Red Flags for the Economy
Warning Signs From the Bond Market
Bonds are signaling that the recovery is in trouble. The yield on the 10-year Treasury (2.97 percent) has fallen to levels not seen since the peak of the crisis while the yield on the two-year note has dropped to historic lows. This is a sign of extreme pessimism. Investors are scared and moving into liquid assets. Their confidence has begun to wane. Economist John Maynard Keynes examined the issue of confidence in his masterpiece "The General Theory of Employment, Interest and Money". He says:
Volatility, high unemployment, and a collapsing housing market are eroding investor confidence and adding to the gloominess. Economists who make their projections on the data alone, should revisit Keynes. Confidence matters. Businesses and households have started to hoard and the cycle of deleveraging is still in its early stages. Obama's fiscal stimulus will run out just months after the Fed has ended its bond purchasing program. That's bound to shrink the money supply and lead to tighter credit. Soon, wages will contract and the CPI will turn from disinflation to outright deflation. Aggregate demand will weaken as households and consumers are forced to increase personal savings. Here's how Paul Krugman sums it up:
More than 8 million jobs have been lost since the beginning of the crisis, but President Barack Obama has made no attempt to initiate government work programs or even a second stimulus. Government spending must increase to make up for the slack in demand and reduce unemployment. That means larger budget deficits until households have patched their balance sheets and can spend again at pre-crisis levels. Withdrawing stimulus now, while the economy is still weak, will crimp spending, collapse state tax revenues and send unemployment skyrocketing. Here's an excerpt from an article by James K. Galbraith which helps to explain what's needed to get back on track:
The economy cannot grow without private sector credit expansion. But the banks are constrained by toxic assets and the lack of creditworthy loan applicants. At the same time, deleveraging households and consumers are less inclined to borrow at any rate. Retirement age "boomers" have lost nearly $12 trillion in net wealth since the crisis began and must save for the years ahead. They are no longer in a position to spend freely figuring that their home equity will rise 10% or 15% per year creating a cushion for the future. Those days are over. Bond yields are telling us that retail investors have lost faith in the housing and equities markets and moved their savings into the most risk adverse, low-yielding, assets available - US Treasuries. Here's what Keynes said on the topic:
So hoarding reduces spending which leads to economic contraction. But behavior can be altered by changing incentives, raising incomes or restoring confidence. Keynes was less sanguine about increasing the money supply which he compared to "trying to get fat by buying a larger belt". The point is to increase consumption, which means that money has to get in the hands of the people who will spend it to grow the economy. Bank reserves alone won't do the trick. Fiscal stimulus is the way to go.
Presently - according to data collected by the Federal Reserve - companies are hoarding capital due to the lack of investment opportunities. High unemployment has led to falling demand which is stifling investment. As households cut back, more companies will opt to pay down debt rather than seek new investments. (which is what happened in Japan) This will cause a dropoff in economic activity and deepen the slump. The government must increase the deficits to offset cuts in state and private sector spending and to avoid another excruciating cycle of debt deflation.
The economy is at a tipping point. Unemployment has flattened out at 9.5%, but 650,000 discouraged workers have stopped looking for work altogether which will add to the slowdown. The cash-strapped states are laying off and furloughing workers in droves. The rate of underemployment has soared to 16.5%. There are 6 applicants for every new job created. Conservatives believe that the ongoing crisis creates a unique opportunity to crush the labor movement and to force down wages. Republican senators and congressmen have quashed a bill that would extend unemployment benefits to over a million workers. Apart from the appalling cruelty of the action, GOP obstructionism only adds to deflationary pressures. It is an entirely counterproductive move.
Nomura economist David Resler says that congress's action will have an immediate and damaging effect on the economy and could trim GDP by 0.2 percentage point this quarter and by 0.4 point in the period from July through September. (Bloomberg) Republicans are precipitating a crisis to garner support in the upcoming midterm elections, but they may not fully appreciate the knock-on effects of their vote. Here's a clip from economist Steven Keen who sheds a bit of light on the topic:
So, yes, in the short-term, falling wages may seem desirable for management, but in the long-term, it could trigger an industrywide collapse.
The FOMC's June statement was a real stunner. The economy is losing-ground in nearly every area. Household and business spending, bank lending and home sales are all either slowing down or falling sharply. The Commerce Dept. revised its first quarter estimate of GDP from 3.0% to 2.7% due to lower than expected consumer spending. The recovery is largely a mirage created by inventory adjustments and fiscal stimulus. 46 of the 50 states are mired in huge deficits that will require substantial cuts to balance. That will be a drag on activity going forward. This is from Bloomberg News:
State budget cutting will swell the unemployment lines and slow consumer spending. With fiscal stimulus quickly running out and the deficit hawks pushing for greater austerity, the Fed will be forced to intervene in the 4th quarter resuming its quantitative easing bond purchasing program to pump more liquidity into the financial system. The recovery is not self sustaining.
In Europe, the situation is even worse. ECB head Jean-Claude Trichet has been preaching austerity while conducting a massive stealth bank bailout, providing limitless funds in exchange for dodgy collateral, overnight deposits for wary banks that no longer trust the repo market, and bond purchases of sovereign debt that is vastly overpriced given the fiscal position of the issuers. Germany is calling for additional belt tightening across the eurozone to protect against fictitious inflation. German policymakers don't understand that their trade surpluses translate into deficits in the Club Med nations, or that their solutions will only exacerbate existing imbalances, increase the budget deficits, and put the EU on course for another contraction. Here's an excerpt from the Wall Street Journal:
After Lehman Bros. collapsed in September 2008, the world was pulled back from the brink of depression by an activist Federal Reserve that (arbitrarily) assumed the authority of congress and conducted a massive rescue operation that provided unlimited liquidity and government support for teetering financial institutions. And, while the Fed's uneven treatment of Wall Street has been widely criticized, (the banks have been allowed to carry on much as they had before) the precipitous slide into the abyss was halted. Now, congress seems eager to reverse that achievement for fleeting political gain.
It's important to understand the process so we can settle on a remedy. Economist Bradford DeLong explains what's going on with the economy in greater detail and why it would be a mistake to count on the so-called "self correcting" power of the market rather than government intervention. (additional fiscal stimulus) Here's an excerpt from DeLong's blog "Grasping Reality With Both Hands":
True, in some perverse sense, the market is "self correcting", but in this case, it would take years, if not decades, of high unemployment, overcapacity, dwindling investment and social unrest to put the ship aright. Are we ready for that? The preferable solution is to plug the regulatory holes that allow financial institutions to speculate in massively-leveraged instruments (that have implicit government guarantees), and promote income growth so the supply/demand balance that is essential to economic growth is restored. The way out of this mess is through more jobs and better pay. But that will take a mass mobilization of working people and whopping big deficits.
Mike Whitney lives in Washington state. He can be reached at [email protected]