A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Saturday, July 28, 2012

Transcript: Forecast Redux

Today on the podcast, I told you so Part 6, bouncing along the bottom with downside risks.

About this time last year, or maybe slightly earlier, we raised Part 5 above the parapets, and had to duck down again as the recovery archers pelted our position.
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Over the past 18 to 24 months we have dropped one element from the forecast -- the potential for downside crisis stemming from commercial real estate, its similar securitization problems and the exposure of the smaller and regional banks.  The crisis was resolved by traditional banking methods, actual write-downs and reworking of terms, but also because financial insecurity drew foreign capital to dollar-deonominated real assets and because people fleeing homeownership kept multi-family rents from collapsing. There was no crash in commercial real estate. Well, there was a crash, but it didn't bring down the smaller banks. Well, a couple thousand failed and the FDIC is still going from town to town, but the system of smaller banks did not fail. That is, well, they are not making loans and producing credit, .... Let's just say it's not like the crisis we suggested might come. And it is certainly not the crisis of the Eurozone which we also pointed to early last year.

In the euro area a radioactive seventeen-atom molecule is reaching critical mass.

This situation has been engineered by policy makers insisting on austerity, public and private. Early on we heard the explicit promise by economists and others that cutting budgets, pensions, social safety nets and wages to free up funding for bond payments would lead to increased investor activity and lower interest rates. Now we don't hear that so much. And of course, the austerity measures were not explicitly contingent on this rosy scenario playing out on the ground. So what we got was recession, the inability to make good on the draconian structural adjustment measures, rising debt to GDP, rising and now lethal interest rates, and no return of capital. The confidence fairy was a no-show.

This all cycles through the fundamental imbalances in Europe, the export surpluses of Germany and Finland, and the mirror of debt in the southern so-called periperhy. The next step for some is a mutualization of debt to bring down the interest rates that were not supposed to go up because the confidence fairy would come through.

The success of the chosen solution that was insisted upon by the ECB depends on debts being repaid that cannot be repaid and on imbalances evaporating that are entrenched.

We are still far short of this realization.

A series of comments by Mario Draghi of the ECB sent stocks soaring. Draghi is the man who insisted on austerity in exchange for ECB aid.

Tim Duy has a mainline view. Quoting

Tim Duy


It looks like Draghi finally found that panic button. This is crucial, as the ECB is the only institution that can bring sufficient firepower to the table in a timely fashion. His specific reference to the disruption in policy transmission appears to be a clear signal that the ECB will resume purchases of periphery debt, presumably that of Spain and possibly Italy. The ECB will - rightly, in my opinion - justify the purchases as easing financial conditions not monetizing deficit spending.

So far, so good. But there is enough in these statements to leave me very unsettled. First, the claim that the Euro is "irreversible" should send a shiver down everyone's backs. Sounds just a little too much like "the crisis is contained to subprime" and "Spain will not need a bailout." Second, the bluster that "believe me, it will be enough" is suspect. The ECB always thinks they have done enough, but so far this has not been the case. Moreover, he is setting some pretty high expectations, and had better be prepared to meet them with something more than half-hearted bond purchases.

Also, note that despite Draghi's bluster, the rally in Spanish debt send yields just barely below the 7% mark.
More distressing to me was Draghi's clearly defiant tone, reminiscent of comments earlier this week from German Finance Minister Wolfgang Schäuble. The message is that Europe has done all the right things, it is financial market participants that are doing the wrong things."
 In the real world the correction of the underlying imbalances will never take place while the export nations are calling the shots, as now, and the debts that cannot be repaid will not be repaid. The chosen path ends either in break-up or in the current perhaps worse path of long-term stagnation as the core,  including the ECB bribes the periphery to accept permanent recession.

What does austerity look like in the US?

The fiscal cliff.

The U.S. is attracting capital because it is the cleanest dirty shirt, some have said.  Why is the shirt even partly clean? Because growth continues and the banking system, as weak as it is, is not as weak as in Europe. Why is the shirt dirty? Because the government deficit continues at plus one trillion dollars. This is the standard line. Not Demand Side's view.

A big government deficit according to the standard line, means the government is subtracting from economic vitality. the end of this government profligacy is the fiscal cliff. Economists of all stripes predict a huge subtraction when sequestration kicks in and various tax cuts expire. Austerity.

To Demand Side, the U.S. is the cleanest dirty shirt also. Clean becauseit has not instituted austerity. Dirty because it remains exposed to unresolved unaddressed financial sector decadance and corruption, because its deficits are simply supports to consumers and pass-throughs to  corporations, and because it has no plan to put people to work.

In the current political drama, the two sides have marshaled their forces on the battlefield over tax cuts for the rich. A side show. The reenactment of a tired conflict, chosen only because the story  is familiar to the  onlookers, the audience of fevered partisans. The battle lines can be clearly drawn. The heroes' faces can be clearly exposed to their fans. Unfortunately both armies will be wiped out by the same bombs, as well as the onlookers and the media vendors in their midst.

No matter the devastation, the story is likely to survive and be replayed.

Why not employ people doing things that need to be done?  Infrastructure needs to be built, people need to be educated, whole generations of transportation and energy systems need to be built. Most of this could be financed off budget, in infrastructure bonds guaranteed by the government with revenues tied to taxes connected to that infrastructure. Similar bonds could be issued for other tangible utilities. Short term  bank financing for energy efficiency and retrofitting should be easy. Other probably tax-based or deficit-financed schemes for education are well within reason. Savers tired of zero returns under current Fed strictures would flock to offers of very low rates.

Footnote: The student loan bubble cannot be ignored. Trillions in student loans that cannot be repaid,especially by people entering a stagnant job market, could be converted to a simple 5 percent of income and collected through the IRS. We cannot destroy completely the prospects and incomes of our young people. At a minimum they will rebel and take it out on us.

So.  Forecast remains, bouncing along the bottom with downside risks. Coming off the bottom not now in prospect.

Check out the whole supporting material with Demand Side the Book at Demand Side Books dot com. Out at Amazon. Buy as many as you want at $8.95. Going up September 1 to $12.95. Kindle is operational, we were quite happy with the response to the review and comment edition. This is improved.

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