Transcript: 415 The Greenspan put expires with the economy out on a limb

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We were somewhat taken aback this week when Calculated Risk, one of the people we rely on most for data and analysis -- find him at CalculatedRisk.com -- opined that things were getting better. Our view at Demand Side, as you know, is and has been that things are bouncing along the bottom with significant downside risks for another crisis.

We'll look today at what CR sees, and then we'll offer a little pushback from an important piece from an another anonymous but very influential analyst. We'll also get to the economic models that worked, from a paper by Dirk J. Bezemer, Groningen University, and get some audio from the always pungent and perspicatious Steve Keen, whose accounting framework modeling is the cutting edge.

Sunday, November 28, 2010
The recent improvement in economic news
by CalculatedRisk


It is worth noting the recent improvement in economic news:

• The October employment report showed a gain of 151,000 nonfarm payroll jobs, the most since April ex-Census. Expectations are for a similar gain in November, although probably not enough jobs added to push down the unemployment rate.

• The BEA estimated real GDP grew at a 2.5% annual rate in Q3. This is still sluggish, but an improvement from the 1.7% growth rate in Q2.

• The Personal Income and Outlays report for October indicated incomes grew at a 0.5% rate (month-to-month), and it appears PCE has grown at about a 3% annualized rate over the last three months. The personal saving rate was 5.7% in October, and although I expect the rate to increase a little more - it appears a majority of the adjustment is behind us (a rising saving rate is a drag on personal consumption).

• The 4-week average of initial weekly unemployment claims has declined to 436,000 last week from over 480,000 at the end of August. The weekly reading was 407,000 last week; the lowest since July 2008.

• Most regional manufacturing surveys, with the exception of the NY Fed survey (empire state), has shown a pickup in manufacturing. This suggests the manufacturing sector is still improving (the ISM manufacturing index for November will be released on Wednesday).

• Trucking and rail traffic improved in October, although the Ceridian diesel fuel index was weak.

• The Architecture Billings Index (a leading indicator for commercial real estate) is near flat - suggesting investment in commercial structures such as hotels, offices and malls will stop contracting next year. (addition by subtraction!)

• Even small business optimism has improved slightly.

Most of the reasons for the recent slowdown are still with us - less stimulus spending, the end of the inventory adjustment, problems in Europe and a slowdown in China, and cutbacks at the state and local level - but it appears Residential investment (RI) has bottomed and will most likely add to GDP growth in 2011. I believe the RI drag is now behind us, and RI is usually the best leading indicator for the economy.

The data is still mixed and fits with my general view of a sluggish and choppy recovery (my view since the spring of 2009). Although I don't see a sharp increase in growth, I think the pace of recovery will probably pick up a little bit in 2011, and I'll take the over on the consensus view of 2.5% GDP growth in 2011. My guess is 3%+ GDP growth in 2011 - still not a strong recovery given the amount of slack in the economy, but an improvement over 2010.

Unfortunately there probably will not be enough growth to significantly reduce the unemployment rate in 2011.

Note: I'll add more before the end of the year, but I've been sharing my thoughts with a few analysts and economic commentators and I try to post my views whenever they change - even a little. Right now it looks like the "slowdown, but no double dip call" was correct (it is still early), and now I'm becoming a little more optimistic and taking the "over" on 2011 GDP growth (still no v-shape recovery though).

That from the mysterious Calculated Risk. Not so different from our bouncing along the bottom with downside risks, except CR seems very willing to extrapolate the bump in good news. We are not. And for some of the reasons why, we yield to another anonymous voice:

Ananomen Analyst is a wealth manager associated with a major Wall Street investment bank who uses a pseudonym to avoid any incorrect implication that his views might reflect those of his firm.

Writing under the head "The Greenspan Put Expires Worthless in the Eye of the Hurricane" courtesy of EconIntersect.com

The Fed Used to be Important: The Greenspan Put

For many years our writing has been focused on the Federal Reserve, since monetary policy easily has the largest influence on the economy and financial markets. Since World War II, every recession was preceded by a tightening of monetary policy and higher interest rates, and every recovery spurred by lower rates and an easing of monetary policy. Every cyclical bear market and bull market was also strongly influenced by changes in monetary policy. Since the stock market crash in 1987 and the 1998 collapse of Long Term Capital Management, investors have believed the Federal Reserve also possessed the capacity to manage every crisis. Since those two crises occurred when Alan Greenspan was Chairman and Maestro of the Federal Reserve, it became known as the ‘Greenspan Put’. This reference to the value of a put option during a market decline, increased investors bravado that they needn’t worry about a negative Macro event, since the Fed would simply exercise ‘Greenspan’s Put’ and restore order.

The current financial crisis has exposed numerous fissures in the U.S. economic foundation, which will be addressed later. More importantly, it has shown that the Federal Reserve no longer possesses the capacity to manipulate economic activity, as they did during the last 60 years. The balance of power has shifted from the Federal Reserve being proactive and exerting a strong controlling influence on the economy, to one of being reactive. The Fed can now only indirectly affect the numerous drags on economic growth, despite an unprecedented level of monetary accommodation. This change in the balance of power, from the Federal Reserve being proactive to reactive is significant, since it means ‘Greenspan’s Put’ has expired.

The majority of mutual fund managers, market strategists, economists, and investors have not yet realized that this shift in control and power has occurred. Their continued faith in ‘Greenspan’s Put’ may cost them dearly in the next few years, as the Federal Reserve struggles to keep the credit bubble from deflating.

The Eye of the Hurricane

The financial crisis that kicked off in August 2007 has never really ended. Much like a Category 5 hurricane, the global economy was battered by the outer wall as it came ashore in 2008 and early 2009. The eye was created, as every central bank adopted an extraordinary level of monetary accommodation. Governments around the world launched massive fiscal stimulus programs that resulted in historic budget deficits in almost all of the developed countries. In the United States, the eye of the hurricane allowed GDP to grow, but at a sub-par pace. Compared to the recession of 1973-1974, the first five quarters of GDP growth since the summer of 2009 have averaged 2.8, half as fast as the first five quarters after the 1973-1974 recession. The first five quarters after the deep 1981-1982 recession averaged GDP growth of 8.4%, three times the strength of this recovery.

There are a number of indications that suggest we will be moving out of the hurricane’s eye sometime in the next six months. Most of the Federal fiscal stimulus has been spent, without launching a self-sustaining recovery. Job growth has been exceptionally weak when compared to other post World War II recoveries. Without a healthy increase in disposable income, consumer spending will not elevate GDP growth above 3% on a sustainable basis. The only way that will occur is if solid job growth of 300,000 jobs per month kicks in, and that’s not likely anytime soon. Spending may marginally pick up during the holidays. Keeping a rein on spending gets old after a while and the holidays are a good reason to loosen up a bit. Unfortunately, millions of unemployed workers will see their unemployment benefits expire, unless Congress extends them, which we expect. However, that will only make cutting the Federal budget deficit more of a challenge.



State legislators do have to balance their budgets and they will be raising taxes and fees, and laying off more state workers. Housing prices are set to fall further, as more than 70% of homes in foreclosure have yet to hit the market.

In Europe, the eye of the hurricane resulted in a very uneven pick-up in economic growth. Although Germany has done well, actually recovering all of the ground lost during 2008, many other countries have not fared well. Ireland and Greece are still contracting, while unemployment in Spain is almost 20%. European banks are in worse shape than their U.S. counterparts. Although we expect the European Union to bail out Ireland’s banks, the credit crisis is likely to eventually engulf Spain. This will prove significant since Ireland and Greece combined represents just 5% of total E.U. GDP, while Spain represents 10%.

In response to the global slowdown in 2008, China initiated a $570 billion stimulus package, and ordered state run banks to lend aggressively. In 2009, Chinese banks increased lending by $1 trillion, an enormous amount given the size of China’s economy, $4.5 trillion. The combination of fiscal and monetary stimulus had the desired effect of boosting China’s economy, but has also resulted in a burst of inflation in 2010. In October, official consumer prices were up 4.4% from year ago levels. The real inflation rate in China could be at least twice as high. China has not revised its CPI since 1993, and the weighting of many food components are not realistic. According to official government data, food prices have risen just 19% over the last three years, but over that period, rice was up 38%, wheat up 35%, and beef and milk prices rose 44%. In contrast, two major supermarkets reported that rice prices had soared by 132% and 190% over the last three years.

In response, China’s central bank has raised its lending rate and bank reserve requirements. Rising inflation isn’t just limited to China, but to most of the Asian countries, which have been enjoying solid growth. South Korea had increased rates once, but Australia has boosted its bank cash-rate seven times from its 2009 low of 3.0% to 4.75%. India has hiked its repo rate six times to 6.25% from 4.75% in early 2010. Inflationary pressures are likely to intensify, since the output gap between capacity and production have disappeared in India, South Korea, China and Indonesia, according to the Royal Bank of Scotland. This makes it easier for companies to raise their prices. These are the countries with the strongest growth, but the gradual tightening of monetary policy will likely result in a slow down during 2011.

As the back wall of the hurricane approaches the global economy with its Category 5 winds, investors will realize that most of the problems that emerged in 2008 were not solved or fully addressed. The macro tides which lifted the global economy for decades have shifted. Investors will have to focus on preservation of capital in 2011, and batten down the hatches.

Components of the Macro Tides

The following is a list of individual headwinds. Each will weigh on growth in the U.S., keep GDP growth from reaching a self-sustaining level, and cause GDP growth to average under +2.0% in coming quarters. This list will provide a worksheet that will allow us to monitor which headwinds are deteriorating or improving. At some point in the future, the majority of these headwinds will begin to improve and help identify when another eye in this extended hurricane is approaching. Many are interconnected and there is some overlap. The most important common denominator is that solid economic growth will address most of these issues. Adopting policies that will strengthen economic growth is imperative. However, there are no easy choices since there are potential negative outcomes associated with every option. We’re in quite a fix. One, even Houdini would struggle with:

¦ The ratio of total debt to total GDP in the U.S.
¦Monetary policy impotence
¦Finding a short and long term solution for the federal budget deficit
¦Recapitalizing the US banking system, so lending broadly resumes
¦Weak job and disposable income growth
¦The change in middle class spending psychology toward less is more
¦Stabilizing housing despite the large overhang of foreclosed homes
¦Commercial property rents and values
¦Dealing with state budget deficits
¦The demographic shift of baby boomers into retirement
¦Social security
¦Addressing the income inequality gap between the top 1% and average worker’s pay
¦The lack of true leadership from either political party
¦The cost of health care rising faster than personal income
¦Medicare
¦The unintended fallout from financial regulatory reform
¦Deflation
¦Inflation
¦Protectionism
¦The European sovereign debt problems
¦Recapitalizing European banks
¦The global economic drag from closing fiscal budget deficits in developed countries
¦Keeping Israel and other middle eastern countries from starting another war
¦China and its currency and trade policies
¦China’s potential bank loan defaults from excess export capacity
¦The Basil increased requirements for international bank capital by 2020
¦The unanticipated

We can add our own:

Deteriorating infrastructure
Failing educational system
Climate change


Well, that was so much fun we didn't get to the important analysis on why the mainstream economists missed the biggest economic event in half a century. The Queen had the right question, "If this was so big, why did nobody see it coming?" We'll answer that question on our next podcast.

Transcript: 377 Some History and Some Minsky

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Ten years ago Alan Greenspan was in the middle of ratcheting up the interest rates to historic real highs. His tea leaves told him inflation was on the way. Instead of inflation, it was the dot.com crash. Within a year he was well on his way to ratcheting them down. The nominal federal funds rate had been fairly steady through the latter half of the 1990s at between five and a half and six percent. It dipped then rose at the behest of the Maestro to six and a half percent.

The inflation was in the oil price rise. The interest rate hike only exacerbated the demand shock. By 2001 the quarter point steps were heading to the basement. Below two percent by the end of the year. At one percent in 2003. Enter housing boom. By mid 2004 they were on their way back up, getting to five and a half percent shortly after the onset of 2006. Then the crash. Then they came back down.

1990s. Stable interest rates investors and entrepreneurs could count on. 2000s, bouncing interest rates that produced, well, nothing good. A chart of the nominal rates is in the transcript. Notice that the huge spikes in the 1970s and 1980s should be reduced by the rate of inflation. The historically highest real rates were in the Greenspan push of the early 2000s.

It is our view that rising oil prices and a slowing economy that corresponded to this cost Al Gore the election and put George W. Bush in office. That and the Florida vote. But that's another story.

The Demand Side view is historical. Historically speaking, we are in a period of muddling through, or trying to muddle through. Trying to get banks to do what we think they should. While the damage to the economy continues, and conservative estimates have it operating around six percent below capacity. Our estimate is closer to 20 percent. This is analogous to not watering the future and expecting that somehow the plants will grow up and give us a crop anyway.

We have recently reviewed Goldman Sachs from the perspective of Hyman Minsky. The real point was that the increased leverage and reduced regulation that led us into the current economic collapse was built in. In order to compete, as a result of apparent stability, and with bonus results for many years. In popular history, the idiots of the early aughts are the insightful prognosticators of today. The geniuses of Greenspan, Rubin, Summers and the arrayed big banks are now the criminally negligent.

In Demand Side history, the low interest rates and massive tax cuts, along with the huge deficits which began in the 2000's with Greenspan and Bush, DID NOT PRODUCE PROSPERITY OR STABILITY, BUT THE OPPOSITE. The decade of the aughts produced zero new jobs for 30 million new people. It continued the massive accumulation of debt until private debt reached levels above that of pre-crash 1929. We say this not to point the finger at George W. Bush or Alan Greenspan as culpable individuals, but to point out that these policies did not work and to some extent the individuals involved were place-holders, produced by the institutional interests abetted by a vapid academic economics and willing political functionaries.

The markets are behaving as if there is a recovery, but they are also behaving as if there is immense liquidity looking for a home and competing with desperate investors slash savers. We are in the midst of witnessing yet another example of the ineffectiveness of monetary policy.

But also the absence of a comprehensive coherent explanation of what went wrong and how to fix it. Maybe it makes emotional sense to attack and defend, but ... Well, in as few words as possible, and borrowing from Gary Dymski and Robert Pollin, an economy not positioned at full employment can be brought there through several possible channels.

Relying exclusively on the market mechanism, Market Fundamentalism suggest the existing unemployment will generate declines in wages which will lead firms to both lower prices and hire more workers. The increases in employment and lower prices will then promote increases in aggregate demand.

Seeing the sad inadequacy of this excuse for economics, interventionist approaches can take the form monetary interventions to lower interest rates, leading firms to borrow more for investment and beginning the upward recovery segment of the business cycle. Therefore we have zero interest rates and all manner of so-called quantitative easing. To no apparent effect on investment or demand

or intervention can take the form of fiscal stimulus, spurring aggregate demand directly. This is being tried right now, to some effect. This is, in fact, what we at Demand Side proposed a couple of years ago, believing that demand would then instigate investment. And it is what Christina Romer advocated in the speech we highlighted on last week's podcast.

But two years older and wiser and having dipped our toes in the analysis of Hyman Minsky, Demand Side today does not believe fiscal stimulus and deficit spending will lead to anything more than the current stagnation.

These schemes depend on the consensus analysis that at their base markets are efficient and stable. And absent from them is an appreciation of financial relations.

This is not lacking in the analysis of Hyman Minsky, what might be called post-Keynesian analysis, although I'm not sure that's what he would call it. The more we look into it, the more we are convinced that this line of reasoning and investigation is the direct lineage of John Maynard Keynes.

Minsky identified the financial structures as key to the surge and ebb of market capitalism. Hedge, speculative and Ponzi financing. The first is what we normally think of a company doing, borrowing in a form that will be paid back with the expected cash flow from the investment that is being financed. The second -- speculative financing -- is very common. Most companies have a web of financial structures for their operations, many of them short-term, with the expectation of rolling over the debt as it comes due. You can imagine the turmoil that might occur if interest rates spiked or roll-over financing suddenly dried up. The third -- Ponzi financing -- abandons pretense of using cash flows from the investment either directly or in steps, and stakes its hopes on appreciation of the asset value. Bubbles are made of this. The current meltdown is probably the world's largest known version.

"Identifying which category any firm falls into provides a measure of its individual financial fragility; classifying all firms in an economy according to these categories provides a means of assessing the level of economywide financial fragility at any point in time. Clearly, fragility is heightened when the proportion of speculativve and Ponzi units is high. Both speculative and Ponzi units have an inelastic demand for borrowed funds, and rely on the money market to maintain solvency. These units' economic viability is thus threatened by rising interest rates. ... The alternative path for such firms to raise funds is to draw down liquid reserves or sell other assets. But when assets are sold concurrently by many firms ... the price of the assets sold falls as well. In addition, speculative units selling their income-generating assets could transform themselves into Ponzi units.

In short, the higher the proportion of speculative and Ponzi financial units, the greater the fragility of the economy. Fragility in the Minskian sense has two components. First, the economy becomes less capable of absorbing shocks, so shocks are more likely to induce a financial crisis and incipient debt deflation. But in addition, the degree of borrowers' and lenders' risk also rises, and this should inhibit the growth of debt-financed invesment activity."

Now to be clear about two terms we let drop. Borrowers' risk arises to the extent that purchasers of capital assets must debt-finance their investment projects and hence increase their exposure to default risk, the chance a return on investment will be below tghe expected return. Lenders' risk arises from moral hazard and uncertainty. Minsky uses these to get at the price of assets.

And now to our own learning curve. Demand Side is based on hedge financing of investments that produce, at least on average, a net gain. It is from the prospect of profit, which is based on the strength of demand, that businesses invest. From this angle, it is the enormous leverage and overhanging debt produced by the unregulated boom that kills the economy by killing demand. In Minsky's finance-centric view, it is the financial crisis that kills the economy unless the government is willing and able to bail out the banks.

But it seems to us that profit, sound finance and growth all depend on productive investment, which itself is a producer of demand and jobs. And this investment does not exist only in the private sphere. In fact, we question whether the technological advancement so favored by private investors is really so productive. Smart phones replace regular cell phones and in one fell swoop Apple booms and the laggard technologies bust. Huge investment. But productive.

Shumpeter's creative destruction, in one view, can be the replacement of one adequate technology by another more adequate technology at the same time people are starving in Africa and struggling in Latin America. Technology needs not only new ideas, but a customer base.

The simplest example of productive investment is a tool which improves the productivity of labor. The cash flow from increased output pays off the financing of the tool. It is fairly simple to see infrastructure, education and health care in these terms, but what about the favored investments of the private sector? What about technological gadgets and housing?

Housing is not an asset which produces a positive cash flow. Its value is appropriately the rental value. In earlier times the purchase of a house was actually less than the comparable rent, reflecting the financial commitment of the homeowner. Subsequently it became much greater, entirely as a result of the anticipated capital gain. This financial asset aspect of housing is what spawned a nation of Ponzi investors.

At Demand Side we are fond of straying far ahead of the popular debate. And you will not find too many others, though they do exist, who advocate such broad public investment as we do. We have some roots, however. In John Maynard Keynes General Theory, 1936, page 378, you will find.

quote

"A somewhat comprehensive socialization of investment will provide the only means of securiing an approximation of full employment."

unquote

Elsewhere, we notice the NBER

Business Cycle Dating Committee statement:

The Business Cycle Dating Committee of the National Bureau of Economic Research met at the organization’s headquarters in Cambridge, Massachusetts, on April 8, 2010. The committee reviewed the most recent data for all indicators relevant to the determination of a possible date of the trough in economic activity marking the end of the recession that began in December 2007. The trough date would identify the end of contraction and the beginning of expansion. Although most indicators have turned up, the committee decided that the determination of the trough date on the basis of current data would be premature. Many indicators are quite preliminary at this time and will be revised in coming months. The committee acts only on the basis of actual indicators and does not rely on forecasts in making its determination of the dates of peaks and troughs in economic activity. The committee did review data relating to the date of the peak, previously determined to have occurred in December 2007, marking the onset of the recent recession. The committee reaffirmed that peak date.

NBER always waits some time before declaring a recession over.

It took the National Bureau of Economic Research (NBER) Business Cycle Dating Committee over a year and half after the 2001 recession ended to call the trough of the cycle. And it took 21 months after the 1990-1991 recession ended for NBER to date the end of the recession.

The previous NBER announcements make it clear that NBER will not date the trough of the recession until certain economic indicators - like real GDP - are above the pre-recession levels. Any downturn before economic activity reaches pre-recession levels will probably be considered a continuation of the recession that started in December 2007.

All of which recalls our suggestion that the question of whether the economy is in recovery has yet to be decided and will be decided by what happens in the future, not the past. Our second suggestion is that the business cycle is broken. Sitinig a trough absent a strong improvement in investment is meaningless.

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