The Economy Is In Jeopardy Part II

This article is one of a series of occasional white papers from the Daily Capitalist taking a detailed look at specific issues affecting the economy. In this paper I analyze current economic events and give my forecast for the economy. It goes into detail about how I think the economy should be evaluated. This is Part II. Part I was published yesterday.

Part II

Tomorrow

Forecasting Flaws

No one can predict the future. There are too many variables. 

For example, which party will control the government? If the Republicans win, will they make the major changes to government needed for real economic stability and recovery? Regardless of who wins, will Fed policy really change? Will the European Monetary Union disintegrate? Will emerging economies turn away from free market reforms? Will oil production in the Middle East be disrupted by political turmoil? Will major economies endorse leftist-socialist policies?  Will the world break out with free market policies? Will the U.S. suffer another 9-11 attack? Will a volcano/earthquake/flood/tsunami/asteroid destroy a major country or the world? Will someone invent a cold fusion power source. Will …

Stop thinking.

At best we can make educated guesses based on Austrian economic theory and a study of contemporary events. And, at best, we can only make generalizations at that. Hayek tells us that generalizations are as good as it gets; there are just too many individual decisions being made every day in the “economy” to quantify it and that is why economists’ forecasts are mostly wrong. If they are right, they are probably just lucky. So far I’ve been lucky but at least I admit it.

Money

There are three factors driving the economy at this point and two of them are negative indicators. They are:

(i)      real economic production;

(ii)     exports (and imports);

(iii)    quantitative easing.

Each of these factors has something in common and that is money supply and the actions of the Fed.

Real Production

If allowed to function without government interference, “economies” will correct themselves from the consequences of bad investments made during a boom-bust business cycle. People, consumers and business owners alike, will take care of their own problems by reducing debt, selling off bad assets, saving more, spending less, and even going bankrupt. That is, they will do what it takes to try to maintain their lifestyle.

That is exactly what has been going on, more or less under the radar because it is difficult to see and measure. We cannot accurately calculate how much activity is related to this, but the levels of debt write-down, savings levels, and capital spending by manufacturers give us some indication.

The amount of real capital/wealth in the U.S. is prodigious, often underestimated, and it remains the foundation of our capitalistic economy. Real capital is the things we have produced based on organic economic growth, not growth produced as a result of monetary stimulation. During the boom phase huge amounts of what people thought was capital/wealth was created but it was mostly fake, a product of fiat money steroids created by the Fed (“malinvestment”). Eventually malinvestment is always cured by the market. The problem with these boom-bust cycles is that fake capital/malinvestments also cause the destruction of real capital. Since this current cycle has been the biggest boom-bust event in world history, untold amounts of real capital was destroyed and that is what is holding back a recovery.

I don’t wish to belabor points I have covered many times, but federal and state governments are doing all they can to prevent the liquidation of malinvestment; as pointed out above, consumer debt has not been significantly reduced, about 25% of all homes in America are underwater, personal savings are declining, and large amount of underperforming/ troubled commercial real estate loans still plague lenders. Until these things are corrected, recovery will be thwarted. The key to understanding this is that ultimately the markets will cure the problem and all government attempts to stop it are futile and have only served to delay recovery. 

On the plus side, businesses have trimmed operations, including labor, to the proverbial bone, and they are making substantial investments in productivity (capital equipment) and related technology (software). Thus profits in general appear good, but not all profits come from expanded sales, but rather from operating efficiencies. They are positioning themselves for growth or decline and they remain cautious about the future.

The actions by businesses to gain efficiencies is a positive force in the economy and has been one of the drivers of the economy, but it is difficult to measure.

Exports

When the Secretary of the Treasury or the Chairman of the Fed say that the official policy of the U.S. is a strong dollar, they mean the exact opposite. The U.S. has been following a mercantilist policy which sees “nat5ional” prosperity through exports. They like a cheap dollar and are doing their best to continue to devalue it. Devaluation is a function of two things: deficit spending by the federal government and the Fed’s willingness to de facto monetize federal debt. While exporters are favored, the other side of this is that savers and consumers suffer. Savers are consuming capital because of too low interest rates, and consumers have to pay more for imported goods. This policy is a definite negative for the longer-term well being of the economy.

As a result of this policy, exports have been expanding (see above chart). One way to measure the impact of export-based industries is to look at GDP (C+I+G+(X-Y) and subtract the “G”. (Consumer Spending + Gross Investment + Government Spending + {Exports – Imports} = GDP). After all, governments only spend, they don’t produce, and without C, I, and X and Y, they would have nothing to spend. 

The total economy as measured by GDP is about $15 trillion. If you deduct government spending (per NIPA tables), about $6 trillion federal and state, the private economy is about $9 trillion. Exports in nominal terms are about $2.117 trillion of that, or about 24% of the total private economy, a very substantial amount. From the bottom in 2009 when exports shrank to about $1.525 trillion to $2.117 trillion today, exports jumped 39% in a very short time.

The only problem is that an export boom based on dollar devaluation cannot last. There is a limit to a government’s ability to debase the money supply. One limit is inflation, perhaps runaway inflation, the other is a government’s ability to sell its debt. At some point they have to abandon their inflationary policies or the markets or the voters will.

As the world appears to be heading into recession, slow economies will curb imports and this will impact U.S. importers in a significant way. At 24% of the economy, the U.S. economy will suffer.

Quantitative Easing

Money supply (MS) has been expanding as a result of QE1 and QE2.

Here is a chart of what Austrians call True Money Supply (TMS) that was prepared by Michael Pollaro of The Contrarian Take. I added the vertical time bars and the QE information:

This chart is a bit difficult to read but from late 2008 to June, 2011 the Fed pumped almost $2.1 trillion into the system in response to the initial crash (QE1). As the economy started to fade again in 2010 it put in its second round, QE2. QE2.5 (Operation Twist) is the Fed’s attempt to keep long Treasury rates down and shifted its purchases of Treasurys from short-term to longer-term paper. The chart on the right, the red line, shows the history of the monetary infusions.

The left chart reveals that after QE1, MS (I use TMS2) grew until it peaked in December, 2009 (marked by the vertical red arrow). GDP responded and by Q2-2009 GDP starting rising until it peaked in Q2-2010. MS started shrinking again after December, 2009 as credit demand declined and loans were called or paid down, and banks parked money in excess reserves at the Fed. By the end of Q2-2010 GDP started to decline again after 12 months of growth. That prompted QE2 in November, 2010 and MS increased until August, 2011 where it may have peaked (see the second red arrow). GDP also followed, and as of Q3-2011 was increasing.

To summarize, every time the Fed injected money directly into the system via quantitative easing (“helicoptering”), GDP rose after a lag, and when MS started to decline after the injection of steroids ran its course, GDP declined after a lag. Very little real economic growth or capital formation occurred as a result of these Fed actions, otherwise they wouldn’t have needed QE2, and that is why the economy will decline again. I am not suggesting that QE solves anything, but the numbers the Fed looks at will be declining (economic output, employment, price levels) and that will motivate them to do QE3 which they believe will have positive effects on the economy. It is also something that many investors follow and are hoping for. The hope that money “printing” will solve anything is misplaced; it will only cause further harm to the economy.

Pollaro provides the numbers behind the chart that show what the source and type of “money” is expanding or contracting. Not all increases in MS are inflationary. This goes into Misean monetary theory which is too complicated to go into here (see Pollaro’s excellent description and definitions here). But, according to Pollaro’s data, here is what is happening:

1. Inflationary bank credit (loans) have been expanding only very modestly (+7.3% YoY) and may be declining. That is why the above discussion of bank lending (consumer and C&I loans) was important. Loan volume has not taken off, small to medium businesses are not massively borrowing, and that is reflected in this aspect of MS.

2.  Noninflationary time deposits have been growing (+12.6% YoY).¹

3. Demand deposits have increased substantially (+33.5% YoY)  Much of these funds are coming from investors fleeing the euro and are finding their way into excess reserves according to Pollaro and thus are potentially inflationary but haven’t found their way into the economy through expanding bank credit. Another source of demand deposits are from the liquidation of time deposits. This can be inflationary. I believe the source has been mainly consumers liquidating savings accounts (time deposits) in order to fund consumption.

 What does all this mean? MS (TMS2) is growing at 14.9% YoY. According to Pollaro, and I agree with his analysis,

 As readers of the Monetary Watch are aware, the run-up to the housing bubble turned credit implosion turned Great Recession saw a string of 36 months of double digit growth for a cumulative increase of 48%.  So, on the heels of two massive asset monetization programs – namely QE I and QE II – the Federal Reserve has been behind a monetary largesse that, in terms of time and size, is now 83% and 73%, respectively of that which brought on the Great Recession.  Supported by a QE II asset purchase program still alive and kicking through the end of June, we estimate that this, our current monetary inflation cycle, will show a cumulative monetary infusion of about 37% by the time QE II is over, 77% the size of the last inflation cycle.  Yes, not as large as the one that gave us the Great Recession, but one heck of a monetary inflation.

 Crossroads Always Are Difficult

 We are at a crossroad because with the world sliding into recession/depression, with the U.S. economy living off of exports, with a high level of unliquidated malinvestment, with a dearth of productive capital, and with money supply set to decrease, we are headed for economic decline which will impact the U.S. economy by Q2-2012 at the latest. It is likely that we will see another round of quantitative easing (QE3) before then as the numbers start to weaken and as unemployment starts to rise.

 Outcomes

In light of all of the above caveats about forecasts, here are what I believe may be a reasonable future scenario:

1. Recent indicators show that most major economies are slowing down, perhaps heading into recession.

2. The EU is in crisis and weak governments threaten to jeopardize the EMU and the euro. The remedies proposed by the eurozone require bankrupt states to cut spending and increase taxes. This will create economic disruption and economic decline in the countries being bailed out. Greece may withdraw from the EMU. Perhaps only Germany will avoid major problems.

3. If the EMU chooses to inflate (print money through sovereign debt monetization), the euro will continue to decline as the result of price inflation. But, it is likely that will only temporarily relieve the pressure on bankrupt countries and their creditors.

4. U.S. exporters will face declining sales as a result of economic slowdowns in their markets. Pressures on the euro may give the dollar a temporary boost.

5. The U.S. economy will decline and we will see this not later than Q2-2012.

6. U.S. unemployment will increase.

7. The Fed will engage in QE3 as a result of political pressure on them to act.

8. The Fed may charge interest on excess reserves to encourage banks to lend. This will have the opposite effect on banks as credit conditions will actually tighten as money is driven into Treasurys and similar investments. This policy will not create loan demand.

9. QE3 is likely to kick off another round of euphoria in the financial markets, but this time corporate earnings will not be found to support price levels. The euphoria will be short-lived.

10. U.S. savings will decline as consumers turn to savings to fund their living expenses.

11. U.S. banks will accelerate write-downs of CRE debt.

12. Housing will continue to decline in the most vulnerable markets and will remain stagnant in other markets.

13. Bank failures will continue at a steady pace.

14. Prices will start to rise, but the better measure of the declining value of the dollar will be reflected in the price of gold which will continue to rise.

15. At best, the economy will stagnate as monetary inflation continues to destroy real capital.

16. If there are successive rounds of QE, each round will be less effective as more real capital is destroyed, but it will result in price inflation.

 New And Old Dangers

As this never-ending business cycle drags on (we are in the fourth year of this recession), there are further dangers at this stage of the cycle. These issues involve political as well as economic considerations. It will require us all to do more critical thinking about the long term preservation of our wealth and the future of our society. 

1. As things get worse, the Fed will yield to the demands of politicians to do something, and since they have run out of arrows in their policy quiver, they will do what all central banks do best: print money by more QE. While they say they can stimulate bank lending by imposing an interest charge on reserves kept at the Fed, in a declining economy it will not be a dearth of money but a dearth of borrowers that is the problem.

It is conceivable that as things progress the Fed may expand their attempts to revive the economy by purchasing other assets such as municipal bonds, more GSE debt, or even stocks. Assuming that unemployment rises to levels that will panic politicians (say, 12%), we can expect the Fed to do far more monetary expansion than Chairman Bernanke hints at. I do not believe it matters which party wins the election and who is president (other than Ron Paul). In a panic, they will always “print” money.

This raises the specter of high price inflation and even hyperinflation. The question is: how far they will go with monetary stimulus? I have written about this many times. In my opinion hyperinflation is always a political decision, and we will see price and wage controls and currency and commodity controls before that occurs. But high price inflation will do immense damage to the economy and society by further destroying real capital. It is not deflation we must fear, it is inflation (a rise in MS). 

2. Fiscal stimulus will not be a viable policy tool in the near term whether or not the Republicans win the presidency. Assuming the Republicans at least control the House and/or the Senate, they will prevent further make-work projects and attempt to curb indebtedness. That is because they will campaign on a platform of fiscal integrity, a balanced budget, and reduced federal spending. However, I am cynical enough to believe that in an environment where unemployment grows to much higher levels, that even the Republicans will “do something” which will probably be futile massive spending on infrastructure as in Japan.

3. U.S. national debt is unacceptably high and with governments’ current share of economic activity at 45.6% of GDP, this will act as a further brake on the economy. This is known as the Rahn Curve principle, where after a certain point it discourages investment and growth by the private sector. I believe we are at that point or close to it. America is a dynamic, entrepreneurial society so this is difficult to gauge. 

The Rahn Curve aside, the weaker the economy becomes, and as debt remains high, the cost of funding our federal debt service may double as our credit rating is dinged. This will be a clear signal to the world of our second rate status as the U.S. is knocked off of its pedestal. 

4. The European crisis is not just a European crisis, it’s a worldwide crisis because a collapse of the European Monetary Union would cause financial chaos. Declining output in most EU countries will act as an accelerant of the problem because the bailouts are based on economic growth which would allow the bailed countries to meet certain fiscal targets. We may liken their banking crisis to the 2008 Crash that emanated from the U.S. and spread to the rest of the world. This is an unknown quantity at this time. Will the ECB print or not? Will the Germans keep banging their fiscal responsibility drum and oppose the ECB’s purchase of members’ sovereign debt? If they don’t print, then there is a good possibility that countries other than Greece will fail and the European banking system will be put in jeopardy. Printing is not a fix but it will put the problem off for a while.

5. Political dissatisfaction is high. This is not uncommon in times of economic stress. But there are fundamental changes in attitudes about the role of government in society. For one, people look at government at being dysfunctional, but not for the reasons you were hoping for. People now believe that government can solve their problems but that partisan bickering is preventing politicians from achieving a “solution.” That is quite different than saying government doesn’t work and it is the cause of our problems.

The Occupy Wall Street movement is an example of this attitude coming from leftists who wish to see government ascendant. The Tea Party may be a genuine anti-government movement, but there are too many populist elements about it that makes me cautious about seeing it as an ultimate solution. But one can hope.

I think we are at a potentially dangerous point politically. These times can lead to demagoguery, populism, and appeals for a strong government which would have further negative long-term impacts to the economy.

If you are looking for light at the end of the tunnel, then the only glimmer I can see is a Republican, Tea Party inspired takeover in the 2012 elections. A new Fed Chairman who understands what money is, a repeal of Obamacare, and a serious restructuring of federal regulations and taxation would give the economy a tremendous boost. Nothing will be solved overnight, but it is perhaps the only chance we have to avoid economic  mediocrity, fiscal bankruptcy, and monetary ruin.

I wish to thank DoctoRx for his time and valuable contributions to this white paper. His clear thinking made it a far better effort.

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1. Official price indices are in my opinion not accurate reflections of what prices are in the economy. There are other indices that may be more realistic and match consumers’ every day experiences. I like Shadowstats. But to compare apples to apples, the BLS statistics are sufficient to indicate trends that are a result of monetary inflation.

2. If a depositor invests in a two year CD, she gives up ownership of those funds and the bank can lend them without expanding MS. On the other hand if the bank lends the funds for five years (duration mismatch) then some of those funds are indeed inflationary in the Austrian sense. Since bank credit is low, these issues have not been a significant factor in MS.