It has been another tough week for economic data in the US as the pace of economic growth remains anemic awaiting greater clarity on policy after the election. The revised GDP data, personal income and personal spending all point to an economy growing at less than 4% nominal growth – a level of growth that limits the pay down of the massive debt overhang. Data on durable goods orders and the Chicago Purchasing Managers’ report suggest that the economy is stalling out as we await the outcome of the election. Meanwhile, the table setting on monetary policy is clear as the Federal Reserve has embarked on a new round of quantitative easing specifically directed at mortgage rates – and the spread between wholesale mortgage rates and ten year Treasury securities has collapsed to near parity. The shift of Minneapolis Federal Reserve President Kocherlakota into the dovish camp indicates much faster economic growth or inflation will be needed before policy shifts from its aggressively easy stance. We believe the election remains too close to call, as we expect a wave of money will exploit whatever advantageous comes out of the first Presidential debate. We expect that the winning Presidential candidate’s party will carry the Senate as well; making it more likely that there is a solution to the fiscal cliff soon after November 6th.
We have become more optimistic recently primarily because the economic situation has become so bad. It often takes crisis to bring about change. We had a classic example this week as the egregiously bad calls by the replacement referees down the stretch in a widely watched Monday Night game resulted in the NFL owners capitulating to the union. Similar cases of brinksmanship in Europe between the Germans and the Periphery have also resulted in sharp changes in policy. In the US, the fiscal cliff was designed as a crisis to bring about change, as everyone understood that allowing such massive tax hikes and spending cuts was unthinkable. As Herb Stein pointed out, a trend which cannot continue won’t. The economy is dynamic, even if the attitudes of the majority are usually static – protecting or expecting the status quo to continue even in the face of growing crisis. Thus, when change does come, it often takes forms that are unpalatable, and therefore slow to be accepted, by the consensus. Rather than focus on the probabilities of where the economy goes after the election (we will look at that in depth in five weeks) we want to discuss some current shifts that the consensus is finding hard to accept, but that represent the invisible hands ruthless efficiency in bringing imbalance back to equilibrium.
Living Standards versus Jobs
It’s all about jobs, stupid. That is the mantra in this critical election year. We beg to differ. It seems to us that it is all about income, or more properly about spending power and living standards. Unfortunately, it is unlikely that we will return to the employment boom of the pre-Lehman era anytime soon. Even if one could replicate the conditions of low and falling interest rates, low and falling taxes, and easy access to soaring home equity, it is unlikely that heavily chastened consumers or businesses would quickly return to their previous behavior. Prior to Lehman, wage earners were dealing with the consequences of the technology boom of the late 1990s and the wave of deflationary pressure after China entered the WTO in 2000. To shore up living standards, more entered the work force (including many who previously lived on transfers), driving up labor force participation rates; more took a second job; and most resorted to borrowing to fill the gap. After Lehman, with credit largely unavailable (and generally unwanted) and labor markets less hospitable, the adjustment mechanisms to preserve living standards have changed. Many are leaving the workforce via retirement (often early or at 62 when Social Security is first available) or receiving government benefits via disability. Others are choosing school rather than work, aided by government supported student loans. Nearly 3 million have adjusted by stopping payment on their mortgage for at least a year. Nearly one million young people (between 18-30) moved back in with their parents in 2011, and nearly 25% more of this age group live with their parents now than did in 2007. Finally, many workers are simply removing themselves from the workforce because it does not make sense to provide labor at current wages (especially for those with dependent care costs). One extreme example is the reversal of immigration patterns with more Hispanic labor now leaving the US than is entering. Bottom line, rather than adjusting by working more, many are adjusting by working less. As the lack of labor force growth around the world saps strength from the global economy, deflation (especially in housing costs) and refinancing are freeing income making it easier to maintain living standards on less. For the elderly living on fixed incomes, far slower appreciation in medical care costs and expenditures is a primary source of adjustment. These are not the preferred adjustments in a growth oriented economy, but the invisible hand takes the path of least resistance toward equilibrium – and with growth stymied by the fiscal cliff, less desirable and long lasting adjustments are being made.
Why long lasting? As many have noted, a worker who leaves the workforce for more than a year often suffers deterioration in their skills that can permanently reduce their earning power. Among the older workers, in particular, a decision to take social security early is likely irreversible and current decisions to defer or forego medical expenditures may permanently reduce earning power and living standards. For those who have returned to school and borrowed heavily, the future path of credit oriented consumption for cars or houses may be critically altered. For those who have adjusted by drastically reducing housing costs, the question is how their consumption pattern will adjust in the future if they must pay for housing. For immigrants who have returned home, re-entry may be harder in the future. Though undesirable, these are all market oriented decisions to complex personal circumstances. In a growth market, rising wages attract labor and in a falling market labor supply goes away – that is part of the invisible hands corrective process.
Japan’s long deflationary spiral, with less child birth (less investment in the future) as one of the key adjustments to maintaining living standards, is proof that the invisible hand’s solutions are not always growth oriented. In the US’s Great Depression, work spreading became one of the key solutions to the high unemployment rate as each worker got fewer hours as the six day work week moved to five (and a half in many industries). It was not by choice that workers received more leisure time. It was only the Second World War that ended excess labor by moving millions into the military. Fears of mass unemployment after the war were never fulfilled, as many women chose to leave the labor force when the men returned. Bottom line, many felt they were no longer being paid wages that justified their effort, whether it was due to discrimination or social custom is arguable – but the bottom line is it happened and a new equilibrium was achieved.
Capital Destruction Continues
We have argued that zero interest rates are the invisible hands way of indicating that less savings and investment and more consumption is needed. With consumption growth stymied by limited nominal growth, there are four traditional patterns of capital destruction to rebalance investment: 1) Schumpeterian creative destruction (Henry Ford and Steve Jobs), which is preferable; 2) market concentration, where the big get bigger, often by buying the best of the small and killing the rest; 3) increased government interference via new regulation or incentives; and 4) war. Monopolies and governments are inherently less efficient at allocating resources than the free competitive market and war is unambiguously destructive. Unfortunately, creative start-ups like the original Apple are hard to come by when credit is tight – so most product development today is from big companies, like today’s Apple. Market concentration is nowhere more evident than in the improving housing market, where big builders have survived – often by buying up the best small builders – and the number of independent homebuilders has been decimated by lack of access to credit. In Europe, the recession threatens to eliminate many small car makers. In China, fresh stimulus favors the big infrastructure firms despite a desire to spur small and medium sized retailers. Everywhere, governments are more involved in the economy, whether through aggressive monetary policy, austerity, subsidies, taxes, or trade wars as WTO complaints and tariff battles escalate. Most worrying is the rise of martial conflict in the South China Sea and the Middle East. Japanese production is under fire in China as nationalism rises. Similar trends are evident in Europe where spending on German products is shunned in the periphery and a secessionist movement has reared its ugly head in Spain. Meanwhile, sanctions throttle Iran and its oil supply to the world. While it may not yet be a shooting war (though it’s close in many areas), economic war is definitely escalating as nations seek to destroy or nullify the other guy’s capital.
In a world without growth due to lack of access to capital by small potential competitors, a drift toward capital destruction by market concentration, government interference or war will continue until enough existing investment is made unprofitable to achieve a new equilibrium. The Federal Reserve, European Central Bank, Bank of England and Bank of Japan all currently believe that rates will remain near zero for three more years. Their solution is quantitative easing, which generates inflation and currency devaluation – the first reducing the value of current financial capital and the second a form of economic war. By adding targeting – to subsidize housing in the US and the Periphery via a geographical operation twist in Europe – they are practicing government interference as well. Bottom line, there is a lot more effort to destroy capital (including human capital, as noted above) than to promote growth. Investors must remain very wary to assure that is not their capital that is being destroyed. The invisible hand is a ruthlessly efficient arbiter of imbalances – and if growth is not possible, it will shrink the economy back into equilibrium. The question now is whether the shrinkage has reached a pace that fiscal authorities will shake off their inaction and re-establish an impetus for growth. Europe, China and the US are all beginning to stimulate, which is promising for 2013 – but will it be a bounce (like 2010) or a sustainable path leading to the start of a traditional economic cycle?