Commentary

Today’s slide in stock prices around the world is not due to the downgrade of US bonds. It is due to the final realization, by hitherto myopic analysts, that we are on the brink of another recession, and that for all the talk of recovery over the last year or so, what growth we have experienced was fragile enough to wither when stimulus was withdrawn.

This was entirely predictable, and should surprise only those who pay no attention. Unfortunately that includes most of Wall Street and Washington.

There are two sources of this renewed crisis. European inability to resolve the roiling debt problems of its southern tier; and America’s inability to undertake economic policies aimed at growth. Both crises began as economic problems. Both are now wrapped in political ineptitude, weakness of leadership, lack of vision, and internal divisions that appear fatal.

It’s as if the western world has chosen to fail. We have certainly elected leaders way too small when measured against the task at hand. We need leaders to bend into the wind, not sway with it. This is an epic moment and we are blessed with bit part players better suited for walk on, not lead roles.

The drum beat of failure has been constant since our leadership failed to grasp the depth of the crisis. One of last week’s more miserable reports was the release of the re-calculated extent of the decline as the collapse gathered speed. We went way deeper than anyone thought at the time. The distress caused by the banking system’s historic incompetence, coupled with the sudden realization of the dependence of average households on debt rather than income as the drivers of rising living standards, produced an implosion whose aftershocks still rattle through the economy two years later. Indeed those aftershocks are reaching a level of intensity that they stand as crises in their own right.

The current obsession with the indebtedness of nations is a direct consequence of the collapse of the banking system’s “ponzi-style” financial model – a model that has emerged unchanged despite its obvious failure. Governments found themselves facing a choice between economic depression and crippling bail-outs coupled with wildly costly restorative fiscal policy. Since the depression route was simply not an option they chose the latter. Now the banks have the temerity to decry the gaping deficits that they, in essence, created. This is what makes the S&P downgrade of US bonds so appalling: they were implicated in the ludicrous financial illusion that contributed to the mess they now opine on. Their fingerprints are on the very debt they criticize. That no one is sufficiently outraged by the deep ethical duplicity the downgrade represents to enquire whether S&P should be investigated more thoroughly speaks volumes about the total lack of rigor in our financial world.

The more disturbing aspect of what S&P said – to me at least – is that I actually agree with them, the US is behaving like a banana republic, and so it should lose its pristine credit status. Remember that we have just had a conversation, in public, about whether we want to be bothered paying back our debt. As if it was a choice. Think about that: there is a significant part of our Congress quite willing not to pay off our debts. They are acting as if those debts are not part of our shared responsibility, or that they can somehow be defaulted on because the reason for the debts is ideologically outside the narrative these extremists want to tell. This extraordinary and willful negligence is deserving of whatever opprobrium Wall Street, iniquitous as it is, can muster.

To be honest, I am not sure which I disdain the most: Wall Street’s greedy duplicity and connivance in our demise; or those in Congress who see default as a badge of ideological courage. Neither group deserves respect. Yet we have just gone through a period whose features were shaped by those two groups, and these two groups alone. No one else stood tall.

Where were the sane folk supposed to keep the crazy people at bay?

Quivering in self-doubt, surrounded by feckless advisors, and apparently so bludgeoned by the bullies that they lost their voices.

This ridiculous interlude has exposed America as a weak nation. Weak leadership, weakly imagination, weak management, weak education, weak intellectually, and weak infrastructure. Daunted by the problems that have now punctured the illusion of Reagan’s endless dreamy myth of American exceptionalism and effortless superiority, voters realize that it is hard work generating wealth. Yet the response of our elite is to retreat to greater incantations to the gods of market magic; to sleights of hand; and to brazen ignorance of the real ailments afflicting us.

For some reason they have all decided that it is all too difficult. So the fiddling has begun.

Let me repeat: today’s decline in stock markets is a flight from risk due, not to the impudence of S&P, but to the total and abhorrent dereliction of duty of our elites. The world has awoken to the reality that we are mired in malaise and that we have no leadership strong enough or courageous enough to chart a course out. So the reaction is predictable: sell stocks because the outlook for profit is weaker the previously imagined; and buy US bonds because, S&P and Congress notwithstanding, they are much safer than anything equities.

This is the prediction. This is what is happening. Analytically it is straightforward, once we strip away the fantasy.

The penny dropped. The economy sucks. It just happens to have been a very large penny.

Some of you think I am being unduly pessimistic. So I am going to borrow from the Wall Street Journal – admittedly something I am loath to do under normal circumstances – and summarize the state of play as expressed in our latest statistics. Here goes:

1. GDP has just gone through six months of gloom. The economy grew less than 1% in the first half of 2011. In 2010 it grew about 3%. That’s called backsliding. The loss of wealth in 2011 will be around $350 billion as a result. Not chump change.
2. The latest revision shows that the decline in GDP during the recession was about 5% deeper than originally measured. That makes the decline the steepest since the Great Depression. WE all knew that, but it was worse than we thought.
3. Announcements of layoffs at large businesses have accelerated to a 16 month high. This is hardly the stuff of great growth.
4. Payrolls are expanding in general, but at about half the pace needed to reduce unemployment significantly. In many recent months the additions to jobs have been less than population growth, meaning we are going backwards, not forwards.
5. Manufacturing – as measured by the ISM index – has started to slow down sharply. It is now at a two year low.
6. So have services, also measured by the ISM index. This sector is at a 17 month low.
7. Consumer sentiment – as measured by the University of Michigan index – is at its lowest since March 2009.
8. Personal consumption is essentially flat – it was at a 9 month low in June.
9. Sales of existing homes slipped for the seventh straight month in June.
10. Home prices have fallen back again.
11. The trade deficit rose 15% in May despite lower oil prices.
12. Worldwide activity is declining – in some countries it is now back to 2009 levels.
13. Europe is mired in a fiscal crisis as large, if not larger, than ours.
14. And: the Chicago Fed’s broad gauge of indices – it includes 85 such measures – is now back to its October 2009 level.

And I am being pessimistic?

This is a sorry tale indeed. Were it not for the crisis we would all be worrying about the likelihood of an impending recession. Meanwhile our politicians have gone down the debt reduction rabbit hole and are risking making this horrible situation much, much, worse. To say this is bad policy is such an understatement it isn’t worth the effort. For those of you interested in possible outcomes I recommend taking a look at the history of the 1930’s, complete with the civil unrest that the economic failure of policy makers back then engendered. This week’s eruption of black shirted rioters in Greece, and the recent ability of the far right to take the US government hostage are not exactly the portents one looks for in happy times.

Sorry if that all sounds miserable, but that’s the dead end into which we have driven. It will take courage, imagination, new ideas, and plenty of hard work and time to escape. The first three of which we lack completely in our elite.

Hence my opinion: we are stuck.

Lest you think we are now into clear water, let me remind you that the economy stinks. That’s technical economics speak for rotten, as in really bad. Nothing in the great debt ceiling debacle changes anything. While we were all distracted by the farce that is American politics, the economy slid slowly towards the precipice. To put things in perspective: the shortfall between the current pace of growth and our historic trend means we will lose about $350 billion this year. That’s a lot of idle resources sitting about doing nothing. And, since no one is doing anything to fix this malaise, we can safely project that over the next ten years – the horizon of the debt ceiling deal – the accumulated shortfall in our wealth will be between $2 and $3 trillion, or just about the same as the spending cuts. In other words it is highly likely that we will be living through a highly constrained period of constant argument over how to deal with our deficit. Each successive wave of cuts will merely press us down a little more and make reaching escape velocity that much more difficult.

To put it bluntly: we are digging the hole deeper, not filling it in.

The net effect of this debt deal may turn out to be a fat zero. Revenues will be constrained by the weak economy, as well as the constant attack from the far right, while spending will not fall as people expect because our safety net expenses will remain elevated due to the failure to get growth going.

So all in all, it is quite possible that the entire sorry episode was a total waste of time.

Apparently our elite leadership has forgotten that there are two parts to the debt percentage equation and that the second, currently overlooked half, is languishing like a lead weight around all those good, and no-so-good, intentions we just argued breathlessly about. We call this second half growth.

Without restoring annual GDP growth to something like its normal trajectory all our efforts to rein in government debt will be for naught. This is especially true in the short term as the increase in the debt ceiling could well be exhausted by this time next year if growth doesn’t perk up soon. Since I see no such acceleration on the horizon, and since policy makers seem to have forgotten that they could do something to help us all, the odds are heavily stacked towards our having a repeat of the debacle right around election time 2012.

This is an extraordinary situation to find ourselves in, but it is a direct result of our inept economic policy making. No one wants to admit the true depth of the crisis because it implies massive restorative effort at a time when the far right has successfully hobbled the application of such an effort.

For those of you who like to think of economics as somehow scientific now is a good time to break out the popcorn and watch. We are running an experiment for you. The austerity programs now being brushed up for use will cut government down in size. According to the orthodox amongst us this will unleash market magic and more than offset the reduction in government spending. Far from falling, demand will thus increase according to this theory. Let’s see. And let’s also see how long it takes for orthodox theorists to point out all the caveats and loopholes that they will need to insulate their theory from failure. Because fail it will.

As for you Austrian School types, no doubt you are looking forward with glee to the imminent burst of entrepreneurial activity now that the dead hand of government has been lifted somewhat. Good luck with that too.

For those of us with a more realistic bent the outlook is grim. The loss of demand caused by the cuts in spending will not have much impact until 2013, but do any of us truly believe that the economy will be skipping along by then and so able to absorb that loss? As I have said, I certainly do not. And, nor apparently, does big business.

The enormous shift into deeper red ink in the public sector has been associated by an almost equal shift into ever blacker ink in the private sector. This shift has benefitted corporate profits more than anything else. It is, perhaps, one of the more perverse aspects of the crisis that profits have not just held up, but boomed. This even while households wilted. This surge in profits has come largely from productivity gains as business slashed costs and more than compensated for the drop in demand. The consequence is that business is now sitting on an unprecedented amount of cash awaiting deployment. That cash is idle currently thus adding to our continued shortfall in GDP growth. Rather than invest, business is sitting on the sidelines.

The orthodox explanation for this idleness on the part of business is that uncertainty with respect to future taxation is sapping confidence. The additional argument that government borrowing is “crowding out” private borrowing is plainly nonsense: with so much cash, demand for credit in the private sector is a bit thin right at the moment. Now that the dust is clearing about government plans for the next decade, orthodoxy predicts a surge in investment is about to take place.

I don’t think so.

Without a solid level of demand growth there is no compelling need to invest. Since we are not willing to deploy government funds to get demand growing, business is looking at flatlining sales projections. The constraint in government is supposed to stimulate investment despite the lack of sales. After all in classical theory investment begets demand not the other way around. In a period of flat demand the best way to keep profits rising is to cut costs and thus boost productivity. But that will depress demand even more. So it looks like we will be cutting our way towards oblivion.

This is called getting your knickers in a twist, which is not a comfortable feeling at the best of times, and at present is downright nasty. It is the consequence of bad policy. A bad policy that we are now committed too even more strongly.

One last point to mention: if, and when, business starts to invest the way orthodox theory predicts it will, profits will inevitably decline. This is the necessary offset to government deficit reduction – if public sector red ink diminishes, so must private sector black ink, trade being equal. This implies that current stock prices may be overstating future earnings. To keep price/earnings ratios constant that suggests a drop in price. So a rise in demand will be associated with a decline, temporarily, in stock prices.

Not that you need to worry too much about that. Demand isn’t going anywhere just yet.

The drift continues.

As we all sit and wait for the curtain to fall on this embarrassing farce I note a couple of things.

First, a number of commentators and analysts are stepping forward to sooth our nerves by describing this mess as not so outrageous after all. They ask us to remember the controversy and vitriol surrounding the civil rights debates, or even more recently the acid of the health care reform arguments. Fine. That doesn’t excuse a nation for acting this way. Nor does it ameliorate the dire consequences of failure. That the line of civility and reason has been stretched this thin is a telling indictment of where we are. It should never have reached this spot Never.

Second, we are now all supposed to hang breathlessly as the Reid plan is worked through the slow and cumbersome machinery of government. This will, we are told, emerge at the very last moment as the savior of our few remaining shreds of honor. But. And this is not only a big but, it is a monumental but: the Reid plan is a massive, epic, and totally unnecessary act of appeasement. It is a Republican plan. A right wing Republican plan to boot. This is not victory. It is not a Solomon like draw. It is not even an honorable defeat. It is abject capitulation to the hostage taking tactics of the extreme right that now, apparently, sets the entire tone and subject matter of discussion.

That a small group of extremists can seize power and dominate policy debate in the midst of a still weak, and getting weaker, economic setting is shocking. The vapid nature of our leadership – at the top of both parties – and the equally lame response to the overt hostage taking tactic of the extremists underlines just how deep our crisis of leadership is.

The Republican leaders had to re-write their own plan in order to squeak it through the House of Representatives. The wafer thin margin of victory is testimony to their inability to rein in their extreme right wing. And even with the re-write they couldn’t persuade twenty-twop of the most hardline extremists to vote with them. The Republicans have lost control of their own party. We have no loyal opposition at the moment. We have an attempted coup in spirit if not in name.

As for the Democrats? I cannot summon enough of my own venom to describe their failure. That an erstwhile Democratic president could present a plan such as the one Obama has periodically talked about is astonishing. Nowhere is there an effort to defend the role of government. Nowhere is there an effort to defend any of the traditional constituents of progressive politics. The retreat from left of center values is stark and almost total. The constant effort to triangulate, a tactic devoid of principle at the best of times, has been perverted. The triangulation is no longer with the attitudes or opinions of voters, it is with the hostage takers of the far right. Never have I seen a leadership so incapable of resisting a forceful opposition. Never have I been more disgusted with that leadership.

Appeasement never worked. It will not work. It cannot work. It must not work.

All this so-called sensible compromise, now working its way through Congress, does, is to set the limits for the next fight over the role of government. Having surrendered once we should expect a series of further surrenders. The far right smells blood. They will not be denied. The welfare state is in full retreat. Led by a Democratic president.

I would never, ever, have imagined that.