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Wednesday, November 25, 2009

Mechanics I

Yesterday's GDP update for Q3 was more in line with what I had, and it implies that Q4 should show continued growth, and perhaps more growth than Q3.

So why am I so relatively pessimistic about 2010? Well, the first reason is compounded of some of the signs from Asia, which is improving. But growth in China is sustained mostly on a huge stimulus and a huge asset boom, and that has a known ending. Nor will it continue for years - by the end of 2010 some of their banks are going to be in trouble, and China's regulators are aware of the risks. Even rumors that banks will have to raise capital produce a massive fall in Chinese assets - so they appear to be in a tight spot.

Japan's growth is reported as good, but in nominal terms, Japan's economy is still shrinking. Workers' incomes have fallen 2.6% in nominal terms over the last year, and disposable income has fallen 2.9%. Of course CPI is falling as well, but their incomes are still declining in real terms, and the problem should be obvious. Singapore is not much better - take a look at the latest stats from Singapore and tell me what YOU think. I am not hugely bullish on Asia; India and China have maintained GDP growth with a lot of money infusions, but Chinese CPI is down, which makes me think they have a circulation problem. India is the bright spot, but they are now suffering inflation, especially in food.

Incomes are dropping quite hard in almost all of Europe's ring of fire. Ireland and Spain are in unambiguous depressions, as are some of the Baltics. The larger ex Soviets have experienced hard recessions, but one of the main future worries are that incomes are often dropping and there are a lot of foreign currency loans. Things will slowly improve on manufacturing, but those loans are a big worry for consumers; industrial production is no where near its former levels, and government debt is becoming an even bigger worry. Hungary is hard-hit, but Czech auto exports are falling, causing more concern, although by any measure Czech prospects for 2010 are better. Poland is the stand-out for 2009; the Polish economy generates pretty healthy internal demand. For a broader read on Europe, see the Q3 flash. Unemployment stats here. I am still working through Europe, so I don't have a conclusion.

For the US I have done much more, and I am still not very optimistic due to the basic mechanical structure.

The problem is that our current downturn is most similar to the 79-82 period, during which the US went through two periods of declining GDP. Click on this graph and open it up in another tab or window.

Note the Fed Funds rate in the late 70s-early 80s graphed against the producer price index, the consumer price index and the unemployment rate.

Raising rates suppressed the underlying rate of producer price increases, which restored the ability of companies to make money. But it came at the cost of crushing credit (who can borrow at those rates?) and produced a very difficult recession with an extraordinarily high unemployment rate. However, once inflation had been crushed economic growth and credit growth could resume, and there was no protracted drag on the US economy.

This graph shows how we got out of the 80s recession by looking at household sector debt (mostly mortgages at that time), housing starts and total gross private domestic investment. Debt is shown as the percent change from a year ago (left axis), and housing starts and GPDI are shown in units (right axis).

Because interest rates had fallen so sharply from their peak, housing affordability increased suddenly and very significantly, which sparked a round of building, which created jobs..... Etc.

This graph is the same as the one above but it includes the Fed Funds rate.

But we will not have the same dynamic this recession, because we are maxed out on consumer debt (even with a staggeringly low Fed Funds rate). Now we have to depend on the business sector or government for growth in GPDI, and it is hard for either to generate the same type of domestic boom.

Worse yet, if the Fed stops buying mortgage securities, mortgage interest rates are due to rise significantly. Also there is no doubt that mortgage lending standards will have to tighten; the agencies (especially FHA) are experiencing horrendous defaults. Low rates plus high losses = debt no one but the government will buy. And then those housing credits are due to expire....

So basically the housing outlook over the next couple of years is worse than it has been over the last few months. Beyond that, we can only hope for consumer boosts from must-have buying, irrational exuberance, or lower debt loads. Incomes are not increasing for most workers as tax receipts show; the retirement bulge is hitting; and overall taxable wages are still declining. There will therefore be only a marginal consumer pickup.

Needless to say no one is making a lot of money off interest. And worse yet, cost inputs for production are still rising. True, we have reached the Schumpeter turn according to tax receipts - corporate profits are rising - but will that provide enough carrying wave of growth to overcome the real income drops among consumers?

What you see in the latest update to CFNAI is a signal showing that the carrying signal is just not there:

Compare the CFNAI signals from the 1980s downturn to our current downturn. The 1982 recession ended in November. (Recession dating, NBER)

These are the one month CFNAI indexes for the end of the 1982 recession:
Nov: -1.03
Dec. -0.77
Jan. +1.37
Feb. -0.66
Mar. +0.83

Coming to the present:
Now you will note that one month CFNAI has been headed down for a while, and the three month average has now followed.

Postulating that the current growth cycle started in June (many have it in July), here are the comparable months:
May: -2.42
June -1.81
July -0.37
Aug. -0.63
Sep. -1.01
And now October came in at -1.08. We just never climbed out of the hole.

The Fed can fiddle with the timing of the next leg down a bit, but it appears to be coming. Any theory (and it is the Fed's theory) that increased business profits will spark a slow steady growth cycle appears to be foundering on compressed business profit margins, meaning that many large companies are still cutting to try to bolster up profits. Because:

Incomes are not rising (right scale, indexed to 12/2007) and real retail sales (left) are going sideways, and producer prices are slowly rising (right). This is not a recipe for profits, especially since the value of commercial real estate is dropping.

The next impetus that could really help us are consumer debt defaults and writedowns. Once people clear enough debt, they'll have more income left for other things. However that takes years, and the collapse in incomes (aggregate matters less than median) means that the go-to number keeps sliding down a bit.

If people can't spend from rising incomes, and if they aren't able or willing to borrow, and if input costs are rising, the only place companies can look for sustained growth is to external sales. It is not necessarily true that investment related to external sales will be put into the US, which means that GPDI probably will fall next year. And that is the horror scenario.

PS: Happy Thanksgiving, and here is an updated pretty graph of CFNAI:

The harder the Dems make it to do business here, the less GPDI we'll get. What part of "quit kicking the economy when it's already down" do they not get?
John - one tends to wonder if some of them never ran into the fable about killing the goose who laid the golden eggs.

I think over in lala happy land they simply do not SEE the economic distress. After all, the DC area is doing just fine in comparison to everywhere else due to gov money.

Also, many of the congressional critters controlling Congress currently are the types who have driven CA's economy into the ground, and still do not see their error. I think they really believe that solar power is going to create jobs. They have no clue, and the ones whose past work shows that they do (such as C. Romer) appear to have fallen into the DC hole of lala land thinking.

Based on this administration's appointees, I strongly suspect that people were chosen for the ability to suspend disbelief.
Instapundit linked today to a item in The Enterprise Blog that had a graph of percent of cabinet-level appointees with private business experience by administration. Guess where the Obama administration ranks? Coincidence? I think not...
There's a chart circulating the blogosphere today that puts the administration's business lack-of-experience in graphic form (I first saw it at Tigerhawk; the original Forbes article is here.) It's a really bad thing when nearly the only people with a business background in an administration are the Goldman Sachs alums ...
Also, best wishes and a happy Thanksgiving to you and the Chief from the gray and drizzly left coast.
John - great minds think alike, eh :-)
Tim and John - I have been trying to avoid commenting on this, but the people who are running things are in many cases terrifyingly out of touch.

One need not have run a company; some experience in the industry or sector would be helpful. Five Tantas could do this administration a great service, if only the Tantas would gain a hearing. But I strongly suspect that the philosophical bent of the top individuals precludes any real input from individuals with real-world experience.

Instead we have theorists of the happy-slappy kind; I have been nearly comatose with worry ever since viewing a recent Elizabeth Warren interview.
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