.

We end today with a note on one of the more notable failures in economic forecasting -- that of Lawrence Summers. Summers arrived in a caravan, preceded by trumpets, promising that a variant of Timely, Targeted and Temporary would return the economy to 8 percent unemployment. The complete failure of this prediction to prove out is probably the major cause of the lapse in confidence for the current administration. Summers returns to Harvard, but the president is left to explain the failure. Now the substantial investment in public goods by government which was the only way out is further than ever from actual public policy.

We are reminded of an observation by Max Planck:  "... scientific truth does not triumph by convincing its opponents and making them see the light, but rather because those opponents eventually die and a new generation comes up that can accept the truth."

Before we all die.


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  2. Hi Alan,

    I thought you might enjoy watching this video: RSA Animate - Crises of Capitalism


    You have a great podcast!