Wednesday, July 15, 2009 - Everything as it should be…but that's not necessarily good news…
- Are we prepared to sit and wait for inflation?
- Is something underhanded and un-American about Goldman's business?
- Robert P. Murphy on Depression and New Deal fallacies…and more!
An Economy on Life Support
by Bill Bonner
Waterford, Ireland
Our faith is weakening. That is, our faith that the government will be able to
cause inflation, sooner or later.
Let's review our own narrative: deflation now, inflation later.
It's very simple. Maybe too simple. After a half a century of credit expansion,
we now have a credit contraction. In this sense, everything is happening as it
should.
There was a crash and credit crunch at the end of last year. Then, the feds
panicked. They fought back with monetary and fiscal stimulus. Rates were cut
to nearly zero. The Fed flooded the system with cash and easy credit – buying
up Wall Street's bad investments...propping up bad banks...and guaranteeing
trillions worth of bad debt. And the federal government passed a stimulus
program that authorized more than $700 billion in spending.
Beginning on March 9th, we also got a big bounce in the world's stock
markets – just as we should. US stocks are up about 40% since then. Some
foreign markets are up even more. Russian stocks, for example, have more
than doubled. Chinese stocks are up more than 60%.
As the bounce continued, people began to get the wrong idea. They thought
they saw 'green shoots' and the 'light at the end of the tunnel.' But if the
economy is really improving, we haven't seen much evidence of it here at The
Daily Reckoning headquarters. As near as we can tell, housing prices are still
going down and unemployment is still going up...and most important...people
are still acting as though we were on the downward slope of the credit cycle.
The latest numbers we've seen show that they saved more money in the first
half of the year than the total in extra 'stimulus' that they received. Savings –
last reported at 5% in this space – are now close to 7%. This is a just what
you'd expect. But it is a huge turnaround, too.
As to housing prices, there are a million option ARMs still to be reset over
the next four years. They won't peak out until 2011...with average increases
of about 80%. That will cause hundreds of thousands more houses to be
dumped onto the market...and probably push the bottom of the housing
decline to 2012. [You can read the full report on how to protect your assets
from this new market bottom by clicking here.]
As long as housing prices are falling, jobs are declining, and consumers are
inclined to save rather than spend, there will be no real recovery.
In our book, recovery is impossible anyway. Because the pre-crisis
economy had reached the terminal stages of the credit cycle. It was like
someone in the terminal stages of a fatal illness. After they have died, you
don't wish that they could recover...and be just like they were before they
died. They were sick and dying then! No, you sign the book of memories and
condolences and turn the page. You let new life take the place of the dead.
You move on.
But the feds have their ghoulish agenda. They have the poor thing on life-
support. One tube feeds the oxygen of easy credit. Another drips in more
'stimulus.' The economy rattles every time it breathes. Dead companies, such
as GM, say they are reborn. But take away the tubes...and they collapse.
Dead-in-the-water households learn to live submerged in debt ...with special
tubes provided by the feds – such as the underwater mortgage refinancing
offered by Fannie and Freddie, where homeowners can get up to 125% of the
value of their houses. And the brain dead economists at the Fed and the
Treasury department continue to offer their elixirs and panaceas – even
though they have never worked.
Everything is happening as it should, in other words. But what happens
next?
Ah...this is where it gets tough. Because we're losing our faith. We figured the
economy would continue to worsen (after all, you can't correct a half-century
credit expansion in a few months)...and that the feds would continue to fight
it. As more and more people lose their jobs, the feds would become more and
more desperate. Gradually, they'd come to see that they needed to use
stronger, more experimental techniques. This would lead them to be a bit
bolder with their 'quantitative easing,' otherwise known as "a little technology
called the printing press," to quote Ben Bernanke.
We figured that sooner or later, the feds would get the hang of causing
inflation. So, we could just buy gold and wait. [You can also take this route,
and there's a way you can get the yellow metal for only one penny per ounce.
See how here.]
But now we see; we are trapped...just like the feds themselves. Do we hedge
against further economic deterioration...deflation...and falling asset prices? Or
do we hedge against inflation...a falling dollar...and a collapsing bond market?
What if we hold our big position in gold...and feds NEVER are able to cause
inflation? What if the pain of the depression is never severe enough to make
them go whole hog on quantitative easing? What if the Chinese put it to them
straight: if M2 goes up more than 10% a year...we stop financing your
deficits? Gold could sink...or go nowhere...for the next 10 years.
Are we prepared to sit it out...? It's time to go back to the pub...
Now, more news from The 5 Min. Forecast:
"Could inflation be back already?" writes Ian Mathias in today's issue of The
5 Min. Forecast.
"Yesterday we told you about the latest PPI reading. If you recall, producer
inflation popped 1.8% in June, twice as much as Wall Street was expecting
and the biggest monthly gain since late 2007.
"Well today, it's the same story for you and us – lowly American consumers.
The CPI rose 0.7% in June, says the Labor Department, also higher than
expected.
"Factor in CPI and PPI data from the last few months and we're left to
wonder, were rumors of inflation's death greatly exaggerated?
"'This, to me, is important,' says Addison Wiggin, our executive publisher,
'because if inflation is already underway, how is Bernanke going to sop up the
excess money in the system, like he claims he's going to be able to do? This is
the question of our time.'
"Of course it's easy to spin this story in the other direction. On an annual
basis, consumer prices are down 1.4%, the biggest fall since January of 1950.
Music to Ben Bernanke's ears, we're sure. But since we're looking back to
1950, we'd be remiss not to share this historic chart. Betting against American
inflation has been a fool's errand for a long, long time:
Wanna make sure you get The 5 – in its entirety – sent to your inbox, every
Monday through Friday? You can…by becoming a subscriber to one of Agora
Financial's paid publications, such as Master FX Options Trader. Our newest
options trading research service has been on the hot streak of the year,
booking 122%, 76%, 100%, 136%, 124%, 84%, and 100% (again) in just
three months. And, only until tomorrow night at midnight, you can get over
6 months of picks – free of charge. Act now…
And back to Bill, with more thoughts:
This morning our thoughts turn to Goldman.
The news yesterday told us that Goldman execs paid themselves $700
million in bonuses – while receiving bailout money. This morning, stocks in
Asia are rising; they say it's because Goldman had a good quarter – wiping
out its loss from the last quarter of last year…
The news:
"Goldman Sachs reported second quarter earnings of $2.72 billion, up on last
year's $2.05 billion, and easily surpassing forecasts thanks to big gains in
trading and underwriting."
The New York Times offers more details:
"Analysts estimate that the bank will set aside enough money to pay a total of
$18 billion in compensation and benefits this year to its 28,000 employees, or
more than $600,000 an employee. Top producers stand to earn millions.
"Goldman Sachs is betting on the markets, but the markets are also betting on
Goldman: Its share price has soared 68 percent this year, closing at $141.87
on Friday. The stock is still well off its record high of $250.70, reached in
2007.
"In essence, Goldman has managed to do again what it has always done so
well: embrace risks that its rivals feared to take and, for the most part, manage
those risks better than its rivals dreamed possible.
"For all its success, Goldman is not impregnable. In addition to the federal
money it took last fall, it benefited from the government's bailout of the
American International Group, being paid 100 cents on the dollar for its $13
billion counterparty exposure to the insurer, and it has $28 billion in
outstanding debt issued cheaply with the backing of the Federal Deposit
Insurance Corporation."
Not everybody likes a winner. There are some who think there is
something underhanded and un-American about how Goldman does
business. Making billions trading bonds? It is almost as if they knew better
than anyone else what the feds would do next. Maybe they do.
The DR Australia's Dan Denning offers his two cents on the subject:
"We'd suggest that whatever Goldman did to goose earnings is probably
not going to be possible for the rest of corporate America." Furthermore,
Denning points out, most other American financial institutions are continuing
to play "hide the bad asset."
"A New York Times story suggests that government capital injections and loan
guarantees, along with new equity offerings, have allowed banks to evade the
inevitable consequences of the popped credit bubble.
"'The capital provided by the government through TARP, etc. has allowed the
banks to continue holding deteriorated assets at values far in excess of their
true market value,' says Daniel Alpert of Westwood Capital in a note to
clients, according to the Times. 'It is unrealistic to believe that home or
commercial real estate values are destined to recover any meaningful portion
of bubble-era pricing.'
"This means all the new equity raised by banks after the stress-tests has
merely papered over capital adequacy and solvency issues for now," Denning
continues. "The banks have simply refused to revalue loans on their books
and continue to carry them at unrealistically high valuations. If they sold
them, they'd get a lot less for them, forcing them to raise more capital (or
wiping out their capital and revealing them to be insolvent)…
"The default and foreclosure data coming out of the US housing market
suggest the banks are kidding themselves, or misleading shareholders, or
both!" says Denning. "It's the sort of calculated mistruth that can cause a
short-term crisis to last years and years. The correction is postponed through
phony accounting. It leads to an 'Ushinawareta Junene,' or 'lost decade,' as
the Japanese say."
Until tomorrow,
Bill Bonner
The Daily Reckoning
P.S. Dan Denning will be among those speaking at this year's Agora Financial
Investment Symposium in Vancouver, British Columbia. If you haven't yet,
there is still time to secure your ticket to what promises to be the investment
event of the year. Get your ticket here: Agora Financial Investment Symposium, July 21-24
P.P.S. For those of you who can't join us at this year's Symposium, all is not
lost. Colleague Greg Grilliot is going to be updating live from the symposium
using the DR Twitter feed. If you haven't already, you can sign up for a free
account and follow us here.
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The Daily Reckoning PRESENTS: The current credit crisis has been called
the "Next Great Depression" or "Great Depression, Part II." Of course,
economic experts and the Obama administration alike have been looking over
their shoulders at the 1930's for clues from Hoover on how to handle this
crisis, but as Robert Murphy points out in his new book, and the essay below,
the history they are looking at skewed to the nth degree. Read on…
The Politically Incorrect Guide to the Great
Depression and the New Deal
by Robert P. Murphy
Nashville, Tennessee
Since late 2007, more and more commentators have drawn parallels between
our current financial crisis and the Great Depression. Nobel laureates and
presidential advisors confidently proclaim that it was Herbert Hoover's
laissez-faire penny pinching that exacerbated the Depression, and that the
American economy was saved only when FDR boldly ran up enormous
deficits to fight the Nazis. But as I document in my new book, The Politically
Incorrect Guide to the Great Depression and the New Deal, this official
history is utterly false.
Let's first set the record straight on Herbert Hoover's fiscal policies. Contrary
to what you have heard and read over the last year, Hoover behaved as a
textbook Keynesian after the stock market crash. He immediately cut
income tax rates by one percentage point (applicable to the 1929 tax year) and
began ratcheting up federal spending, increasing it 42 percent from fiscal year
(FY) 1930 to FY 1932.
But to truly appreciate Hoover's Keynesian bona fides, we must realize that
this enormous jump in spending occurred amidst a collapse in tax receipts,
due both to the decline in economic activity as well as the price deflation of
the early 1930s. This combination led to unprecedented peacetime deficits
under the Hoover Administration—something FDR railed against during the
1932 campaign!
How big were Hoover's deficits? Well, his predecessor Calvin Coolidge had
run a budget surplus every single year of his own presidency, and he held the
federal budget roughly constant despite the roaring prosperity (and surging tax
receipts) of the 1920s. In contrast to Coolidge—who was a true small-
government president—Herbert Hoover managed to turn his initial $700
million surplus into a $2.6 billion deficit by 1932.
It's true, that doesn't sound like a big number today; Henry Paulson handed
out more to bankers by breakfast. But keep in mind that Hoover's $2.6 billion
deficit occurred because he spent $4.6 billion while only taking in $2 billion
in tax receipts. Thus, as a percentage of the overall budget, the 1932 deficit
was astounding—it would translate into a $3.3 trillion deficit in 2007 (instead
of the actual deficit of $162 billion that year). For another angle, I note that
Hoover's 1932 deficit was 4 percent of GDP, hardly the record of a
Neanderthal budget cutter.
The real reason unemployment soared throughout Hoover's term was not his
aversion to deficits, or his infatuation with the gold standard. No, the one
thing that set Hoover apart from all previous US presidents was his insistence
to big business that they not cut wage rates in response to the economic
collapse. Hoover held a faulty notion that workers' purchasing power was
the source of an economy's strength, and so it seemed to him that it would
set in motion a vicious cycle if businesses began laying off workers and
slashing paychecks because of slackening demand. | “…during the early 1930s, the Fed’s rate cuts ‘for some reason’ didn’t seem to do the trick. In fact, they sowed the seeds for the worst decade in US economic history.” | | The results speak for themselves. During the heartless "liquidationist" era
before Hoover, depressions (or "panics") were typically over within two
years. Yes, it was surely no fun for workers to see their paychecks shrink quite
rapidly, but it ensured a quick recovery and in any event the blow was
cushioned because prices in general would fall too.
So what was the fate of the worker during the allegedly compassionate
Hoover era, when "enlightened" business leaders maintained wage rates
amidst falling prices and profits? Well, Econ 101 tells us that higher prices
lead to a smaller amount purchased. Because workers' "real wages" (i.e.
nominal pay adjusted for price deflation) rose more quickly in the early 1930s
than they had even during the Roaring Twenties, businesses couldn't afford to
hire as many workers. That's why unemployment rates shot up to an
inconceivable 28 percent by March 1933.
"This is all very interesting," the skeptical reader might say, "but it's
undeniable that the huge spending of World War II pulled America out of the
Depression. So it's clear Herbert Hoover didn't spend enough money."
Ah, here we come to one of the greatest myths in economic history, the
alleged "fact" that US military spending fixed the economy. In my book I
relied very heavily on the pioneering revisionist work of Bob Higgs, who has
shown in several articles and books that the US economy was mired in
depression until 1946, when the federal government finally relaxed its grip on
the country's resources and workers.
Sure, unemployment rates dropped sharply after the US began drafting men
into the armed forces. Is that so surprising? By the same token, if Obama
wanted to reduce unemployment today, he could take two million laid-off
workers, equip them with arm floaties, and send them to fight pirates. Voila!
The unemployment rate would fall.
The official government measures of rising GDP during the war years is also
misleading. GDP figures include government spending, and so the massive
military outlays were lumped into the numbers, even though $1 million spent
on tanks is hardly the same indication of true economic output as $1 million
spent by households on cars.
On top of that distortion, Higgs reminds us that the government instituted
price controls during the war. Normally, if the Fed prints up a bunch of money
to allow the government to buy massive quantities of goods (such as
munitions and bombers, in this case), the CPI would go through the roof. Then
when the economic statisticians tabulated the nominal GDP figures, they
would adjust them downward because of the hike in the cost of living, so that
"inflation adjusted" (real) GDP would not look as impressive. But this
adjustment couldn't occur, because the government made it illegal for the CPI
to go through the roof. So those official measures showing "real GDP"
rising during World War II are as phony as the Soviet Union's
announcements of industrial achievements.
If the Keynesians rely on bad economic theory, and misleading history, to
justify their calls for huge government deficits, the Chicago School
monetarists are hardly better when they call for interest rates at zero percent
(or even negative!) and blame the Depression on the Fed's lack of willpower.
In doing research for the book, what I noticed is that from the time it opened
its doors in November, 1914, all the way through 1931, the New York Fed
charged its record-low rates at the very end of this period. The "discount rate"
was the interest rate the Fed banks would charge on collateralized loans made
to member banks. For the New York Fed, rates had bounced around since its
founding, but they were never higher than 7 percent and never lower than 3
percent, going into 1929.
This changed after the stock market crash. On November 1, just a few days
following Black Monday and Black Tuesday—when the market dropped
almost 13 percent and then almost 12 percent back-to-back—the New York
Fed began cutting its rate. It had been charging banks 6 percent going into the
Crash, and then a few days later it slashed by a full percentage point. Then,
over the next few years, the New York periodically cut rates down to a record-
low of 1_ percent by May 1931. It held the rate there until October 1931,
when it began hiking to stem a gold outflow caused by Great Britain's
abandonment of the gold standard the month before. (Worldwide investors
feared the US would follow suit, so they started dumping their dollars while
the American gold window was still open.)
So far my story doesn't sound unusual. "Everybody knows" that the Fed is
supposed to slash rates to ease liquidity crunches during a financial panic. It
helps to ease the crisis, and provides a softer landing than if the supply of
credit were fixed.
But guess what? Throughout the period we are considering, the highest the
New York Fed ever charged banks was 7 percent. And the only time it did
that was smack dab in the middle of the 1920-1921 depression.
Although you've probably never heard of it, this earlier depression was quite
severe, with unemployment averaging 11.7 percent in 1921. Fortunately it was
over fairly quickly; unemployment was down to 6.7 percent in 1922, and then
an incredibly low 2.4 percent by 1923.
After working on these issues for my book, it suddenly became obvious to me:
The high rates of the 1920-1921 depression had certainly been painful, but
they had cleaned the rot out of the structure of production very thoroughly.
The US money supply and prices had roughly doubled during World
War I, and the record-high discount rate starting in June 1920 was a pressure
washer on the malinvestments that had festered during the war boom.
Going into 1923, the capital structure in the United States was a lean, mean,
producing machine. In conjunction with Andrew Mellon's incredible tax cuts,
the Roaring '20s were arguably the most prosperous period in American
history. It wasn't merely that the average person got richer. No, his life
changed in the 1920s. Many families acquired electricity and cars for the first
time during this decade.
In contrast, during the early 1930s, the Fed's rate cuts "for some reason"
didn't seem to do the trick. In fact, they sowed the seeds for the worst
decade in US economic history.
It's actually easier to see what's going on if you forget about a central bank,
and just pretend that we were living in the good old days when banks would
compete with each other and there was no cartelizing overseer. Now in this
environment, when a panic hits and most people realize that they haven't been
saving enough—that they wish they were holding more liquid funds right this
moment than their earlier plans had provided them—what should the sellers of
liquid funds do?
The answer is obvious: They should raise their prices. The scarcity of liquid
funds really has increased after the bubble pops, and its price ought to reflect
that new information. People need to know how to change their behavior, after
all, and market prices mean something.
But in more modern times, thanks not just to Keynes but more important to
Milton Friedman, central bankers now think that during the sudden
liquidity crunch, they are supposed to shovel their product out the door.
But in order to do that, of course, they have to water down its potency. It's as
if a wine dealer suddenly has a rush of customers for a rare vintage of which
he only has 3 bottles, and his response is to put the vintage on sale but then
dilute it with 9 parts water to 1 part wine. That way he can sell to all the eager
customers and not pick their pocket at the same time.
Let's try a different example: If the owner of a trucking company experiences
a huge rush for his services, he might decide to postpone essential
maintenance on his fleet, to take advantage of the unprecedented demand. But
during this period he will be charging record shipping prices to make it worth
his while to deviate from the normal, "safe" way of running his business. He
will only be willing to bear the extra risk (either to the safety of his drivers or
just the long-term operation of the trucks) if he is being compensated for it.
The same is true for the banks. Just as every other business during a recession
wants to bolster its cash reserves, so too with the business that rents out cash
reserves. If there's a hurricane, the stores selling flashlights and generators
should raise the prices on those essential items, to make sure they are rationed
correctly. The same is true for liquidity, the moment after the community
realizes they are in desperate need of it.
Regards,
Robert P. Murphy
for The Daily Reckoning
P.S. Whenever a commentator on CNBC tells us about the "lessons of the
Great Depression," chances are he's dead wrong. Virtually everything we
have been taught about this period is based on historical myths and faulty
economics. For those interested, I set the record straight in my new book. Get
your copy here:
The Politically Incorrect Guide to the Great Depression and the New Deal
Editor's Note: Robert P. Murphy has a PhD in economics from NYU and in
addition to being the author of The Politically Incorrect Guide to the Great
Depression and the New Deal (Regnery 2009), he runs the blog Free Advice.
http://consultingbyrpm.com/blog/
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