money supply

Perhaps it’s simply Spring, but there has been some mildly encouraging data over the past two or three weeks. So the discussion has turned towards the nature of the upcoming recovery. In particular will it be a sharp upturn? Or will it be a long slow slog?

Before we get to that let me first say that the economy remains deeply mired in this recession and that in my opinion all the so-called early signs of our having reached the bottom are just as likely to be false omens.

Having said that, the housing market has shown a little life lately, but much of that activity is in the form of sales of foreclosed homes. These still count as home sales in the aggregate data, but they are hardly an early sign of strength. Quite the contrary. Foreclosures tend to press down on other homes in the same areas, so as sales of foreclosed homes gather pace the effect is to lower home values. Besides, home prices have still not fallen back to a level where affordability gets back to its historic norms. For that to happen we need another 10% – 15% drop.

With unemployment hanging ominously across the nation, and home prices still falling it is hard to paint an aggressive recovery picture.

Nonetheless some analysts are now predicting a very sharp upturn later this year and early next. I don’t agree with this outlook. Or at least I fail to see anything to support such a prediction yet.

The main premise upon which the optimists rest their case is the historic data since World War II. Every steep recession since then has been followed by an equally steep recovery. Conversely, slow or shallow downturns have been followed by slow or shallow upturns. It is tempting to suggest that this trend will repeat itself now.

I don’t agree.

My reasoning is as follows: most post 1945 recessions have been characterized by very sharp increases in manufacturing unemployment, particularly in the auto industry. Plant closings and layoffs typically accompany the first signs of a drop in demand and contribute to the gathering recession by eliminating wage earning jobs and hence potential consumption. This rapid snowballing of job losses and consequent cuts in consumption produce a sharp “V” shaped recession because consumption postponed by fearful consumers gathers pace anew as soon as the fear of job losses abates. Which it does once industry has closed sufficient plants and people realize ‘the worst is over’. The reappearance of consumers creates demand that manufacturers cannot meet from their diminished operations so they start re-hiring. Quickly this creation of new jobs, which is really the reinstatement of the old jobs, further quells fears and increases consumer purchasing power from the new wages being earned.

So a typical post war recession ends as sharply as it began, leaving the economy back where it was and following its historic growth pattern of about 3% to 4% GDP increase a year – right in line with population growth plus productivity improvements.

This time the downturn is far more widespread across the economy – job losses are not concentrated in manufacturing – and the banking crisis goes on unabated. This last factor alone suggests to me that getting a recovery well established will be difficult. Past post 1945 recoveries have not been as hindered by bank failures as this one will be. Without sufficient credit to fund expansion of factories and other operations businesses will be much more cautious about re-hiring than normal.

As long as we have weak banks, who are either unable or unwilling to lend, we will suffer through a long period of slow GDP increase. There will be growth, but it may well be insufficient to offset population growth, so per capita GDP may fall.

If, as I expect, inflation picks up during the recovery then we could be set for a few years of sluggish growth accompanied by rising prices. This is far from the pleasant picture being painted by the optimists, most of whom are connected with Wall Street so it is their job to paint scenarios in which investing in stocks can be encouraged. By and large these are the same people who said there was no bubble, so I feel comfortable disagreeing with them!

Overall I think the bottom of this decline will be reached in early summer – after further home price declines and all the large lay-offs have taken place. After that we will start the slow climb back. I just cannot see a healthy economy re-emerging until late 2010 or even early 2011. There are too many impediments and too much debris to clear away.

And I am not too sure that we are going to be successful cleaning up the banks any time soon. That’s still the issue to follow most closely.

Addendum:

I mentioned above that I expected inflation to pick up. Here’s why: All that money being pumped into the economy by way of bailouts and stimulus will eventually fuel an increase in prices – inflation. Any time the government increases the money supply at a rate above the general growth rate of the economy it runs the risk of stoking inflation because the increased amount of money is not matched by an increased amount of stuff to spend it on. To bring the amount of money into line with the amount of goods the price per item of goods goes up. Hence inflation.

The only time this doesn’t happen is when the money supply is pumped up while the economy is operating well below its ‘potential’. Under those circumstances the increased money supply goes towards getting the economy back to capacity: it is absorbed by the creation of more goods and services, rather than by increasing the prices of existing goods and services.

To the extent the economy arrives back at its potential, or at least is growing again, any excess money created during the stimulus or through bailouts runs the risk of fueling inflation later on.

Under our current conditions all the extra money being forced into the economy is not likely to create inflation immediately – we are simply too far under potential growth – but is likely to show up as inflation in the medium term after growth has re-emerged.

Hence my prediction of an uptick in inflation sometime next year or early 2011.

By the way: as a government policy I would argue that stoking inflation would be ‘good thing’. It eliminates deflationary fears; it alleviates debt burdens – future debt repayments are in inflated currency; and it pumps up bank profits because it raises interest rates. While it may sound odd to advocate a good dose of inflation, I think it would be sensible public policy right now … as long as we can rein it back in in the future.