Volume 61, Number 5
The closely watched jobs report basically confirmed the markets’ consensus that the economy may be improving, but with little chance of an upside surge and with considerable downside risk remaining. Payroll employment increased by 80,000 – the smallest gain in four months – but revisions added another 102,000 jobs to the totals for the previous two months. This month’s revisions, like last month’s large revision, were heavily in school teachers. Over the past two months, the zero job gain originally announced for August (exacerbated by -45,000 from the Verizon strike) has been revised up to 104,000. The fear of a double dip that that dominated following the temporary failure to raise the debt ceiling and the subsequent downgrade of US debt now appears to have been overstated.
Indeed, looking at the data as currently reported, it appears the economy was improving nicely just before the Japanese earthquake on March 11th. The employment data held up for another month, then supply chain disruptions became clear and a sharp adjustment came in May and June. Since then, job growth appears to have settled into a moderate pace of roughly 135,000 private sector jobs – historically just enough to lower the unemployment rate slowly. The wilder swings in the household report are consistent with its role as a leading indicator – currently pointing away from a double dip. However, the ongoing correction of earlier excesses in the public sector has government employment declining roughly 20,000 a month instead of the normal 15,000 gain at this point in a recovery. Until the drag from the government sector — which represents 20% of GDP — abates, it will be hard for growth from the private sector alone to achieve terminal velocity for a robust recovery.
The global economy continues to tread water as it awaits new policy direction in Europe, theUS, andChina. InEurope, new European Central Bank President Mario Draghi started off with a 25 basis point reduction in the overnight rate and a speech which emphasized the downside risks of the economy, sounding much more like Ben Bernanke than Claude Trichet. Meanwhile, Greek Prime Minister Papandreou survived a vote of confidence and is trying to form a unity government to approve the austerity plan required to get the next tranche of IMF aid. If the aid is disbursed in mid-November,Europewill once again have kicked their can down the road – a bit. Meanwhile, inChina, the government appears committed to reining in real estate speculation and overbuilding, but is loosening the reins on credit to small and medium sized businesses. An unusual surge in new lending in late October, following comments by Premier Wen, seem targeted at alleviating a credit crunch in the private sector. Finally, there are hints (or maybe just rumors) that the US Senate Super-committee may achieve more than the minimum. A coalition of Senators has asked for a grand package and House leader Boehner has indicated that some revenue enhancement may be on the table if entitlement reform is as well. Unfortunately, we have seen these offers before and we are all fromMissourinow – show me!
Too Much Savings
One of our central themes is that the difference between a recession and a depression is the ability of policy to drive an increase in demand to absorb excess supply. Economic downturns are the result of demand falling relative to supply and generating a downward spiral in prices, profits, hiring, and, thus, demand. In typical recessionary periods, monetary and fiscal policies are used to stimulate demand and absorb the excess supply, while poor profitability leads to a restraint in new capital investment. After a period of adjustment, a balance is restored and capital spending begins anew driving economic growth. Most recessions are the result of inventory imbalances, usually in durable goods, which can be quickly corrected. Overbuilding of plant and equipment is harder to resolve – in part because it is usually the result of earlier faulty policies which lead to the recession. In extreme cases – depression – traditional policies prove ineffective in stimulating demand and reduction in supply is needed to restore balance.
We have noted before that leading up to the Great Depression higher tariffs were the traditional solution for a recession. Raising the cost of foreign goods by tariff was a form of currency devaluation when you were on the gold standard. While many blame the Great Depression on Smoot-Hawley, the reality is that these exceptionally steep tariffs did not work primarily because international trade was no longer significant enough to theUSeconomy that excluding foreigners would restore balance. When new Keynesian fiscal stimulus was tried, policy makers were too timid, while the overly cautious Federal Reserve remained too tight. Ultimately, it was only the demand generated by WWII that resolved the imbalances. When that demand disappeared after the war, it was the destruction of capital during the war that provided the basis for recovery through renewal of capital investment.
In the current situation, Keynesian fiscal stimulus has reached its limit in many countries in that higher deficits generate higher interest rates and generate no net stimulus. Monetary ease has also reached its limit in many countries due to the zero interest rate bound. Quantitative easing is the new policy, but like Keynesian deficits in the Great Depression, we may be too timid due to the uncertainty over inflationary effects. Bottom line, stimulating demand is ineffective and outright reductions in supply may be required if a speedier solution is desired. We have discussed at length our concern about excess housing supply and the negative effects on the collateral of the banking system. Last week, we touched on the excess supply of labor and suggested that policies to permanently remove the long term unemployed from the workforce may be more productive than spending more on retraining or job creation (thinkGermany.) This week, we address another imbalance – the excess supply of investable funds.
With interest rates near zero at the short end of the curve and at record lows for the post-war period at the long end of the curve, the market is shouting that there is an excess supply of savings. Real interest rates are negative as inflation eats into the real buying power of savings, slowly boosting consumption relative to income by destroying wealth. Real interest rates are not below zero because there are no investments in the economy that will yield more than the current low rate of inflation. The strength in capital spending in the third quarter belies that view. Rather, rates are low because those in the business community who want to invest are flush with funds from internal cash flow and do not need to borrow. Meanwhile, those who wish to lend through the traditional system of financial intermediation find that the banks and other conduits to investable ideas are shunning new risk-taking due to the unrealized losses already on their books. Bottom line, these highly levered financial institutions are keeping their unlevered clients in unprofitable investments because to recognize their existing losses would put the intermediary out of business. Unlevered investors stay because they are insured or because they have no better alternative – many fearing that even cash in the mattress is at risk from inflation.
Economic theory tells us that there should be new lending institutions competing for these investors’ funds or that investors should buy into the companies with fat cash flow to share in their investment returns. To a degree this is happening, as we see non-financial firms outperforming in the equities market. However, policy makers have made it particularly difficult to start new financial intermediaries. The FDIC will allow the take-over of a weak bank, but no de novo institutions. Meanwhile, uncertainty concerning the regulatory environment due to Dodd-Frank is delaying start-ups in the field. Thus, we are left with an inefficient financial system because intermediaries are not taking losses which would reduce the apparent surplus of savings and allow the market to clear at a positive interest rate.
The bottom line is that in many markets stimulating demand has proved ineffective and it is time to look at policies which directly reduce supply. In the employment market, we have identified the unfortunate few – the long term unemployed – but failed to deal with how to clear them from the marketplace via buyouts or permanent income supports. In the housing market, we have a huge stock of foreclosed and vacant homes, on top of an even larger shadow supply of underwater homes reflecting over-housed inhabitants – yet policies continue to focus on stimulating demand for living space consumers clearly do not want. Finally, in the financial markets we allow the interests of the levered intermediaries who represent a sliver of capital compared to their unlevered clients to keep the market for savings from clearing. In each case, the ever emotionless invisible hand will eventually find a way to balance. Government policy can try and stall this process by protecting the status quo through generating more demand for existing players – or, it can try and smooth the inevitable path of creative destruction by subsidizing new players who will pass some of this benefit along to the losers speeding the process. In an economy which is now three years after Lehman and still struggling to reach potential GDP it is time to try something new. Until we see fresh policies, we expect sub-par growth to continue.