by James J Puplava CFP, President & CEO, PFS Group. November 2, 2001
A Direct Hit
Everyone suspected it was coming. When it arrived, it came as no surprise. The financial community found out what the manufacturing sector had already known -- the US economy had headed into a recession. The economic numbers have been signaling its arrival since last year. Since the economy peaked in the final quarter of 1999 GDP growth has been in decline. The NAPM numbers fell again yesterday from 47 in September to 39.8 last month. The manufacturing report indicated the worst performance since the recession of 1990-91. Contributing to its decline was the biggest drop in consumer spending in 15 years. The drop in consumer spending has been the single most important factor contributing to the economy's decline. Until the third quarter, despite slowing income and job growth across the nation, consumer spending had held up well. Consumer spending and the real estate market were the last two strong pillars holding up the US economy. Now spending and housing have joined the rest of the economy in decline. Undermined by the plunge in confidence and constant layoffs, new home sales have dropped off sharply. If housing continues its descent, the recession will deepen significantly.
At this point, the key questions are how bad will the recession get, how long will it last, and what will the recovery look like when it emerges? At the moment nobody really knows. There is a lot of speculation as to what happens next, but there are no firm convictions to back them up. All we have is conjecture as to what might or might not happen. What we do know is that the downturn is global in its reach. The International Labor Organization estimates that 24 million jobs or job opportunities will disappear by the end of 2002. Economies in Europe, Asia, and in the developing world are in decline joining the US in what is emerging as a global recession. Hopes of a US-led rebound have now disappeared. There is still a lingering hope that monetary and fiscal measures implemented in the US will revitalize our economy next year. Experts predict a resumption of consumer spending and business capital investment to pave the way to recovery. As in past recessions, world leaders are hoping the United States will lead the way. Economic growth in many nations is dependent on exports to the US. Our trade deficits are a reflection of this fact.
Closer examination shows that there are many flaws to these expert predictions. The consumer is burdened by debt and corporate balance sheets are heavily leveraged. Rising interest expense has been one of the major reasons behind the decline in corporate profitability. Consumer debt will also have to be reduced before any meaningful spending surge can reemerge. Leading the world out of recession through imports is fraught with many dangers and chief among them is the strength of the dollar. The US economy is importing over a billion dollars of capital a day to finance its trade and current account deficit. We have been trading capital assets for consumption and in the process consuming our seed corn. The risk of capital flowing out of the US is a real danger, not only to the US, but to the global monetary system as well. The dollar has been remarkably resilient in light of these trade deficits. It is more probable that the US dollar will drift lower over the next few years. This presents a major problem to world leaders who are trying to manage its decline and keep it from turning into a worldwide currency crisis. Up until this point, the greenback has been the beneficiary of any world economic or political crisis. When crises erupt, money flows into the dollar, which allows the US to conveniently finance its current account deficits.
A Two-Front War
What makes this situation more difficult now is that fighting a recession and a war at the same time means that the US will start running budget deficits. The terrorist attacks and recession have changed the fiscal position of our nation from surplus to deficit. The events of 9-11 have destroyed the dream of balancing the non-Social Security budget and retiring the national debt. The proposed fiscal stimulus is going to be huge, ranging from spending to tax cuts. The result of government efforts to revitalize the economy is what economists expect will bring a rebound by the middle of next year. This remains the consensus on Wall Street and in the nation's capital.
Reviewing Past Responses
However, this consensus doesn't line up with historical facts. Post World War II recessions in the US have lasted between 8 to 11 months. Most of these recessions have been inventory related. They resulted from too much supply versus demand. Once that supply was reduced, the economy recovered. Wall Street has treated this downturn as a simple inventory-related slowdown. They feel that once excess inventory is eliminated, the economy will revive. But this isn't a simple matter of inventory correction. The problems are systemic and more indicative of the kind of recession the US experienced back in 1973-74.
Out Maneuvered and Under-Gunned
Source: Marketwatch, October 2, 2001
The first indication that something more serious is at hand is the failure of the stock market to respond to nine cuts in interest rates in one year. Everyone expects another rate cut this coming Tuesday as well when the Federal Open Market Committee meets. In what has been the most aggressive monetary response in post World War II history, the stock market and the economy have failed to respond to Fed moves.
The Damage Appears Structural
The problems besetting the economy are more structural in nature and will take more than interest rates to fix them. As outlined in my Storm Series, they stem from the credit boom of the Clinton years when monetary policy went unchecked, feeding a constant supply of credit into the economy. Consumers and businesses overbought, overspent, and over-borrowed. Credit excesses take time to work off. Balance sheets will have to be repaired and debt will have to be paid down.
The Band-Aids Aren't Working
The aftereffects of the credit boom are only now being felt by the rise in delinquencies, defaults, and bankruptcies. In flush times, lenders relax credit standards in an effort to expand lending profits. When the economic cycle changes from boom to bust, the process reverses. Credit standards are tightened as borrowers begin to default. This applies to both consumer and corporate debt. As of mid-year reporting, banks had $7.8 billion in losses on large syndicated loans. The FDIC rates $117 billion in loans as doubtful or substandard in comparison to last year when that number was only $63 billion. The same process is unfolding in the bond market where 185 companies have defaulted on $76 billion in bonds which is 55 percent higher than last year. The larger question is the extent this tightening credit cycle will have on depressing the economy further. As the Fed moves to aggressively lower interest rates, its efforts are being defused by tightening credit standards and reluctant borrowers. As the economy weakens, job layoffs increase, and corporate profits contract, it is getting harder for debtors to pay back loans. This process, which is now in the process of unfolding, argues against a quick recovery in the second half of next year.
Known and Unknown Variables
The single most important economic variable at the moment is not the stock market or the economy. It's the war against terrorism, which is a big unknown. It is having the biggest impact on consumer confidence. It is a variable that the government can't control. The length and the success of US efforts to defeat bin Laden and al Qaeda without igniting a conflagration in the Middle East, is a big "if". There are many unknowns associated with it. There is the chance of a widening war, the possibility of another 70's type oil embargo, or a financial mishap coming from a leveraged financial system. Osama bin Laden has stated that the West, and in particular the US, has been underpaying for Middle East oil. The leader of al Qaeda has said he will make the US pay. He plans to drive the price of oil up to his target price of $144 a barrel. It wouldn't take much to do it. Closing off the Straits of Hormuz, the Bosporous, or the mouth of the Caspian Sea would choke off the majority of the world's oil supply. Sinking a tanker, blowing up bridges across the Caspian on which petroleum is transported would achieve that objective. Osama bin Laden has an army of kamikaze terrorists who are willing to give their lives to accomplish this objective. It may be one reason the President moved this week to begin the build up of the nation's Strategic Petroleum Reserves. There is a growing rift within the Saudi Royal family with its relations with the US. The Royal family has written the Administration that it desires to see a change in US policy regarding the Middle East, its relations with Israel, and a Palestinian State. Saudi Arabia is OPEC�s swing producer and accounts for 20% of US oil imports.
The Siege Mentality: Circle the Wagons
The war may be a factor in the larger picture, but it is also having an immediate impact on consumer confidence. It is hard to bolster confidence when consumers are bombarded by constant images of war and bio-terrorism on a daily basis. The terrorists have been clever in their strategy. By targeting the media with anthrax, they have garnered maximum publicity. They understood the two governing rules of modern network news, which are "If it bleeds it leads" and "We, the media, are the real story". Those rules have governed media news coverage since the late 80's. So far, four people have died as a result of anthrax. There are more people dying each week in this country from influenza or the common cold. Like the coverage of the O. J. trial, or the death of Princess Diana and JFK Jr., the media has flooded the airways and the print medium with constant coverage that is out of proportion to the events. Images of consumers buying gas masks, bio-terrorism suits or stocking up on Cipro portray a nation under siege. The psychological damage caused by this constant coverage has put the public in a heightened state of anxiety. Anxious consumers turn into cautious shoppers. Consumer sentiment and psychology will be critical to the key fourth quarter, which accounts for 40% of all retail sales.
Gauging what happens next to the economy, it is important to monitor the attitudes of consumers and business. Both are dependent on each other and are critical to the economy's recovery. If consumers pull back on their spending, business will respond by further restructuring and increased layoffs. Unfortunately, the cycle begins to feed on itself. Already business travel plans have been sharply curtailed because of the uncertainty. This has impacted the travel, hotel and tourism industry. Corporations have turned skittish and that mood has translated into a cutback in capital expenditures and a hiring freeze. Projects have been shelved and expenditures postponed as business now turns its efforts to shore up security. Increasing security may take away some of the anxiety of employees, but it isn't a recipe for economic growth. While business remains on hold, consumers are coping with mounting debt loads, economic uncertainty and the prospect of more layoffs. Average household credit card balances are $8,528. The drop in consumer confidence and rising credit card balances mean that it is unlikely we will see a consumption binge return in the fourth quarter or next year. So, throw out the second half recovery scenario unless there is a turn around in both sentiment and financial conditions for both consumers and businesses.
US Countermeasures Launched
This leaves only the government as the main engine of economic stimulus. Since 9-11, the government has moved on all fronts to fight the war and resuscitate the economy. Like a submarine or fighter jet that has been attacked, the government has launched full countermeasures at thwarting a recession and winning a war. At the moment, there is consensus for spending more money. That is the easy part. The consensus evaporates when it comes to stimulus measures outside of spending. Both sides of Congress are divided along traditional party lines. The President and congressional leaders have tried to forge a bipartisan consensus. The Democrats are falling back on their Keynesian roots, resorting to their traditional spending philosophy with a host of spending measures designed to reward traditional constituencies. None of the measures, if adopted, would act as a long-term stimulus for the economy.
Party Lines Are Drawn in The Sand
Both parties approach economic policy in fundamentally different ways. Democrats concentrate their efforts on Keynesian prescriptions that spur consumer spending. The emerging economic stimulus package working its way through Democratic ranks includes tax rebates for low-income groups, health-care subsidies, and other subsidized construction projects.
The Republicans adhere to traditional free market principles that rely on building the capital stock of the country through economic incentives like lower taxes. Lower tax rates stimulate investment in property, plant and equipment, which in turn, generate enduring economic growth. When the capital stock of the country is expanded, more jobs are created which makes the recovery and the nation stronger economically. It boils down to the old fishing analogy. Give a man fish and you feed him for a day. Teach him to fish and you feed him for life.
The arguments working their way through the halls of Congress go back to the Great Depression when John Maynard Keynes wrote "The General Theory of Employment, Interest, and Money" back in 1936. Keynes' prescription for any economic malady was for government-sector spending to make up for the lack of private-sector consumption. Adherence to Keynesian economics did more to shape and prolong the Depression than anything else. Back then, It took a World War to pull the US economy out of depression. Keynes set back classical economic theory and turned economic analysis upside down with disastrous results wherever Keynesian theory has been applied. It didn't help the US during the 30's, nor has it helped Japan in the 90's. The real danger going forward is that we may revisit the Ghost of Christmas Past if Democratic arguments hold sway in the upcoming economic debate. If that happens, the government may turn a recession into a depression or at best, a prolonged recession.
Democratic leaders Tom Daschle in the Senate and House minority leader Dick Gephardt are pushing for more government spending on social services, income transfer payments, and targeted tax cuts aimed at lower income groups. Their argument against further tax cuts for the wealthy relies on class envy. Wealthy people don't need more money. Their argument ignores what happens when wealthy individuals get to keep more of what they own. They can choose to buy a luxury car, take a luxury vacation or invest the money in the capital markets. All three choices stimulate the economy.
We've Consumed Our Seed Corn
The different approaches between Democrats and Republicans both increase spending. What matters most is what happens to future spending as a result of present actions taken by government. Different kinds of spending produce different results for the economy now and in the future. Consumer spending is temporary. It amounts to consuming your seed corn. It does nothing to build up the economy's productive capacity. Lower tax rates, on the other hand, raise the after-tax return on capital investments, which serve to increase demand for more capital spending. Higher capital stock increases productivity, which raises living standards and economic growth rates. One of the main problems of the Clinton bubble economy was that is was based on a gigantic credit expansion, which fueled consumption. Instead of building factories, we were selling them. America's capital stock was being consumed. Our major network of infrastructure has been allowed to decay. Our energy infrastructure is in decline resulting in more imports of foreign oil. No new refineries have been built in decades. Pipelines to supply new power plants are in short supply. Everything from roads, bridges, and airports to plant and equipment has been allowed to decay.
The 90's were a period marked by horse-trading by major corporations. Companies consolidated, restructured, and merged. In a macro sense the economy contracted from corporate activity; while personal consumption made up the difference with debt-financed consumption. Plant capacity never reached its full potential because excess demand was made up by the importation of goods, which in turn gave us our large trade deficits. We squandered a good deal of our productive capacity on goods that do little to provide the goods and services we need to operate an industrial society. America can't survive on microchips alone. We still need an industrial base. The more that base is allowed to decay, the more dependent we become on imports. There is real danger that we are moving away from self-sufficiency and being the world's leading economy to dependency and decline. You can't borrow and consume your way to prosperity. There is a real danger to an economic recovery, if the Keynesian arguments for pursuing consumption-oriented fiscal measures proposed by Democrats, win the economic debate. They will not produce an economic recovery. They will only prolong the recession or worse turn it into a depression. Given the spending orgy of the 90's, there has never been a better argument for rebuilding our nation's capital stock, starting first with our energy infrastructure. That would make us less dependent on events in the Middle East or a madman in Afghanistan.
As the government pursues various countermeasures with fiscal stimulus, it is important that it is not squandered. You don't get many chances to correct your mistakes. The fiscal and monetary excesses of the 90's have led us to this precipice. It now remains to be seen whether the current counter measures can effectively offset them. That will depend on which side wins the economic debate.
The Treasury's Surprise Counterattack
While Washington moves on the fiscal front, the Treasury moved on the monetary front by launching a surprise attack on the bond markets. Even though the Fed has aggressively lowered interest rates nine times this year, long-term rates have remained stubbornly high. Short-term rates have plummeted with Fed rate reductions. Up until Wednesday, long-term Treasuries hovered above 5% as the yield curve steepened. This is because the Fed has greater influence over the direction of short-term rates through its influence over the Fed Funds Rate. Long-term rates are controlled by the actions of the bond market. When bond investors are leery of inflation, they demand a higher return on their investment. Bond investors focus on future indicators of inflation such as the money supply and government fiscal policy. The money supply growth has gone parabolic as the Fed floods the financial system with ample credit and cheap money. If we add fiscal stimulus to the equation, the result could be inflationary.
During times of war, the government spends more money on the military. Already Congress has authorized more than $20 billion for increased defense spending. Over $50 billion has been authorized to rebuild New York, bail out the airlines and for the war effort. This is just a down payment. More spending is being considered. War produces greater government expenditure for raw materials, weapons and soldier salaries. More of the nation's raw materials will be allocated towards defense. The government's budget will expand to cover the added cost of waging war abroad and at home. For the first time, many aspects of this war will be fought on American soil. The new Cabinet post of Homeland Security will place emphasis on beefing up domestic security. All of which will require that the government spend billions of extra dollars on security measures from air marshals, intelligence gathering to more law enforcement personnel. During times of war, the government usually runs a budget deficit as it spends more than it takes in taxes. The added stimulus through deficit spending and the monetization of debt creates inflation.
It is this fear of inflation that has kept long-term interest rates from coming down. Unable to bring down interest rates the Treasury has intervened by its decision to stop selling 30-year bonds. After Wednesday's announcement the bond market experienced its biggest two-day rally since the stock market crash of 1987. Institutional investors have rushed into buy on fears of shortages of longer-dated debt. The key 5 3/8 bond maturing 2031 has risen by close to 7% driving its yield down below 5% to 4.79%. Bond traders have bet that the government would continue to sell 30-year bonds to finance a budget deficit created by a recession and the war on terrorism. As the two graphs of the Treasury curve show up until recently the yield curve has an upward slope. Now that slope has narrowed turning down. Short-term yields are rising on fears the government will sell more short-term debt to finance its deficits while the scrambling by institutions to buy longer dated bonds drives down their yield. The spread between the two has narrowed to 232 basis points as of the market close on Thursday. Bond traders whom have been betting on bigger government deficits have been buying short-term debt. This has produced the steepening yield curve with short-term rates falling more dramatically than long-term rates. Now traders have been forced to reverse those trades as shown in the Yield Curve October 31, 2001 graph on the right.
Simply a Matter of Supply and Demand
What the Fed was unable to do through lowering interest rates, the Treasury has accomplished through its decision to alter supply. By cutting off the sale of 30-year bonds, which normally pay a higher interest rate the Treasury is forcing investors to buy shorter-term debt. By making the 10-year note the new government benchmark, the government has altered mortgage rates and corporate bond yields which are influenced by the 10-year note. By creating a shortage in long-dated bonds, the Treasury has successfully achieved what Greenspan hasn't. They have lowered long-term rates.
Unlike the last recession, where long and short-term interest rates fell, this time around, the impact of a slowing economy has fallen mainly on short-term yields.
What the government and the Fed are trying to do is control the price of money by artificially controlling its price. The demand for credit is still growing, despite the economic slowdown. As pointed out in last week's update, net credit market borrowing increased at an annual rate of $1.8 trillion. Non-federal borrowing increased at an annual rate of $1.25 trillion with consumers borrowing money at an annual growth rate in credit of 9.3 percent.
Strategic Command is Working Overtime
With the economy worsening, the Fed is flooding the market with money in an effort to meet a rise in the demand for money from companies and investors who are showing an increase in preference for liquidity. This would normally raise the cost of money. By shrinking the supply of bonds, or in other words, by limiting their sale, the government is trying to lower the cost of money, by driving down its price. It is hoped that by keeping the price of money low, corporations can refinance their debt or increase their borrowings. By making credit plentiful, consumers will continue to borrow and spend. By re-liquefying the financial markets, financial crises will be avoided. These are all countermeasures designed to head off attacks and contain brush fires. The government is moving on all fronts. The Plunge Protection Team is trying to put a floor underneath the stock market. Bullion banks are trying to suppress the price of silver and gold. Short sellers are trying to keep the cost of energy from rising, despite demand. The Fed is keeping the markets liquid by increasing the supply of money. And yet, there are too many brush fires that are erupting everywhere. The question remains, can they all be contained or are we looking at financial contagion compounded by war?
It All Depends...
I go back to my original questions posed at the beginning of this article. How bad will this recession get, how long will it last, and what will the recovery look like if and when it emerges? That depends on many things that may be beyond the government's ability to control. It will depend on whether there are further terrorist acts and how quickly we are able to end this war. It will depend on consumer and investor confidence. It will depend on the strength and confidence of the dollar. It will rest on chance that there will be no more financial contagions or brush fires that will have to be put out. It will be based on the hope that inflation doesn't resurface, that energy prices remain stable, and the price of gold and silver can be kept from rising. "Depends" and "if" are big words in a time of recession and war. It will take more than countermeasures to keep them from striking their targets.~ JP
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