Double Dip?

It’s extraordinary how quickly we can go from over-estimating the recovery to near panic over fears of a double dip recession. This volatility of the markets should kill off once and for all the ludicrous notion that markets are somehow ‘efficient’ or ‘rational’. Those two concepts are pillars of text book economics which has now ben exposed as rubbish. Unfortunately it is rubbish held dear by most of the key players in banking, and so I doubt that we can expect any improvement in the tone or quality of their reactions to events any time soon.

But what of this double dip threat?

For those of you who read my comments here regularly, the fact that the recovery will be a long slow and very hard slog should be no surprise.

Let me repeat: recoveries following a financial crisis are always – always – difficult and slow. This is because a key mechanism fueling recovery, notably the banking system, is preoccupied with healing itself rather than in performing it role of being a credit supplier. Without this flow of credit a recovery is likely to stall at the slightest hiccup. And we have hiccups aplenty.

Last week’s report on employment was the most immediate source of panic in the markets. On the surface it looked good: well over 400,000 jobs produced in one month. That’s the number we generated in the entire Bush presidency! However the devil was in the details. Only 20,000 of those jobs came from the private sector. The rest were directly attributable to the government hiring of census workers.

This was not so good.

In fact it was very bad.

The result was a massive sell-off on Wall Street [which remains overvalued in my opinion anyway],and the sudden burst of dire predictions about a double dip recession.

My view is a little different.

I have always argued that the recovery would be very difficult, and that job generation would be extremely slow. By any measure this was an awful recession and the damage has been huge. We should not fall prey to the news media’s need to move onto to a new story: the economy is still very fragile and will remain that way for months if not years. Yes, years.

Having said that a mere 20,000 new jobs is very worrying. Clearly private business is in no mood to lead the way. I have to assume that businesses everywhere have difficulty planning for a surge in sales and have hunkered down to weather the presumed storm. This, of course, simply ensures the arrival of a storm since the process of hunkering down sets in play a self-fulfilling spiral downwards. At least the planners look good. Every one else suffers the consequence.

The fear that seems still to grip business is only partly justified. The recovery is well established, we have now had three quarters of growth, two of which have seen good growth. As with all recoveries the early stages have been unbalanced with some sectors getting going sooner than others, but the encouraging news from the recent GDP report was that all sectors are now showing signs of life. We seem set for continued growth.

But that growth will not be as strong as the prevailing wisdom suggested. The Fed has fallen prey to the hoopla and has raised its forecast for GDP to above 3.0% for the year. I don’t agree. But if you are an optimist and have moved your forecast upward, that jobs report must come as a nasty shock. Hence the sudden backpedaling.

Just what are the chances of a double dip?

Oddly I think the primary cause of renewed recession would be more a failure of policy than a feature of the economy itself.

Given my premise that the recovery will be slow, and will only eke out growth rather than boom ahead, any tampering with the stimulus or with interest rates will, in my view, cause a downturn. The economy is simply too weak for us to take any pressure off stimulus. The jobs report supports that view. This week’s retail sales report – due Friday – is being heralded as confirmation of a renewed weakening. Rumors are that consumers cut back last month from the relatively lively pace of the month before.

But.

This does not mean we are doomed to fall into recession.

If you hold my view, it was inevitable that the economy would drop away from its fourth quarter 2009 and first quarter 2010 pace. Both those periods were heavily distorted by the effects of the stimulus. Anything more than a cursory review of the numbers would have shown that the underlying rate of growth – with the training wheels kicked off – was much slower. All that is going on at the moment is that we are regressing to that underlying rate, which is much lower than the 3.0% to 3.5% that had become the norm being kicked around in the media.

Within a weak growth scenario such as mine any efforts to cut back on the Federal deficit or to raise interest rates to head off inflation would be a massive mistake and would produce a more pronounced slow down, and, maybe, even a renewed recession. Without any changes in policy, however, I think we can look forward to weak, possibly very weak, growth, but growth nonetheless.

What of those calls for budget cuts and higher rates?

They are foolish and premature.

The will always be people advocating a tighter federal budget or higher rates. These ‘hawks’ are usually politically rather than economically motivated. Right now there is no evidence of an impending surge in inflation. So raising rates is not necessary. On the contrary, inflation has all but disappeared, and the bigger risk is of deflation rather than of inflation. Nor are international money markets clamoring for a tightening of policy. US Treasury interest rates are lower now than they have been for a while. Were the markets calling for budget cuts or anti-inflation moves rates would have started to climb. They have not. The so-called market sentiment is a figment of the imagination of people who are predisposed to such policies. There is no pressure at the moment for change.

But there are risks, and they are increasing.

The credit markets are jittery due to the backwash from the Euro mess. It is an over simplification to extrapolate from the Greek debacle to the US – or the UK for that matter. The circumstances are very different and so the policy options are also very different. Bank risk measures are moving back towards post-Lehman spreads largely because of the potential losses that the Greeks could impose on European banks. Plus there is a growing swell of commercial construction credit losses here in the US. That puts the banks back at the center of things over the next few months.

But we have fixed that problem … no?

No.

The so-called bank reform making its turgid way through Congress at the moment includes a few nifty things like better controls over derivatives and better consumer product regulation, but it fails – totally – to deal with the root causes of the bank implosion of 2007/2008. The banks remain too big and too complex. They remain impossible to regulate. They remain too powerful. Too interconnected. Too prone to swings in asset values. Too able to game the system. And way too concentrated. This last point being the most important. Our banking system has become more risky, not less risky. The share of total assets held by the big six is now much larger than it was before the crisis. They are more, not less vulnerable. And, since they are all much larger, we have become more enmeshed in ‘too-big-to-fail’, rather than less. The fact that the reform includes procedures to wind up a massive behemoth like Citibank doesn’t mean that the regulators will have the courage to call for such an action. More likely is another bail out. In Citi’s case bail outs are a frequent event. This last one was not the first and will not be the last.

So.

If we add the chance that policy makers will go off the deep end and tighten prematurely, which is unfortunately looking probable, to the edginess in the credit markets, and to the continued fragility of our banking system, it is easy to get downcast.

The common theme to all those problems is that they are entirely contrived. They are not outcomes of the economy. They are outcomes of weak leadership, poor analysis, or irrational fear mongering. In other words they are within our ability to avoid.

The fact that we botched bank reform doesn’t bode well for the others.

If we get a double dip recession it will be our own fault.

In this crisis we have, as someone once said, ‘fear itself’, but we also have weakness and incompetence. That’s a toxic brew.

But if we manage to dodge those self-inflicted wounds we will muddle through without a double dip recession. And that’s good news.