Green Shoots?

By Jeff Harding

President Barack Obama said on Tuesday that aggressive efforts to boost the US economy were beginning to bear fruit, even though the recession would cause more pain this year. Also on Tuesday, Federal Reserve Chairman Ben Bernanke provided some hope that recession may be losing its momentum, when he said he is “fundamentally optimistic” about the economy’s longer term prospects and spoke of tentative signs of a slowdown in the decline in economic activity.

There is a lot of talk about the economy turning the corner. I saw this post on Michael Panzer’s Financial Armageddon blog:

These days, lots of people seem to be reading from the same script:

“CBI Says Worst of British Recession Over” (Reuters)

“China’s Premier Says Economy Better than Expected” (Associated Press)

“Dubai’s Ruler Says the Worst Is Over” (Financial Times)

“U.S. Officials Suggest Worst of Recession Is Over” (Reuters)

“Italy Employers See Signs Worst Over in Crisis” (Reuters)

“Worst Over? Just Maybe” (Associated Press)

“‘Worst Is Over; India to Be on Recovery Path in 2-3 Quarters’” (Business Line)

“US Hopes the Worst Is Over” (The National)

It’s true: politicians are seizing on the least bit of data that offers hope for a quick recovery. I have to admit that the Obama Administration can turn a phrase: we see the term “green shoots” being applied. It is as if the sun is coming out, trees are budding, and our beehive of economic activity stirs.

I don’t see it.

How can we really know what’s happening and what’s the best way to assess the data? One way is to know how these boom-bust cycles operate and see where we are in the cycle. Here’s a quick history of how our cycle unfolded:

1. The Fed flooded the economy with credit: from January 2001 to June 2004 the federal funds interest rate went from 6% to 1%.
2. This Fed tinkering disturbed the complex mechanism that interest rates normally represent in the economy and gave false signals to business borrowers about which goods to produce.
3. As a result, businesses made bad investments in the wrong goods: in this boom it was housing and commodities.
4. As the new cash (credit) made its way through the economy, consumers bid up the price of goods, especially housing.
5. There was no real economic reality to this boom; rising prices were really a result of inflation. It was classic bubblemania.
6. Eventually, the Fed stopped expanding credit and interest rates went up: from June 2004 to September 2007 the federal funds rate went from 1% to 5.25%.
7. What was once “profitable” became unprofitable as interest rates rose and housing prices and other assets started falling (deflation).
8. Businesses activity contracted, workers are laid off, and bankruptcies rise.
9. Assets are liquidated to pay off debt—further deflation.
10. Consumer spending drops off substantially as unemployment continues to rise, prices continue to fall, and people hold on to their cash.
11. Savings increase as a result of financial uncertainty.
12. Once debt is liquidated, assets, especially housing, will hit bottom. (Still happening.)
13. Savings increase, and, if the government doesn’t interfere with this process, recovery begins.

Right now we are in the 8 through 12 phase. Items 12 and 13 are essential to recovery but are still occurring. Contrary to popular views about economics, the deflation phase is absolutely necessary for recovery.

What is the glimmer of hope that President Obama sees? He said on April 13 that the tax cuts are giving 120 million workers bigger paychecks, clean energy companies are rehiring, and police departments are cancelling planned layoffs. Bernanke says that the rate of economic decline is slowing as seen by data on home sales, home builders, and auto sales. That’s not much.

Here’s the reality of the biggest credit bubble in history:

• Consumer prices fell 0.4% in February, the first time since 1955 (54 years).
• Retail sales decreased 1.1% from February to March (seasonally adjusted); sales are off 10.7% from March 2008 (retail and food services decreased 9.4%).
• The net worth of American households – the difference between assets and liabilities — was $51.5 trillion, down $11.2 trillion or nearly 18% from 2007.That sets Americans’ total wealth back to levels lower than 2004. It is the first decline in American household net worth since 2002.
• Mortgage credit fell to $10.5 trillion, the first decline since the Fed started keeping track in the 1950s.
• Americans’ homeowners’ equity as percentage of the value of their homes fell to 43% in 2008—lowest since before WWII.
• Industrial production fell 1.5% in March from a month earlier; down 13% since the recession began in December 2007, worse than every recession since World War II.
• National Federation of Independent Business Small Business Optimism Index for February was down 1.5 points to 82.6 (1986=100), the second lowest level in the 35-year history of the survey. This has significant implications for employment and loan demand.
• According to RGE (Nouriel Roubini) many US banks are insolvent: overall banking capital before the crisis was $1.4 trillion but there are expected losses of $1.8 trillion. Losses from loans and securities generated by US financial institutions are estimated to have been $3.6 trillion at its peak.
• Defaults on corporate bonds bought by U.S. life insurers may cost “substantially” more than losses on securities linked to subprime, Alt-A and commercial mortgages—further deflation.
• According to the most recent data from the U.S. Department of Education, default rates for federally guaranteed student loans are expected to reach 6.9% for fiscal year 2007, and are climbing dramatically.
• Credit cardholders had $962 billion in unpaid balances on general purpose and proprietary cards at the end of 2007, an 8.6 percent increase from the previous year. That figure is expected to climb to $1.2 trillion by the end of 2012, or $6,373 per cardholder.
• Two-thirds of the $154.5 billion of securitized commercial real estate mortgages coming due between now and 2012 won’t qualify for refinancing; Deutsche Bank, Goldman, and others estimate declines in commercial-property values of 35% to 45% from the peak in 2007. They believe the commercial real-estate slump will rival or even exceed the one in the early 1990s, when bad commercial-property debt played a big role in dragging the economy into a recession.
• Deflation continues worldwide: Japan, Germany, and China are all experiencing deflation.
• U.S. unemployment is now at 8.5%.

I’ll stop now.

But here are two bright notes:

• Housing inventory is at 9.7 months, still historically high, but below the 11 month peak, and appears to be declining. Almost half of the sales are from foreclosures and short sales. This is a good thing. Prices will decline further until we hit bottom, which is when inventory has declined to a normal 4 to 6 months supply.
• Saving are up: as a percentage of disposable personal income the savings rate was 4.2% in February and 4.4% in January; the last time the saving rate exceeded 4.0% two straight months was August and September 1998. Expect to see savings continue to climb and consumption decline.

Every business cycle has an end if deflation is allowed to run its course and inefficient firms are allowed to fail.

The experts seem to ignore the the 1920-1921 recession. In 1920 there was a market crash of almost 33% (in 1929 the market went down 17.2%), unemployment averaged 11.7% by 1921. By the end of 1921 the market was up 12.7%, in 1922 it was up 21.7%. The recession was over in 18 months. How was it cured? Presidents Harding and Coolidge did almost nothing. It corrected itself quickly.

Contrast that with the Great Depression—Hoover meddled with the economy from the start and Roosevelt just added to the problem with his radical programs. Little known fact: the Dow Jones average did not recover to pre-1929 levels until 1955. The Japanese experienced the same things: the same Keynesian “solutions” caused an almost 15-year (1990–2005) stagnation of the Japanese economy. They seem to be doing the same things again and their economy is falling off of a cliff.

Which brings us to the present.

We’ve talked at length about the Obama Administration’s Keynesian interference with the recovery process. My guess is that this recession will last a lot longer than the experts predict because of what the government is doing. Most economists now realize that maybe this time the cycle is different than before. Of course they weren’t saying this initially as was The Daily Capitalist. We pointed out that the size of the credit bubble was so big and so widespread that it dwarfed prior cycles and was looking a lot like the 1929 cycle or the Japanese experience.

The problem with any prediction for recovery is that what the government does or doesn’t do has everything to do with it. The Fed and Treasury are trying to stimulate consumption by inducing inflation. They are trying to stall debt liquidation by bailing out bankrupt companies. That will delay recovery: new capital won’t invest in business activity until people perceive that asset prices have stopped falling and new savings have replaced lost capital.

History shows that the “average” credit cycle lasts four years. We are in year two. It seems that this one could last even longer.