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Tuesday, May 19, 2009

Oh, Could We Deal With Reality?

I would like to discuss some pretty important stuff that is a bit of heavy going. It relates to monetary policy, economic policies, social policies and the constraints upon all three. Neil, in particular, has asked a number of questions about US debt. Obviously Medicare and Social Security are in the news, as are energy taxes and universal health care. So this is topical, but it is not exactly beach reading.

As a prelude, I'd like to invite you all to drop in at Frontline and read this edition of the investor newsletter.

I think some important issues are discussed, there are some nice tables showing the effect of different debt and GDP growth scenarios, and I think the presentation is not deliberately obfuscated.

However, I would also like to invite anyone who reads this to go through until the graph with the three intersecting circles forming the US recession, and then stop and ask yourself "What is missing?" Because something very basic is missing, and it's something quite essential for future policy.

It's quite frustrating to read so many genuinely intelligent, hardworking and ultimately pretty successful analysts and yet find oneself wondering if they can collectively produce much useful guidance to government in the absence of a little more attention to detail.

I'll explain the glaring defect I see in this analysis later. I am extremely curious about whether readers of this blog also see it.

Update: Answer tomorrow (and so far I am impressed by the responses). But does anyone want to change his or her answer after contemplating these excerpts:
In our 2008 research programme, we focused on three issues. First, what exactly caused the worst credit crunch the nation has arguably experienced since the depression of the 1930s? Second, how did the downturn in the US morph into a collapse in Planet Earth's GDP rate from nearly 5% in June 2008 to -0.5% in winter 2009? Third, can traditional macroeconomic policy suffice to turn around the economy?
To explain the collapse of economic growth worldwide in an astonishingly short period, we utilized a game theory model that explained how the cessation of inter-bank lending amongst the principal money center banks of the world precipitated the first known case of global credit market emphysema: The availability of credit dried up almost everywhere in the course of six months, from Auckland to Iceland. We stressed that this credit contraction had little to do with "globalization" as properly understood, and had no counter-part in history.
Before extrapolating from the past to the future one must accurately examine the past.

Inflation/dollar debasement.
I'll take "Energy Constraints" for $600, Alex.

Although, to be fair, 2/3 of an energy policy circle might be overlapped by "Implosion of Global Trade" and "Implosion of Household Balance Sheets".
Uncertainty in government policy and application of law: Right now there is no clear indication that the US government is going to follow contract law or that basic property rights will be upheld by this current administration. Once cannot successfully plan for recovery or even continuation of one's company (or investing in same, think Chrysler secured bondholders) if it may be looted by the powers that be to satisfy some favored group.
Govt bal sheet ???
One word...........TAXES
I'd say energy costs, given that oil is already going up and Obama plans to tax it to the sky.

But, long term, for me the gorilla in the room has always been the nightmare scenario of having to service the national debt at interest rates such as we had in the late 70s and early 80s. All it takes os for the world to wake up to the fact that we are never going to pay this off in real money.
Government micromanagement of the economy, along the lines suggested by Mr Sensitive. Not just specific policies, but the general attitude of hostility toward the wealth-creating classes.

See Arnold Kling for some pretty scary thoughts about the future:

"The developed world enjoys an open-access order, in which both politics and economics are highly competitive. The rest of the world is in a natural state, in which only the members of the governing coalition are fully free to own property, participate in the political process and--most importantly--form durable organizations.

The United States is currently taking a giant step backward in the direction of a natural state. NWW would say that we are still an open-access order. However, the importance of the rule of law is declining, and the importance of political connections to the elite is increasing."
The glaring omission I notice in the article is any mention of monetary policy. The graph includes three "implosions": trade, banking and household balance sheets. But doesn't include the "explosion" in the money supply that led to the above and will inevitably lead to a repeat of the above if not reformed.
There is a complete lack of any discussion of commodity prices over the span 2004-2008, especially the extreme runups seen last year. There is some discussion of future energy problems buried farther down, but not as a cause of the economic collapse.

Discussion of demographic shifts is also buried in the text. I found it fascinating that the paper's authors anticipate that the boomers will have a de facto retirement age of 70+ because they simply won't be able to afford to retire any sooner. Query: where do these people find the jobs? It's notoriously hard for a worker near retirement age to find new work in their field as it stands, let alone after reaching retirement age.

Also, what if the boomers don't do as these policy wonks expect? Suppose they retire anyway? What's that going to do to the budget projections as the retiring boomers shift from being net fiscal contributors to net fiscal drains? It'll blow them out of the water.

I think that we're going to rediscover the "joys" of three generations in one house. The old folk are going to have to move in with their kids, or vice versa.
Government policy that encouraged high risk mortgage lending and allowed financial institutions to create risky MBSs that were erroneously rated AAA. A FED that kept interest rates low for too long, and then raised rates too quickly.

High energy prices were the blow that kicked the house of cards over.
With stagflationary in my name, I'm heavily inclined to say oil. However, since that is discussed later in the article I'm going to say jobs instead. It sounds too obvious and simple-minded to say jobs I know, but I think it is much more than that.

My history lesson goes back to non-farm payrolls. Why do we speak of them? We speak of them because it takes a lot FEWER workers to farm these days. That's what farming productivity miracles have given us.

My #1 concern going forward is that all these productivity miracles combined with billions of new workers competing for decent jobs is going to be a nightmare for all involved. Can you say college degree glut?

We gave our manfacturing jobs to China because we knew we could not compete on price. We thought we could somehow make it up by apparently specializing in tecnological and financial innovation. Oops! When half of it began to unravel as the dotcom bubble imploded, we put the full burden on financial innovation. Here we sit in its aftermath, as it imploded even more spectacularly.

What's next? I recently asked in the comments on my blog what exactly George Jetson did for a living? Why was he needed? Even his maid was automated. Something tells me that the workers of tomorrow are not going to be that fortunate. Companies of today have a knack for laying off workers who are no longer fully productive.

We also had a nice automation boom heading into the Great Deppression, did we not? You know who else loves automation and robots? The declining population of Japan, that's who.

Oil is not what turned me bearish starting in 2004. Trying to keep the never ending prosperity dream alive by borrowing ever increasing sums from China AND our unborn grandchildren is what turned me. Needless to say, our current borrowing binge feels like deja vu on steroids.

So what do I do? Greenspan once said that there is no safe store of value in a welfare state. I agree. I've been hoarding what I know I will someday personally use. I sit in I-Bonds and TIPS on the hopes that if the government someday defaults, I'll at least be dead and buried first.
I want to add another guess that's related to my previous one.

Income Inequality

Picture two people.

1. Both have moderate debt, moderate savings, and moderate income. Their "average" situation is okay.

2. One has high debt, low savings, and low income. The other has low debt, high savings, and high income. Their "average" situation appears okay (and perhaps identical), but it is a crisis waiting to happen.

I believe that income inequality was also a major "surprise" factor heading into the Great Depression. The "average" prosperity was looking very good.

I think of this every time I look at that averaged data in the Flow of Funds reports. I also think of it when I read the BLS average hourly earnings growth.

Had the Captain of the Titanic been looking at "average" sea conditions? In general, it was mostly water with just a hint of ice. Why worry?
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