deflation

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GDP: Crawl, But No Stop

Today’s much hyped release of the revised GDP figures for the second quarter delivered as promised: the economy is moving at a snails pace, but it hasn’t yet stopped.

The revision shows growth of a paltry 1.6%, which is down both from the original estimate of 2.4%, and the now final number for the first quarter of 3.7%. Our fears that the underlying economy is weak without the support of the stimulus have been completely vindicated. Likewise fears of a double dip recession have grown, but we are still not there. Just.

The numbers don’t need much analysis:

Consumption contributed +1.4%

Investment contributed +2.1%

Inventory Adjustments contributed +0.6%

Trade deducted -3.4%

Government Spending contributed 0.9%

These raw figures mask some interesting details.

Private investment, particularly in machinery and equipment surged by 19.5% during the quarter. Even residential investment picked up, admittedly from a very low base, and grew 27.2%. This latter number seems enormous but we should remember that residential investment has collapsed over the last few years, so this rate of increase cannot be sustained and merely reflects the extraordinary depths of the recession, rather than reflecting a renewed vigor.

Consumption had a decent, but not great, quarter. Durable goods expenditures were the key, growing 6.9%. This makes it two quarters in a row of solid gains for durable goods, which is usually a sign of gathering strength for the economy as a whole.

The big shocker in the quarter was the radical change in the trade figures. Exports grew 9.1%, but were swamped by a 32.4% surge in imports. This truly horrible performance was driven the increase in consumer demand for electronics and other ‘hard’ goods, as well as a recovery in the demand for autos. The size of the shift in imports was so large that I cannot see it being repeated, so we should expect the third quarter to show a much lower negative impact from trade.

The government spending numbers are also interesting for what they don’t show: the steady reduction of spending at the state level abated temporarily and actually reversed slightly. So the 9.1% increase in Federal expenditures were not offset by a local government contraction as has been the case recently.

So what?

The economy is obviously going through a very weak period. We should be extremely cautious in our expectations for the next few months. Growth of around this same level is what I think is a reasonable projection, absent any major shocks. More to the point: I think there is sufficient strength – only just – for us to avoid a further slowdown into recession. Final demand is healthy at around 4.1%, and as long as the trade figures for the second quarter are an aberration rather than a new norm, we should eke out growth over the rest of this year.

The problem is that growth at these meager levels doesn’t feel healthy and will not generate an improvement in the job outlook. As a rough rule of thumb we need around 2.5% GDP growth for unemployment to stop growing, and about 3.5% for it to start to drop. We are nowhere near those levels and so there is a distinct chance that unemployment could tick up as the year progresses.

It is that possibility that undermines everything else. Higher unemployment could tip consumption back down and ruin business prospects. That would bring a halt to the current increase in investment and thus throw us into contraction.

So the entire focus of policy makers should be on jobs. That means spending government money.

The chances of that remain poor as the GOP obstructs and the Administration dithers.

Instead of action on jobs we hear far too much discussion in policy making circles about the need for a tightening in monetary policy. One Federal Reserve bank president – Kocherlakota from Minneapolis – has attracted the scorn of some economists by arguing that we need to raise interest rates in order to fend off deflation. But low interest rates are not a cause of deflation, but they may be a symptom of an ongoing disinflationary process. It is true that long term rates are lower now, and that a possible reason for that is the reduction of the so-called inflation premium embedded in them. But the causality runs the other way around. We raise short term interest rates in order to alter the economy’s path by slowing the demand for credit, and to signal an outlook for acceptable inflation at all levels of GDOP activity. In a period of high inflation this has the effect of reducing expected inflation and, thus, long term rates decline. So lower long term interest rates reflect, rather than cause, reduced inflation. That Kocherlakota got his Ph.D. from Chicago, hotbed of monetarist economics, merely adds to the confusion and merriment.

Meanwhile millions of Americans continue to struggle needlessly because our elites – political, business, and academic – are too embroiled in re-hashing discussions first held during the 1930’s. Keynes was right then and is right now. That some classical economists don’t like that, or that some Republicans want to score short term election points, is not a reason to keep people unemployed.

We could do better than this.

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Bond Market Warning Signs

Given the continuing focus of those with the most influence on the need to placate the bond market I feel I am required – duty bound almost – to point out that the US government 2 year bond rate is now at 0.45%. That’s the lowest level on record. On record. Ever.

The 10 year bond also slid to 2.57%, and the 30 year is close to its all time low of 3.60%.

This is not a market telling us to cut deficits. This is not a market so slated with bonds that it is choking and requiring penalty levels of interest.

This is a market so scared that we are headed into recession that it is screaming for help.

The message from the market is: more stimulus please!

Anyone who doesn’t read this message correctly is just plain stupid. Or willfully and ideologically motivated to inflict harm and unnecessary pain on the economy.

Besides: think of this from a simple financing strategy: with money so cheap, why are we not borrowing as much as we can? At these cheap rates any stimulus thus financed would more than likely return a profit to the taxpayers. Using the Congressional Budget Office analysis from last May – it produced a very detailed analysis of the success of the original stimulus – I think we can safely assume that a a trillion dollar investment in targeted job creating programs, not the dross included in that last package, would produce about 2.5 million jobs, bolster tax revenues from the increased demand, and go a long way to kicking the economy into gear.

Now I realize that the Treasury has all sorts of funding issues to deal with, such as borrowing along the yield curve, meeting the demand for different maturity tranches, and maintaining liquidity in the bond market, but money this cheap is a rare opportunity.

Setting that all aside. The one thing we can all agree on – the scare mongers and myself – is that the credit markets are flashing warning signs. Where we disagree is what the warning is about. The scaremongers argue it is about imminent inflation and the crowding out of private investment. I think it’s about the risk of deflation and renewed recession.

These warning signs are real. We had better take notice.

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It’s The Demand, Stupid

Things are not looking very good. When we have luminaries such as Greenspan and Rubin agreeing that the economy is weak, but that it will get through this minor lull in good shape, we have to worry. Neither of them has much credibility any more, so I take their unanimity on the positive outlook as a bad sign: the economy must be getting weaker.

In any case the data seems to suggest we have hit a tough patch. How tough is all we are debating.

The problem is that I don’t think there’s any way to tell exactly where this slide will end up. It is easy to make the case that GDP could continue to drop back into negative territory. It is also easy to argue that we will pull put of the dive before we hit the ground. My own view is that the evidence suggests a rocky second half with very low growth, but growth nonetheless. This is small comfort to the unemployed: it would be no surprise at all were unemployment to creep up as the swoon continues.

It is remarkable how quickly the discussion has turned to towards trying to size up the decline. Only a few months ago those of us who warned of a tough road ahead were being called unduly pessimistic. After all profits were rebounding, manufacturing was on the up, productivity was rising, and even housing had a semblance of life. Only profits remain healthy. Everything else has hit the proverbial bump in the road.

If you recall my view of 2010 was conditioned by the oddity or imbalance of the spurt in activity that generated all that hope. There was a genuine rebound from the depths of 2007/2008, especially later last and early this year. My issue was with the froth over and above that base rebound. A big inventory cycle reversal and the benefits of the stimulus, neither of which were permanent features of the ongoing economy, made it very difficult to determine just how robust the recovery was.

We are now finding out.

Which brings us to the question of what policy should be going forward.

The main line of attack should be supportive. Of that there is no doubt. Now is far too early to start any tightening. In fact, while I have argued against tightening throughout the past few months, that position is even more important now.

The Fed acknowledged as much yesterday with its begrudging approach to the money supply. As I predicted, the Fed basically avoided making any move in either direction, it stayed pat. It accomplished this by announcing that it would reinvest the proceeds of any maturities in its portfolio back into more investments. This means that it is not reducing its level of support for the economy. Nor is it adding anything.

Meanwhile the war amongst various policy camps rages on.

There are those who argue we should reduce or simply get rid of the stimulus since it has not achieved a total reversal of the crisis. This is, of course, nonsense. I agree that the stimulus failed to turn the unemployment situation around. But that was entirely predictable. It was too small to begin with. What the stimulus achieved was a far more limited goal: it stopped us falling into depression. So far anyway. The notion that we should look to investment activity and business to lead the way is totally without credibility. Yet this is the alternative being pressed by those who opposed the stimulus. Their line of attack is that we should reduce regulation and other ‘encumbrances’ on business. We should reduce the uncertainty in the business environment. We should subsidize investment. We should throw tax breaks to businesses. And, most of all, we should get rid of any silly notions of government interference in the ‘natural’ workings of the economy. Once this is all done, the sun will rise again, the birds will sing and we will emerge into a re-run of the good old days. Oh and there will be plenty of jobs in this rediscovered capitalist nirvana.

This sort of reasoning is the time honored approach adopted by all right of center thinkers. It can be summed up as: ‘get government out of the way and we’ll be fine’.

The problem I have with this is that all the evidence contradicts it.

Profits are strong. Companies have cash to spend. Interest rates are very low, which means that borrowing is cheap, and that even marginal investments will make a profit. Project hurdle rates are minimal. The economy is awash with cash – if it isn’t why are people concerned about the inflationary impact of the money supply?

Yet despite all this, business is still retrenching or standing still. The investment environment is strong. Why aren’t we seeing a surge of construction, development or expansion?

It’s the demand stupid!

Demand is weak.

That reduces the prospect for sales and so offsets the low cost of capital. This weak sales outlook cripples business expectations. And as any Keynesian will tell you: the most volatile component of the economy is business investment based upon those expectations. Until demand picks up even ridiculously low interest rates and the total elimination of regulation will not be sufficient to spur investment.

Which also undermines the parallel argument we hear from the same analysts that all that government debt implied by the stimulus soaks up the available savings and so ‘crowds out’ private investors from the credit markets. This is specious for the same reasoning. We are suffering from excess savings not insufficient savings. There has been a remarkable collapse in business investment. So there is no demand for capital coming from that quarter. In any case profits have recovered, so businesses are generating capital from internal cash flows. They don’t need, necessarily, to borrow. That represents a problem for the capital markets: where does the cash all go, if not into private investment? Into government. All that is happening at the moment is that the government is borrowing instead of the private sector, and spending, instead of the private sector, because the private sector has no intention of doing so.

Were the government deficits crowding out the private sector we should be seeing interest rates rising in response to the capital squeeze. But they are falling, not rising. If the prospect of government debt inundating the market was as awful as the deficit hawks tell us it is, those fears would be translated into higher rates, not lower rates.

The point is simple: all the signs are that the credit market fears continued decline more than it fears the bloating of government debt. This makes perfect sense when we look at the cost of lost wealth from recession/depression versus the cost of debt accumulation. The cost of carrying debt is far less than the cost of all that lost wealth from our failure to reignite the economy. The tradeoff is simple and the credit market is voting with its feet for more stimulus and more debt. Despite all the bleak words flowing from the denizens of the market. Plus, once we get GDP rising at reasonable rates we can run deficits for long periods and still lighten the debt load. This is because of basic math: as long as the increase in GDP outpaces the increase in debt, the debt load and its cost as a percentage of GDP goes down.

The goal has to be getting GDP going at decent rates. Not managing the debt downwards.

To put this in perspective: the rate on inflation proofed government five year bonds fell below zero this week. Think about that. There are sufficient investors, with enough cash, who are so concerned about the economy’s prospects that they will pay the government to keep their cash safe rather than look for an opportunity to invest it at higher rates. That’s what a negative rate implies.In other words business expectations are so bleak that the government could borrow almost endlessly at almost zero cost and still not absorb all the money looking for a safe home.

There is a savings glut.

We are in a liquidity trap.

The only exit is through more expansive government activity.

There is only one target for policy:

It’s the demand stupid!

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The Fed And Deflation: Are We There Yet?

Who knows?

Most likely nothing but issue a statement designed to let us know that they are still vigilant.

The problem is that the Fed is now highly divided between the fiscal hawks, and the newly energized deflation worriers. Under normal circumstances the Fed airs its differences around the table and not in public, but as the economy stalls – and there is no doubt it has turned down – a much more open argument has broken out.

And the stakes are extraordinarily high.

In many ways we have had an oddly asymmetric recession and pseudo recovery. We are now suffering from an all time record number of long term unemployed. As a percentage of all unemployed, those out of work for 26 weeks or longer is now almost twice its previous post-war record. That’s an astonishing level, and one that explains the enormous cost of the unemployment relief programs throughout the crisis. Any attempt to understand the Federal budget deficit must include an acknowledgement that much of the swing deeper into the red has been directly a result of unemployment relief payments. Normally this far into a recovery those payments would be shrinking rapidly and thus reducing the deficit. This time any reduction is more due to workers falling off the unemployment rolls because they have exhausted their support rather than having found work.

This stubborn refusal of unemployment to drop has re-opened a lively debate about the nature of the labor market. There are those who argue that the problem remains lack of final demand – I am in that camp – and there are those who suggest that we are experiencing an unusual level of ‘structural’ inflexibility in the market. The structuralists argue that we have a very large number of workers whose skills are inappropriate for what jobs the economy is generating, and thus they are unemployable rather than simply unemployed. I have pointed out in the past that this structural argument should be supported in the data by sectoral lumpiness: there should be some industries with very high rates of unemployment and others with little unemployment. The lumpiness results from the oversupply in the declining industries and the undersupply in the newer or emerging industries. Obviously, so this argument goes, not all skills in the declining industries are transferrable, so some workers find themselves unsuited to the kinds of jobs that are available. And with abundant labor supplies there is no or very little incentive for firms to hire unsuitable workers and then train them. Hence the long term unemployment problem.

While the structural argument may have some truth to it, in my mind it fails to explain the enormous level of long term unemployment we now have. Besides the sectoral data doesn’t have the kind of lumpiness in it that I think should be there to validate the argument.

A far better explanation for our ills is that final demand is just too weak. Yes it has perked up somewhat, but we are still suffering from a lack of demand sufficient to get us moving again.

And it seems to be getting worse again.

Plus, as I have argued here before, there are worrying signs that we are slipping into a Japan style deflation. That can only make matters worse. Much worse.

It is in this context that the Fed is now riven through. Long gone is any semblance of unanimity with respect to policy. Behind the scenes the staff is now more worried about deflation than inflation, but at the top of the house there are still hard line deficit hawks peddling the bond market crunch and imminent inflation threat theories. Bernanke himself seems to be in the deflation fears camp, or at least he ought to be based upon his academic research, but he has to balance the two factions.

Policy freeze is a likely outcome, pending more data.

I suspect one thing is certain though: there will be no tightening any time soon.

The war inside the Fed mirrors the war being played out in economics generally. And that war is eerily reminiscent of the 1930’s, when almost exactly the same arguments were being made.

Lest you think that the 1930’s were simply a case of Keynes versus the rest, let me draw your attention to a paper written by Irving Fisher, a giant of early 1900’s economic theorizing, in 1933. Entitled “The Debt-Deflation Theory of Great Depressions” its policy analysis is strikingly relevant to today’s problems and is very Keynesian at the same time.

The most notable part of the Fisher paper is his suggestion that it is the combination of a debt driven collapse, as in the case of an asset price bubble driven by borrowing, along with a subsequent bout of deflation that inevitably causes depressions. Unless the government steps in to bolster demand. Looking at Fisher’s paper today I am struck by how prescient it seems. It also fits well with Minsky’s analysis of financial instability being the root cause of crises. There can be no more vicious threat to our wellbeing than the combination of a banking/debt crisis followed by a steady downward spiral into deflation: debtors can never catch up with their debts and are thus driven to keep on liquidating assets to pay off creditors. This drives asset prices even lower, which means that the next round of asset liquidation yields less. And so on. In Fisher’s phrase: “The more debtors pay, the more they owe”. Since deflation means that cash gains in value in real terms, and since steady liquidation of assets reduces the value of assets with respect to cash, debtors can never catch up. They are doomed to end up in default, which undermines the banks and causes further panic.

While we are not yet in the cold grip of such a deflationary cycle, its potential presence should be enough to cause the Fed to act to head off the problem.

Anyone who is arguing against an anti-deflationary policy is most likely doing so on the basis of an ideological stance rather than an economic theoretical stance. Such a division along ideology rather than economic theory are exactly what Michael Kalecki spoke about in his 1943 paper “Political Aspects of Full Employment”.

Kalecki and others argued that perpetual government deficits are an essential feature of any economy running at full employment, and that any argument to reduce of eliminate such deficits was more driven by ideological than economic factors. Kalecki, unlike Fisher, seems outdated in light of the subsequent history, but there remains a kernel of truth in his position: those who are arguing for deficit reduction are almost always on the right in politics and pro-business rather than pro-worker. Such people do not fear radical crises since it strips workers of bargaining power and opens up opportunities to reduce wages relative to profits.

Lest you all gasp at the implied ‘class’ struggle nature of that argument allow me to point out a simple fact:

Profits are strong. Even in this crisis, firms have been able to protect earnings and avoid widespread bankruptcies. Indeed, despite the headline counter examples like GM, this cycle has been very benign for most businesses. They have stripped down their workforces and maintained payouts to investors. Cost cutting has protected business from the extent of the damage suffered by households. And this is not new. As I have described before, the Bush administration saw the same phenomenon: jobs were hammered, but profits rose.

It is this dichotomy, where some parts of the economy are doing well even in the depths of crisis, while others are being crushed, that gives Kalecki a glimmer of relevance. There is a clear political bent to the economic argument. We have long passed the point where the policies that helped the economy had no political ramifications, and thus little political controversy.

It will be interesting to see how the Fed reacts. My bet is that nothing much will be done. Things will have to be worse before the political gridlock breaks in the face of greater crisis.

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Deflation Express?

“It is hard to see a light at the end of the tunnel for housing. Lower rates are not spurring activity because the light may be from a deflationary train.”

Thus ends an article on the Federal Reserve Board’s holdings of mortgage backed securities in today’s Financial Times.

I hate to keep harping on this topic, but I see far too many articles cluttering up good media space talking about inflation and the impact of the huge government debt now piling up.

Yes the debt is an issue to deal with in the future. No it is not a problem today.

People keep thinking of the debt in all the wrong ways. The best way to keep a perspective is to calculate the cost of carrying that debt, not just its aggregate size. It is the burden of interest payments on future budgets that matter more than the total amount of debt. That burden can be managed only if we have a healthy growing economy. In other words we need to get GDP rising from its current slowdown. And we need to avoid deflation at all costs. If GDP grows at anything like its historic rate the debt burden is automatically reduced both as a percentage of GDP, and as a percentage of the budget. It is basic math. But if we wander around trying to cut and slice the economy in order to reduce the deficit, the chances are that we will shrink the economy by reducing growth rates. So all that hard thrift and blood spilling will actually end up increasing the debt as a percentage of both the economy and the budget. Again: basic math. Thrift is self-defeating. Keynes taught us that in the Great Depression. Evidently much of our supposedly well educated analysts community never read Keynes.

And another canard to avoid: I read in some places that people calculate the debt burden and then argue that the interest payments are equal to a certain dollar amount per person. In one example I saw the figure $30,000. I am not going to dignify that calculation with a direct response, but I want to point out an even more obvious issue: those supposedly crippling debt interest payments go somewhere. Most likely into a US based pension fund or similar creditor account. It’s called double entry bookkeeping. Something the Venetians invented centuries ago. This means that the ‘crippling’ payment is someone else’s, presumably less than crippling, income. This is crucial to bear in mind. Too often we forget that the biggest investors in US bonds are US citizens. Notwithstanding the brouhaha over Chinese investments in the US the vast majority of US debt is held domestically. So one person’s crippling burden is another person’s safe retirement fund. Yes the cash is re-allocated from one set of folks to another, but basic accounting tells us that it has to go somewhere, and that somewhere is predominantly right here.

Now back to the FT article.

The big point is that for all the cash sloshing about the US economy, investment is still weak.

Why?

Classic Keynes: business expectations are very negative. This means that businesses are refusing to invest in new plant, equipment, or workers because they are afraid of the future. These negative expectations are driving – perhaps not driving is a better way of looking at it – the entire economy at present.

And, as the FT hints at, the prospect of deflation will make matters much, much, worse. Firms just won’t invest if the economy is about to fall into a deflationary spiral. On the contrary, because deflation acts to create a positive return on plain old cash – which increases in value as deflation drives prices lower through time – it makes sense to build up cash reserves rather than spend it on speculative stuff like factories etc.

The same goes for households. Cash becomes king in a much bigger way than usual. The loss normally created by holding cash rather than investing it is eliminated by deflation, and the incentive to grow is sucked out of the economy.

Under those circumstances those debt burdens come into focus very rapidly.

Forgive me for saying it, but we need a healthy dose of inflation along with that stimulus. Not exactly what the textbook tells us, but exactly what Keynes would advocate.

Why are we even arguing about this?

Oh yea … politics.

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