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Tuesday, December 05, 2006

The Limits Of Economic Resolution

This week has further batches of economic news. MSNBC has a pretty good summary article. ISM Services is up for November. The wages and benefits annual growth rate for the summer was revised down from 3.8% to 2.3%, and worker productivity was estimated to gain only 0.2 percent. While slower growth in wages is something the Fed has seemed to like in recent history, the bottom line is that worker's inflation-adjusted incomes are falling, not rising. (The big chains all chased and some exceeded WalMart's electronics cuts. What the stores are clearly experiencing is an extremely price-sensitive public. The WalMart prescription cut was immediately matched by Target earlier this year. The stores catering to the bottom half of the income bracket seem to be pulling out the stops to draw traffic and expand their market base.)

Durable goods orders dropped 4.7%, which is a big decrease and will probably cause many economists to take a potential recession more seriously. More layoffs are in the pipeline, largely from autos, but the employment picture is not at all clear. There have been plenty of reports of retailers having trouble hiring holiday help. Probably lower-wage jobs are still increasing, but higher-wage jobs are becoming more scarce. UPS hires a lot of seasonal help, and those are pretty good-paying jobs.

I think activity in the stores always flags a recession at least six months before the Fed gets word through their statistics, and so I think that a recession is now locked-in. See Fed Vice Chair Donald Kohn's speech on December 1st:
What are the basic sorts of uncertainty faced by central banks? In informal terms, we are uncertain about where the economy has been, where it is now, and where it is going. ... As for where the economy is headed, central banks confront many sources of uncertainty but tonight I will focus on one in particular, namely, our inadequate understanding of the public’s expectations.
In other words, they know little about the real state of the economy, and later Kohn notes that even when they are relatively confident in their measurements, they don't know what forces are driving the economy. He then goes on to discuss the inadequacy of measuring public expectations and the various theories of whether public expectations are rationally founded:
...if people expect the central bank to follow a price-stabilizing strategy, and the central bank ratifies that belief, then any undesired movement in inflation will be quite short lived. And restoring price stability in such a world will likely involve little cost in terms of real activity.

At the other end of the spectrum are policymakers who suspect that most firms and households form their expectations using something closer to simple rules of thumb based on recent history. Under this alternative worldview, a string of adverse supply shocks is dangerous because it has the potential to cause rising inflation to become embedded in expectations.
At the end he mentions that there are extremely varying views within the Fed. I'd say that Kohn is an inflation bug, and that he thinks inflation is the monster to be controlled, but that an opposing minority view is gaining strength. He also mentions that there are two views about housing inflation; the first camp believes that rising incomes led to housing inflation, and the second is that it is a speculative bubble.

I have often seen the Fed and very brilliant economists be wrong, but I have found the supermarket index (my private name for observations from mass-market national retail chains) to be highly reliable. If you will read Kohn's speech, you can understand why. It's not that the Fed is malicious or stupid; it's that the thousands of individual pieces of data that represent sales in each store amount to millions of readings on consumer conditions and expectations each DAY, as opposed to the relatively small sample sizes gleaned from economic surveys.

According to the supermarket index, this will be a trickle-up recession, and it will be severe. What is triggering this recession is a loss of earning/keeping power, and it is compounded by high debt and high taxation. The skew in incomes is now literally becoming dangerous to the nation's economy. To understand how deep that skew is, you only need to read this excerpt from Kohn's speech;
Measures of labor compensation pose their own special problems. To begin, the available indicators often do not tell a consistent story. For example, the data in hand last week showed hourly compensation rising almost 7 percent over the past four quarters based on the national accounts measure, but only 3 percent as measured by the employment cost index. Beyond this, the compensation figures in the national accounts are subject to significant revision, as illustrated by the release of new data this week that suggests hourly compensation rose only 4-1/2 percent, not 7 percent, over the past year.
followed by this passage from the MSNBC article linked above:
The 2.3 percent increase in labor costs followed a 2.4 percent plunge in the second quarter and a 9 percent surge in the first quarter this year. The quarterly changes have been skewed by the payment of large bonuses at the beginning of the year.
Those bonuses go almost exclusively to the very top income brackets. It should be obvious that an economy which is estimated to be 2/3rds dependent on consumer spending is very dependent on most people doing well. When large groups of the population fall consistently behind over a period of years, it impacts both services and housing, which are huge components of the domestic economy.

Failing to correctly measure the impacts by aggregating income measures in this way is skewing the Fed's and Wall Street's perceptions. The Reagan revolution was a populist revolution; it concentrated on allowing free markets to work but also on improving the rewards for productivity at an individual level. That engine has almost ceased to function.

This skew in incomes means that the slowdown in construction will have a disproportionately large effect on consumer spending and basic consumer stability. Construction work is one of the few relatively high-paying employment sectors left, and a big dropoff in new home building will have a greater effect than it did historically, given the continued erosion in average incomes in this demographic group.

It should be obvious to almost everyone that paying a $100,000 bonus to 2 employees out of 100 doesn't have the same stimulative effect on the national service/retail sector as paying bonuses ranging from $500 to $10,000 to 50 employees out of 100. Worse yet, there are many relatively high-income individuals with staggering levels of DTI, and this trend has greatly accelerated because of the housing inflation and the resultant rise in debt levels. A great many people with very healthy earnings are going to be working off their debt for 5 to 10 years. All of this indicates that the service/retail sector in the US will face a very rough road in the coming years.

There's really no great way to get out of this trap, except to invest in manufacturing. All the ridiculous proposals to hand out closing costs, or the FHA insure no-money down loans aren't going to help the fundamentals at all. Government didn't create this debt bubble; individual irrationality exercised by tens of millions of people did. Government cannot correct the irrationalities in investment and in business administration that are causing this creeping rot.

Government could correct the extremes of our legal system, which are a bizarre and costly tax upon the productivity of the American population. Government could lift some of the barriers to new development of anything except houses. Government could adopt a realistic national energy policy that allowed for reasonable development of our domestic energy resources, because right now any extremist group can block erection of anything from a windfarm to a nuclear power plant using environmental litigation. Government could also correct the illegal alien/off-the-books employment situation quite easily, and this would give the average person a little more earning power. It's not that we need to stop immigration - that's a net benefit. Illegal immigration has created an easily exploited group of people with no bargaining power and little economic stability in this country, who cannot invest and who often cannot move up.

Our government has made terrible mistakes over the last few decades; it has erected barriers to productivity itself. Those barriers, believe it or not, have contributed to the succession of bubbles which is driving this economy. I am very afraid that the Dems will try to push this country into socialism as a way to cope with the irrationalities in our economy. If free-market conservatives and/or libertarians don't want that, they had better get serious about the situation FAST. It's very possible that the Dems could win the House, the Senate and the Presidency in 2008, unless those who have different beliefs about the prequisites for success explain their beliefs and make the case for a different way.

Free markets only function well if they are rational markets, and when productivity investments are controlled by the fringe zealots among us, those markets will develop increasing irrationalities.

MOM, if you haven't already seen it you might be interested in this blog from the National Association of Manufactureres. They also linked this interesting article from the UK.

See also my post Misvaluing Manufacturing.
Blimey! I had forgotten that a couple of decades ago 'economics' was my thing. I think I need to spring clean my brain and regenerate some old synapses [if they're still there].
David, those are extremely good links. Thank you. I had never run into the NAM blog. I had noticed the news that the House failed to get it together yesterday on the energy bill. They say they might try next week. I'm disgusted with this Congress.

MCEwen, I'm afraid economics are going to be next year's Oprah topic. So brush up and publicize!
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