A recent poll shows that most economists now believe that the recession, which began in December 2007, will end in the third quarter of 2009. There’s been an uptick in manufacturing and consumer confidence, and the decline in housing prices appears to be flattening out. Unfortunately, the return to positive GDP will likely be short-lived. The current surge in production is mainly the result of President Obama’s fiscal stimulus and the rebuilding of inventories that were slashed after Lehman Bros defaulted in September, 2008. These factors should boost GDP for two or perhaps three quarters before the economy lapses back into recession.
The most serious problems facing the economy have not yet been addressed or resolved. Consumer spending and bank lending are still contracting, and the banks are buried beneath $1.5 trillion in toxic assets and non-performing loans. Also, the wholesale credit system, (securitization) which provided up to 40 per cent of the credit flowing into the economy, is barely operating. No one really knows whether the system is salvageable or not. On a fundamental level, the financial system is broken and neither the Fed’s zero percent interest rates nor Obama’s gigantic fiscal stimulus has reversed the prevailing downward trend. Capital has stopped moving; the velocity of money has slowed to a crawl. It’s true, things are getting worse slower, but the signs of "recovery" are as faint and irregular as a dying man’s breath.
The financial media has played a key role in restoring consumer confidence. Negative reports are air-brushed or shuffled to the back pages while modest improvements in housing, corporate earnings or "clunker" sales are splashed boldly across the headlines. Naturally, most of the media’s attention has focused on the 6-month rally in the stock market. The S&P 500 has lunged ahead 52 percent from its March 9 low. But equities are merely reacting to the ocean of liquidity the Fed has poured into the financial system through its quantitative easing (QE) and liquidity swaps. Market analyst Andy Xie explains how it all works in his article "New Bubble Threatens a V-shaped Rebound":
"Central banks around the world, although they haven’t done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets….
"A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn’t take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble’s burst.
“What we are seeing now in the global economy is a pure liquidity bubble. It’s been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
“What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus." Andy Xie, "New Bubble Threatens a V-Shaped Rebound"
Fed chair Ben Bernanke’s low interest rates and monetization programs have flooded the markets and created the illusion of economic recovery. But investors and consumers remain skeptical. In fact, (according to zero hedge) less than $400 billion has moved from Money Markets into stocks in the last 6 months even though the index value has increased by more than $2.7 trillion. So, where did the money come from? The Fed has taken trillions in toxic securities onto its balance sheet, thus, providing financial institutions with the liquidity they need to goose the stock market. With securitization in a shambles, the banks have fewer opportunities to meet earnings expectations. Lending is down, but speculation is up. Way up.
Bernanke knows that neither stimulus nor liquidity will fix the economy. That’s because many of the financial institutions that took out loans from the Fed are technically insolvent. (Borrowing more money won’t help if you’re already drowning in red ink.) Even so, he is committed to keeping the big banks afloat and patching together the flawed wholesale credit system any way he can. This is why Bernanke should never have been reappointed. True, he demonstrated impressive imagination and skill in pumping liquidity into the financial system, but he’s done nothing to role up insolvent institutions or to purge toxic assets and non-performing loans from the system. The Fed has merely provided enough taxpayer-funded scaffolding to keep a rotten system propped up a little longer. What good does that do?
As early as 2006, the Bank for International Settlements (BIS) warned that loose monetary policy and complex debt-instruments were increasing systemic risk and could trigger a 1930s-type slump. In June 2008, the UK Telegraph wrote:
"A year ago, the Bank for International Settlements startled the financial world by warning that we might soon face challenges last seen during the onset of the Great Depression. In a pointed attack on the US Federal Reserve, it said central banks would not find it easy to "clean up" once property bubbles have burst…
“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period….The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning…
“Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off. To deny this through the use of gimmicks and palliatives will only make things worse in the end." (UK Telegraph)
Far from heeding the BIS’s warning, Bernanke headed in the opposite direction, doing everything in his power to avoid price discovery and keep the price mortgage-backed securities (MBS) and other toxic assets artificially high by providing full-value, rotating loans to underwater financial institutions. At the same time the Fed was using public funds to prop up financial markets, Bernanke was shrugging off Congress’s attempts to find out which companies secured the loans; how much the loans were worth, the terms under which they were issued, and the true "mark-to-market" value of the collateral accepted by the Fed. On Aug 24, 2009, a federal judge ruling on a case brought by Bloomberg News against the Fed decided that "The Federal Reserve must make public reports about recipients of emergency loans from U.S. taxpayers under programs created to address the financial crisis, a federal judge ruled." There’s no doubt that the Fed will refuse to provide the relevant information as it would surely expose the Fed’s cozy and collusive relationship with the nation’s biggest banks. The Fed’s stonewalling in the Bloomberg case and refusal to let Congress audit its books stands in sharp contrast with Bernanke’s professed commitment to "transparency," a handy buzzword typically invoked by confidence men and charlatans when they feel noose tightening around their necks.
Green Shoots or “Sugar High”?
The bond market has not been duped by the "green shoots" hype. As Paul Krugman points out:
"Net yields on most longer-term Treasury securities are lower today than they were at the end of May, even as the economy has shown signs of recovery. The 10-year T-note yield is at 3.45 per cent today, down from 3.74 per cent on May 27….There’s no hint in the data of fears about (a) crowding out (b) inflation (c) default." In other words, bonds are priced for deflation, which casts doubt on the rally in the stock market.”
Deflation is now visible in every sector of the economy. The banks are facing major losses from dodgy assets and non-performing loans. (A recent article in US News and World Report predicted that the loss rate on bank loans could rise to 9.1 percent, worse than the 1930s.) Financial institutions and households are continuing to deleverage and pay down debt, business investment is a record lows, and unemployment is soaring. Rising defaults, foreclosures and bankruptcies all add to the massive debt liquidation that has brought about a steady decline in economic activity.
Exports are down, so is trucking. Railroad freight is off 18 per cent year-over-year. Department stores, building materials, restaurants, furniture sales, appliances, travel, retail, outdoor equipment, tech; down, down, down, down, down and down. You name it; it’s down. Consumer credit is plummeting and personal savings are up. Industrial production is down, PPI down. Capacity utilization has slipped to 68.5 per cent (another record). There’s so much slack in the system, inflation could be low for years. Commercial real estate — a $3.5 trillion industry — is plunging faster than residential housing. Corporate bond defaults are at record highs, Treasury yields are flat, and the dollar index is teetering at the brink. It’s a wasteland.
The main problem is falling demand from stagnant wages. 30 years of anti-labor hysteria and trickle down economics has produced a system where GDP depends on ever-increasing amounts of personal debt. But that only works for so long. When the housing bubble burst in 2006, asset prices began to tumble, and the debt-to-equity ratio for millions of households slipped into the red. Now comes the digging out phase.
It is mathematically impossible for the economy to recover without a strong consumer, but consumer spending will continue to fade until household leverage returns to its long-term trend. (Household borrowing is presently 27 percent above normal trend; about $3 trillion.) Economists Martin N. Baily, Susan Lund and Charles Atkins have written an invaluable "must read" analysis of the plight of the US consumer for McKinsey Global Institute titled: "Will U.S. Consumer Debt Reduction Cripple the Recovery?" Here’s an excerpt:
"Between 2000 and 2007 US households led a national borrowing binge nearly doubling their outstanding debt to $13.8 trillion. The amount of US household debt amassed by 2007 was unprecedented whether measured in nominal terms, as a share of GDP (98 per cent) or as a ratio of liabilities to personal disposable income (138 per cent) But as the global financial and economic crisis worsened at the end of last year, a shift occurred; US households for the first time since WW2 reduced their debt outstanding…. We show that the hit to consumption from household debt reduction, or "deleveraging" will depend on whether it is accompanied by personal income growth.
“Over the past decade US household spending has served as the main engine of US economic growth. From 2000 to 2007 US annual personal consumption grew by 44 per cent, from $6.9 trillion to $9.9 trillion — faster than either GDP or household income. Consumption accounted for 77 per cent of real US GDP growth during this period — high by comparison with both US and international experience. The US spendthrift ways have fueled global economic growth as well. The US has accounted for one-third of the total growth in global private consumption since 1990…. Powering the US spending spree through 2007 were three strong stimulants; a surge in household borrowing, a decline in saving, and a rapid appreciation of assets." (Martin N. Baily, Susan Lund and Charles Atkins, "Will U.S. Consumer Debt Reduction Cripple the Recovery?" McKinsey Global Institute.) To repeat: "Consumption accounted for 77 per cent of real US GDP growth during this period…"…"The US has accounted for one-third of the total growth in global private consumption."
It should be fairly obvious by now that US consumers are undergoing a generational shift and will not be able to lead the way out of the recession as they have in the past. Nor will they miraculously "bounce back" and provide demand for products made abroad. In fact, the export-driven model (Germany, South Korea, Japan, China) is sure to be challenged in ways that were unimaginable just two years ago. With credit lines being cut, and outstanding credit shrinking by trillions in the past year alone, and unemployment nudging 10 per cent (16 per cent in real terms) the consumer will not be the locomotive driving the global economy. Credit destruction, asset firesales, defaults, and foreclosures will continue for the foreseeable future choking off growth and pushing unemployment higher. Consumption patterns are changing dramatically, although their impact won’t be fully-felt until government stimulus programs run out. That’s when the signs of Depression will reappear once more.
This is why Bernanke should never have been reappointed as chairman. Bernanke understands the issues — underwater banks, overextended consumers, exotic debt-instruments (derivatives), and an out-of-control financial system — but he’s refused to do anything about them. He’s made no effort to re-regulate the financial system, but (oddly enough) wants Congress to reward his inaction by elevating him to "Chief Regulator." Go figure? He’s also done nothing to determine which institutions can be saved and which should be taken into conservatorship and have their assets put up for auction. Instead, he’s given a blanket guarantee to every brokerage house on Wall Street; their garbage paper can be easily traded for US Treasuries or liquidity at any of the Fed’s handy-dandy lending facilities. That’s not a sign of sound judgment; it’s a sign of "regulatory capture." Bernanke is a push-over; Chairman Milquetoast. That’s why Wall Street loves him; he gives them cheap capital with one hand and a pat on the back with the other.
It’s no secret what’s wrong with the economy; the banks are struggling and consumers are broke. But there are remedies, they simply require fresh thinking about regulation and how to maintain aggregate demand. (A boost in pay would be a good start.) The real problem is the institutional bias of the Fed itself. The Central Bank’s policies are shaped by its allegiance to its constituents, particularly the big banks. Anything that doesn’t advance the objectives of the financial establishment, is just not on the Fed’s radar. That’s why Bernanke’s lame efforts to revive the economy will continue to sputter, because we’ve gone as far as we can without fixing household balance sheets and purging the excessive debt from the system.
The Fed is an obstacle to change, which is why more and more people are starting to figure out that the Fed has got to go.
Mike Whitney [send him mail] lives in Washington state.