Tuesday, January 29, 2008
what kind of recession? it's up to china
fortunately such analysis is going on elsewhere. james hamilton at econbrowser notes the market response to monetary stimulus has thusfar been positive, though fiscal stimulus is receiving a drubbing in many economic quarters. what is clear is that all the stops are being pulled by the government to support an old (at more than five years) and failing recovery.
i deeply question the intelligence of this. the market -- not just housing, but debt in general -- has been in a mania in some respects induced by the collusion of government (by its refusal to properly regulate and its willingness to allow the inflation of the money/credit supply) and banking (by its adoption of the financial engineering which expanded the money/credit supply), and has obviously been mispriced. this in fact is the essence of the housing bubble: credit was too cheap and too easy. and the essence of the bust is that widespread malinvestment is being made obvious and credit prices marked up where it is being extended at all -- as in every bust.
government stimulation represents an effort to extend that collusion of credit mispricing in an effort to maintain high prices -- an effort to fight the clearing mechanism of the marketplace, which is falling prices.
such efforts are inherently misguided in my view. what is happening in the marketplace is not irrational; it is a return to rationality. it reminds me of murray rothbard's description of the efforts of the government in the 1920s and 1930s.
throughout the early interwar era, the united states countered a global price deflation which began in the depression of 1920-21 with inflationary monetary policies, underwriting an expansion of bank credit that had near its root an effort to restore great britain to the gold standard at its prewar par. in an effort to allow britain to counter the deflationary economic pressure of currency convertability by attempting a policy credit inflation, the united states stemmed the flow of gold from an inflating britain by itself creating an inflation -- effectively subsidizing britain's ill-judged economic policy. as natural deflation of basic commodities were offset by inflation in capital goods, consumer and wholesale price averages gave the illusion of price stability on the whole even as prices by type were bifurcated and the capital system became dangerously overleveraged.
this is similar in some respects to our current situation. china has played the role of the 1920s united states, abetting the inflationary policies of america (playing the role of 1920s britain) even as real american wages erode by joining in with its own inflation, transmitted by its currency peg and huge subsidy of american profligacy by the recycling of its dollar trade surplus into american assets. a strong natural price deflation eminating from china and the rest of east asia as it industrializes has been countered in the united states by the massive expansion of credit, backed by this asian subsidy, which has flowed into finished goods and assets such as stocks, bonds and housing even as consumer prices have seemed to show no inflation at all.
this was a policy direction that in the 1920s thrived until it couldn't. once the asset bubble broke in 1929 and leverage became the enemy, further furious efforts at policy reflation did little that lasted. heavy discount rate cuts, massive open market operations -- with bank reserves in late october 1929 expanding by 10% in just one week thanks to federal reserve operations -- and fiscal stimulus packages stemmed the stock market fall in mid-november after three weeks, the dow industrials having fallen by 50% from its september 3 high. what then followed was a 5-month, 60% rally which recovered just over half the initial decline.
britain, however, had already suffered terribly in the 1920-21 depression and had been in a depressed state throughout the 1920s. policy reflation in the aftermath of the first world war had never really offset postwar credit contraction. returning to the prewar gold exchange rate in 1925 (a political expedient) further crippled british exporting, the core of its economy, by making the pound too expensive relative to other currency-debased european economies. subsequent attempts at policy inflation had been subsidized by america, and when that ended depression struck.
britain's novice labour government too attempted for some time to maintain gold convertibility, wage rates and government spending, but in 1931 finally cut government spending and wages radically to put incomes in line with the reduced cost of living. this gave more efficient lines of business a chance to return to profitability quickly, while the earlier boomtime malinvestments in coalmining, shipbuilding, textiles and steel continued to be liquidated until 1934.
in the united states, however, the government embarked upon the new deal -- first under herbert hoover and then franklin delano roosevelt. the primary object of the program was to support aggregate demand by maintaining high wage rates (through government coercion and then make-work employment) and prices (through price controls), which were wrongly seen as guarantors of consumer demand rather than the outcome of corporate profitability. overpriced labor through 1931 helped lead to mass corporate bankruptcy, accelerating forced asset liquidation and bringing more severe unemployment than was seen in britain. by 1933, this process had forced widespread bank failures and the most thorough systemic deleveraging on record.
there are differences here, but parallels can be drawn from 1920s britain to the need of the 21st c united states to draw on chinese credit throughout the last decade in order to facilitate reflationary efforts of modest effectiveness. modern china has also adopted highly inflationary policies to create a very overextended financial and corporate system, one that would seem to be deeply vulnerable to a potential asset market collapse. should the chinese bubble pop and its offer of credit to the united states be curtailed, the effects in the united states would be incredible -- this would be what the bank credit analyst has called the end of the debt superycle.
at this point, of course, that has not happened. foreign capital inflow has remained strong and continues to be strong. until events in china cut the tether of credit, one should expect the united states to muddle through short of depression no matter how overlevered.
jeff saut of raymond james yesterday called for a strange sort of recession.
By studying the charts, one observes that until recently recessions have been a normal conclusion to the business cycle. As seen, however, recently this has not been the case. In past missives we have railed at the central banks, as well as the politicians, for their continuing efforts to prevent the normal business cycle from playing. They did it again last week when the Federal Reserve panicked and cut interest rates by 75 basis points with a concurrent $150 billion economic stimulus package from the politicos. And if this is a typical recession, such maneuvers will likely ameliorate the downturn. But, what if this isn’t “your father’s typical recession?”
Consider this: typically a recession follows a tightening cycle by the central banks causing the entire interest rate spectrums’ yields to rise sharply. Clearly, this has not been the case. Moreover, recessions tend to occur in a high “real” interest rate environment where interest rates are higher than the inflation rate. Currently, when you compare the nominal, or headline, inflation rate to ANY of the government complex of interest rate yields (Fed Funds, 2-year T’bill, 10-year T’note, etc.), you find “negative” real interest rates. Ladies and gentlemen, negative real rates have always sewn the seeds of economic recoveries. Further, recessions are accompanied by soaring unemployment reports, and hereto this is just not happening. [here i disagree.] The final ingredient of the typical recession is a huge buildup of inventories, but given the current record low inventory-to-sales ratio, this too doesn’t “foot.” Therefore, if we are entering a recession, it is probably a financially-induced recession and not your father’s typical recession, begging the question, “Will the typical remedies work?”
How we got into this mess can be directly traced to the “powers that be” attempting to stave off the normal business cycle via the engineering of a too-low Fed Funds interest rate (1%), too much liquidity (pumping up the money supply), and a financial complex that spun the situation into a spider web of leverage resulting in an enormous abuse of credit. ... The question du jour is, “Will the rate cuts, combined with the economic stimulus package, be enough to prevent the normal ending to the business cycle even if this is not your father’s typical recession?” Evidentially, the D-J Transports think so given their 7% rally last week! Yet even if successful, the nation faces a painful deleveraging process that will take time. As John Stuart Mill wrote in 1867, “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed into hopelessly unproductive works.”
so perhaps the united states is for now stuck in limbo. with a crippled financial system and heavily indebted consumer sector with a negative savings rate, it would seem the pump is primed for a reduction in both the supply and demand for credit. but with the entire construct still being supported by chinese capital and receiving massive government stimuli in the hopes of sustaining the unsustainable, it seems just possible that the final disaster may yet be deferred even as housing continues to deflate.
at this point, my eyes turn to china. would a stock market collapse end the inflationary mania that has helped to keep the united states afloat? i think quite possibly so. many chinese companies are doing what american companies did in the 1920s to improve profits -- that is, ignoring their lines of production to borrow and speculate in equities. dumb money had of course already been piling in at record rates. a crash and rapid exit of foreign speculative capital could have massive ramifications across corporate and banking sectors, with banking having been acknowledged for some time as a potential weakness. (more on the subject from brad setser.) and the pattern frankly looks very pessimistic, with chinese 'A' shares down 27% from their highs three months ago and still making new lows.
i think rothbard and his acolytes would have to suggest today that the terrific (and global) credit inflation of the last several years has already baked in a terrific (and global) recession. and i think as a group they would oppose the kind of stimulus packages which we are seeing that amount to anti-market measures. but whether or not that recession and liquidation of non-performing loans leads immediately to an american (indeed global) depression is quite possibly going to be decided in china because the american government is going to try to reflate until their source of credit is removed.
UPDATE: some more on china's internal economic condition via russ winter:
There is a chart ... from CLSA Asia-Pacific and shows PMI input and output costs. Both are rising, but input costs are racing far ahead of outputs, indicating unprofitable, money losing make work activities.
- Account receivables are up 20.3% yoy running far ahead of reported GDP growth. This is reminiscent of the tech bubble when companies generated sales via extremely lax credit.
- Inventories are up 18.8% yoy. I think much of this is crack up boom input and commodity hoarding. At any rate it is far ahead of the overreported malinvestment influenced GDP number.
- Fixed capital formation is now 41% of GDP. This makes zero sense now, and is probably 8% too high in normal times. These are not normal times, and I expect that to plunge taking away ALL of China’s GDP growth, perhaps even pushing it negative.
-Real consumer spending growth is 10% adjusted for inflation. It’s been that way for several years. Not really even close to what you would expect for this supposed great “decoupled” economy. Once inventories and labor is liquidated by poor demand and Road Warrior economics, that 10% will too.
indeed, CLSA's january china PMI report said as much:
"Activity indicators ticked up in December after November’s sharp fall. But the key issue revealed by the December PMI was not the pace of growth but inflation and margin pressure. Both the output and the input price indices rose to new highs. But, as in previous months, input price inflation is far above output price inflation squeezing profits. Pressure to control costs is apparent in a wide range of the PMI indicators. Finished goods and raw materials inventories are being reduced and for the first time in more than a year employment is being cut."
in short, commodity inflation -- a byproduct of runaway credit growth -- is killing profits and choking off manufacturing activity. the chinese government is installing price controls to prevent further inflation, and that has had the predictable effect of creating shortages as goods become underpriced. but bank credit is now tightening, as can be attested by house price declines in boom-center southern chinese cities. these are ominous warnings, and will be compounded (as brad setser repeats) by a slowdown in exports to both america and europe as credit tightens in both areas. it seems to me that problems are growing in china now, and the 'A' shares could be indicating that they will be forced to a head sooner than anyone imagines, making sites like china economic review regular reading.