The Bear's Lair: The Draining National Prosperity

The Bear's Lair: The Draining National Prosperity

By Martin Hutchinson | 10 May 2008

The first quarter Gross Domestic Product rise of 0.6% was greeted with considerable relief by most Wall Street commentators; they had expected the chaos in the housing market and the banking system to have pushed the US economy into recession. This was unreasonable; the huge monetary stimulus currently being hurled at the economy was always likely to prevent immediate recession, while the fiscal stimulus of the $110bn rebate package is likely to prop it up through July or so. Beyond that, the future becomes less clear: at some stage the monetary and fiscal stimulus must run out.

As I have frequently written, monetary conditions have been pretty lax since 1995. It had been becoming difficult to determine how lax since March 2006, when the Federal Reserve stopped reporting M3 money supply, the measure used in by the European Central Bank and other monetarist organizations. However the St. Louis Fed, which for the decade until April was run by the monetarist William Poole, has constructed its own measure of broad money, Money of Zero Maturity, which is a reasonable proxy for M3; it consists of M2 plus institutional money market funds minus small time deposits. Like M3, MZM began to expand excessively in early 1995; in the 13 years to March 2008 it grew at an average annual rate of 8.88%, compared with growth in nominal GDP during that period of 5.25%.

Thus monetary policy, however measured, has been excessively expansionary since 1995, in the sense of expanding the money supply faster than output. As I have written previously, the inflation-creating effect of this excessive monetary expansion has been suppressed for a decade by the Internet, which has had a similar deflationary effect through enabling outsourcing to cheap labor countries that the railroads and refrigeration did in the 1880s through allowing cheap agricultural produce from the Midwest, Canada, Australia and Argentina to be shipped worldwide.

From the beginning of 2008, however, monetary expansion has sharply accelerated. In the three months to April 21, the latest data available, MZM expanded at an annual rate of no less than 28.7%. This extra-rapid expansion is not surprising— the Fed has been terrified that the US financial system was about to collapse, and has been making funding available in large quantities in a variety of ways. Indeed on May 2 the Fed, concerned about the credit card financing market, allowed banks to use credit-card-backed AAA bonds as security for Fed loans— needless to say this involves yet more monetary expansion and further risk to the taxpayer. Monetary stimulus of this extraordinary magnitude will have an effect, it has to.

Other countries have also been expanding their money supply excessively. The European Central bank has allowed euro M3 to expand by 11.1% in the three months to March 2008, following an increase of 11.5% during 2007. As in the United States, this increase is much faster than that of nominal GDP, and it had been continuing for several years, with annual growth rates of 7.4% in 2005 and 10.0% in 2006. Of the major emerging markets, China and India have both been operating expansionary monetary policies and now have considerable inflation problems. Vietnam too has been surprised in spite of its rapid growth by inflation surging towards 25%. Only in Japan, where "broadly-defined liquidity" has been increasing at rates in the 3-4% range in 2006-08, has monetary policy been reasonably consistent with low inflation.

Monetary stimulus generally works with a lag of several months at a minimum. Thus it is likely that the extremely lax monetary conditions of the past few months have not yet produced their full effect. Nevertheless it is remarkable how rapid has been the advance of energy and commodity prices, with the Reuters CRB commodity price index up 24% since the Fed began its misguided interest rate cutting campaign on September 18 last year. It is also remarkable how feeble growth in the United States has been.

With the Fed essentially printing money as fast as it could, the US economy grew only 0.6% in each of the fourth and first quarters. Since the US population increases by around 1% per capita, the economy has thus been in a per capita recession since September. In the first quarter indeed, even ignoring population growth, the economy was only pushed above the flatline by increases in inventory and government spending, both detrimental to economic output in the long term.

Over the next several months, it is likely that current trends of feebly advancing GDP and soaring commodity prices will continue. Certainly the stock market seems to think so; it has recovered nicely from its mid-March low and is now above the levels when the crisis hit last August, even though earnings in the financial sector, representing more than 40% of total US earnings before crisis hit, have essentially disappeared in the last two quarters [[indeed, for the last 6 years or so, for only losses as yet admitted: normxxx]]. The Fed may not currently intend to push interest rates down further, but it has already forced them more than 2% below even the thoroughly fudged statistics of inflation produced by the Bureau of Labor Statistics.

It is perhaps disappointing for bears that a crisis may not occur immediately, but there can be no question that the vigorous monetary and fiscal medicine administered by the Bernanke Fed and the George W. Bush administration will have its effect. Indeed, far from declining in the second quarter, as has been confidently predicted, Gross Domestic Product may even tick up a bit, boosted by monetary and fiscal stimulus, perhaps to around 2% or 1% after population increase has been taken into account.

At some point, a crisis will arrive. Inflation in the eurozone, China and India is already at levels deemed unacceptable, while even Japan has positive inflation for the first time in many years. In the United States, the producer price index increased 6.9% in the year to March, while that for crude goods increased more than 30%. Like a bowling ball swallowed by a python, that inflation will move through the economic system and eventually be reflected in consumer prices. Indeed, it may already be showing up there; the seasonally unadjusted consumer price index for March was up 0.9% (an annual rate of around 11%) and only a heroic seasonal adjustment of 0.6%, double the next largest seasonal adjustment for any month in the last ten years, brought the figure down to an acceptable 0.3%.

The Bureau of Labor Statistics explains on its website that its seasonal adjustment methodology changed in January; should it be the case that this is being used to suppress evidence of consumer price inflation even further, even the dozier members of the media will come to notice after another couple of months have passed. In any case, it is likely that by the latter part of 2008, consumer price inflation in the US will be running at more than 10%, and that even the heroic mavens at the BLS will be unable to suppress that information completely (though on past form they will undoubtedly try.)

There will come a point at which the irresistible force of gradually increasing GDP and continually optimistic stock market will meet the immovable object of consumer price figures that can no longer be ignored. At that point, the US will suffer not merely a monetary crisis but a political crisis. President George W. Bush, with his refusal to see recession, Treasury Secretary Hank Paulson, with his background in an institution, Goldman Sachs and a market, the Wall Street of 1995— 2007 that together bear a very substantial responsibility for the problem, and Bush’s appointee Ben Bernanke, with his continual insistence that inflation is imminently about to disappear, will be discredited by reality and unable to provide leadership. Awkwardly, it is more likely than not that the crisis point will occur before November, so there will be no fresh-faced President-elect to take control of the situation.

Almost certainly, it will prove impossible to put the entire US economy on ice until January 20, 2009, so the financial markets themselves, probably the Treasury bond market, will take control. With the US Treasury’s funding need in the fiscal years 2008 and 2009 already around $500 billion in each year, hiccups in the bond market have an almost immediate way of making themselves felt. To avoid a collapse in the bond market and a catastrophic decline in the dollar as foreign central banks withdraw their money, short term interest rates will have to be raised very quickly to at least 3% above the then prevailing level of inflation. That would imply a level of 7-8% today, but probably considerably more by the time the crisis hits.

Once interest rates have been raised, inflation will not decline immediately, but nor will the US descend into a re-run of the Great Depression. There will be a lengthy and grinding recession, probably persisting throughout 2009 and into 2010, with GDP declining maybe 4-5% from top to bottom and inflation coming definitively under control only towards the end of the period. On the other hand, the dollar will stop being weak, since US interest rates will be internationally attractive, and the US balance of payments position will swing back sharply towards balance as US consumption and therefore imports decline sharply. The US savings rate will also increase, allowing the country to finance new capital investment from domestic resources, and giving it once more a substantial capital cost advantage over the emerging markets with lower labor costs.

The wild card will be politics. It is not yet clear who will be the next President, and it is abundantly clear that this pretty unpleasant economic environment will dominate that President’s first two years in office. As happened to Herbert Hoover, it will be possible for the new President and/or Congress, through misguided protectionist or anti-capitalist policies, to make things sufficiently worse that a Great Depression, Version 2.0, ensues.

Since none of the three remaining Presidential potential candidates has a firm, well thought-out commitment to economic policies that would alleviate or solve the problem, and all have tendencies that might exacerbate it, the safest choice is probably to go for raw intelligence, and hope that the new President can learn on the job.

Which is as close as this column is going to get to an endorsement!

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Normxxx    
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