Tuesday, July 21, 2009

Economic Forecast: the Great Stagnation

By the norms of the post-World War II era, current economic data send conflicting messages. Corporate profits, especially in the banking sector, have exceeded expectations. The stock market has enjoyed renewed exuberance. The Fed predicts that the economy will stop contracting by the end of the year and start growing slowly.

However, unemployment levels keep rising. Unusually for a recession, labor productivity is also rising, which suggests that employers won't rehire as much when the economy turns around. New housing starts rose recently but remain at very low levels. Home prices keep falling and the inventory of houses for sale is still very large (with lots of foreclosed properties waiting in the wings to be placed on the market later). Banks are stable, and even thriving with the benefit of extraordinary government subsidies and support. Companies and industries not protected by the government are hurting. The economy is still shrinking, although probably at slower rate. Just about everyone predicts that unemployment will keep rising into 2010. Unless you work at a large, government subsidized Wall Street bank, your salary or wage, and bonus (if any), probably aren't growing. Many have had their compensation reduced.

The situation doesn't look like the downturn and then nicely executed upturn that characterize most post-World War II recessions. Instead, the economy is balkanizing. Some sectors are doing well, especially the big banks that the government protects at all cost and the oil companies, which benefit from mysterious levitations in petroleum prices. Other sectors struggle to stay minimally viable.

There is little chance of a brisk upturn. New lending by the big, government subsidized banks is about as commonly observed as Brontosaurus. Thus, neither consumer spending nor corporate investment is likely to be the locomotive to pull the economy upwards. The big banks continue to hold trillions of dollars of toxic assets. Those assets consist mostly of real estate loans (personal and commercial), along with some consumer loans and corporate debt, all mixed together in a complex mish-mash of CMOs, CLOs, CDOs, and CDOs squared. Newly capitalized courtesy of the taxpayers, the big banks have been able to sweep many potential losses on these assets under the rug of relaxed accounting standards that Congress forced on the accounting authorities. In other words, we're all supposed to pretend that those assets ain't pigs wearing lipstick. But as the real estate market continues to decline, the banks will have to record losses eventually. (That, indeed, is likely to be a strong reason why they don't lend; they're hoarding money against the eventual writeoffs.)

The continued tightness of credit (except in the banking system, where Uncle Ben provides as much credit as any big bank wants before breakfast, essentially free of charge) means that a crucial reason for the Great Depression--a contraction of the money supply--exists today. Credit, especially in the recent days of credit card and home loan ubiquity--is the money supply. Since 2008, credit has contracted for everyone outside the banking system. Importantly, small businesses have suffered sharp reductions in credit. Since they tend to do much of the early hiring in an economic revival, credit cutbacks limit their potential role as an economic locomotive. While the situation doesn't appear to be as dire as it was in, say, 1933, the shrinking of today's money supply via the credit contraction is likely to have the same type of effect it had in the 1930s--stagnation.

That's also what happened in the 1870s, when a financial panic in 1873, coupled with a law that ended the government's usage of silver for currency, produced an economic downturn and a reduction of the money supply that led to a five and a half-year period of stagnation. Credit contraction also contributed to Japan's Long Stagnation following its 1989-90 stock market and real estate market crashes (from which it still hasn't recovered).

Continued over-allocation of America's capital to the banking industry won't produce lasting benefits--Iceland's wild and ultimately destructive spree into banking bet the entire nation on finance, and now that entire nation is paying the price for believing that shuffling money around is the path to prosperity. Lasting wealth won't come from more mucking around with the creation of derivatives that consist of interests in other derivatives. Wall Street thought it could get rich by selling risk--that's essentially what the derivatives market did. But this eventually became little more than an unregulated casino, where the house wound up holding the bag because it didn't know how to manage its risks (and ultimately survived only by passing the bag onto the taxpayers). Finance doesn't produce true wealth. In its best form, it may facilitate the production of true wealth. But that's all.

Government stimulus programs will produce statistical improvements to GDP. But the mere distribution of government cash doesn't produce lasting benefits (see Japan, post-1989). Our best hope lies in producing things that have tangible value, which can be sold domestically and to people around the globe. We should look to the sectors of the economy that take advantage of America's strengths--innovation and creativity. High tech, biotech, green tech, entertainment and perhaps aviation could serve as the engines of America's future growth. These sectors would take a long time to revive the economy. There isn't much credit or other capital around for a quick jump start because so much of our national wealth is tied up saving big banks. Until then, expect the economy mostly to muddle along and the stock markets to bounce around in mini-bull and mini-bear markets.

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