It was an interesting and volatile week for economic expectations. On the political front, Romney’s dominance of the first debate appears to have narrowed the polls back to a dead heat, with both the Presidency and the Senate in the balance. By the end of the week, the surprisingly low 7.8% unemployment rate gave Obama a badly needed life preserver. Now, the issue will be money and spin, as it is not until October 16th when the Presidential candidates face off again, next time on foreign policy. The President reported a hefty $181 million rolled in in September, a record for this campaign, but slightly less than in September 2008. The Romney campaign has not reported yet, but the bottom line is neither side is hurting for cash flow. The gloves are off and it is still quite unclear who will emerge victorious. The final outcome for both President and Senate is critical to the resolution of the fiscal cliff and the risk of a 1937 style mistake that could extend or worsen the current economic malaise.
Conversely, the recent economic data suggest that without a fiscal cliff the outlook for the US economy in 2013 is looking up. The national ISM index broke back above 50 in the latest reading, with new orders above 50 as well for the first time in three months. This is consistent with the improvement seen in the Philadelphia Federal Reserve Index, but contrary to a slump in the Chicago Purchasing Managers’ reading – which might reflect a planned slowdown in auto production as we near year end. Motor vehicle sales were strong in September, rising to a 14.9 million unit rate from 14.5 million in August – the highest sales pace for the expansion since “cash for clunkers”. Still, the improvement was entirely in sales of imported vehicles, as Japanese manufacturers are using big incentives to reclaim the market share lost after the Tsunami. Nevertheless, the stronger auto numbers point to both greater demand and easier access to credit for consumers. Two articles this week in the Wall Street Journal indicating that Amazon and a Wilbur Ross controlled mortgage servicer were beginning to lend to their customers shows that low rates are generating both greater risk taking and the vertical integration we have expected in the coming upturn.
The employment report was also moderately bullish, with 114,000 new employees in the payroll report and hefty upward revisions to the previous two reports – entirely in teachers. Now, some will argue that since these jobs are not in the private sector they do not count as much – but, as retailers know, income is income. Moreover, as we have argued at length, it has been a significant drag from the public sector which has held back the realization of a decent expansion in private sector GDP for all of this tepid recovery. Since the bulk of public sector GDP is compensation, the rise in public sector employment suggests a boost to third quarter GDP which could lift it above 2% stall speed. Whether the gain in teachers is sustained – reflecting better state and local finances – or a figment of seasonal adjustment waits to be seen in next month’s data.
And what about that crazy 0.3% drop in the unemployment rate to 7.8%!? Bottom line, the household survey is an extremely volatile series based on a small sample of 50,000 phone calls (as opposed to the payroll survey’s relatively hard count of 135 million workers.) Most professional analysts would never pin any interpretation on less than a three month moving average, which showed a more reasonable 186,000 job gain – with job losses summing to 314,000 in July and August offset by the 873,000 gain in September. In fact the unemployment rate has been stuck between 8.1-8.3% since falling to 8.3% back in January. Since then, the household report has averaged a 167,000 a month gain in employment and an 84,000 monthly gain in labor force – translating into a roughly a one tenth of a percent decline in the unemployment rate every two months. Longer term average job gains in the household report track with changes in the payroll report – which averaged a 146,000 monthly gain since January. At this pace, the unemployment rate would take three more years to get down to 6% — where one might begin to worry about full employment. Job growth has been good, but not great, for the past year – just like economic growth. A more robust recovery awaits the election and a resolution to the fiscal cliff.
Going Off the New Gold Standard
A central tenant in Federal Reserve Chairman Ben Bernanke’s view of the causes of the Great Depression is that US adherence to the gold standard exacerbated the depth of the downturn. Indeed, he argued that those who went off the gold standard first suffered less, as they were able to fight deflation more effectively. After the inflationary 1970s, in the decades between Reagan/Thatcher and Lehman, the gold standard was effectively replaced by a commitment from most central banks to hold down inflation (by various measures) in their fiat currencies ultimately to around 2%. Like in the 1930s, as this depression has deepened, all the major players have moved away from defending a 2% inflation target quasi-gold standard to the use of quantitative easing. Initially, QE was to limit deflation and keep the growth of the fiat money supply positive, just as Bernanke argued the US monetary authorities failed to do in early 1930s. However, more recently the US Federal Reserve has committed to open ended QE and to holding interest rates at exceptionally low levels even after the economy begins to recover – with a vague hand wave at the consequences for inflationary expectations with inflation already near 2%. The European Central Bank, Bank of England, and Bank of Japan are all in various stages of quantitative easing as well, suggesting that defending 2% inflation has lost out to the political goal of preserving growth (or jobs, or votes depending on how cynical you are.) There is a vigorous debate within the central banking community as to whether lax monetary policy can generate real GDP growth – rather than simply raising inflation – but the reality is everyone is quantitatively easing while they discuss the risks. The fact that the big four currencies are all easing forces many others to go along, or face sharply appreciating and potentially economy wrecking foreign exchange rates, as seen in Switzerland before it committed to parity with the Euro.
We are not concerned with the correctness of whether central banks should be quantitatively easing or not (because, after all they are), but we wonder how does one stop and go back to a new-new gold standard? Almost every nation went off the old gold standard before WWI to finance that war. The US went back on in 1919, but Europe did not – which helped the budding US economy grow rapidly as its stronger currency made it the financier of the world, replacing the British. The value of the dollar was not an impediment to international trade as the US was the sole producer left undestroyed by the war, while currency exchange was critical in Europe both for trade and reparations (hence, the Weimar hyper-inflation of 1923). The British went back on the gold standard at the pre-WWI level in 1925, a move that then Chancellor of the Exchequer Winston Churchill later called one of the worse mistakes of his career. By going back on too soon and at too strong a value, the strengthening pound throttled UK growth. Other European nations were able to return to gold under the umbrella of a strong pound, but at more reasonable levels. Gold flowed out of Britain to those nations (especially France) which had weaker currencies and, as a result, better trade balances. In 1931, as the Depression took hold, the UK went back off the gold standard, as did most of Europe, while the US suffered by remaining on until 1933.
To return to global monetary standard after WWII, and to avoid the problems seen post-WWI, all 44 allied countries convened at Bretton Woods in July 1944 – just one month after the allied invasion on D-Day and under the auspices of the world’s leading economist John Maynard Keynes. Even with the unity seen at Bretton Woods negotiations took three years to culminate in the IMF in 1947. Will the big four currencies agree to a new Bretton Woods, or continue to play beggar thy neighbor? Currently, we cannot even get the nations inside the euro to agree to play nice never mind those in the EU but outside the euro. At least in the near term, it appears that all central banks have decided to use QE to appreciate assets – particularly housing assets – until the value of the debt against those assets is no long prohibitive. Then, banks can write down their losses and go back to the old pre-Lehman rules of the road. That suggests to us either a sustained period of higher inflation or a long period of very low rates. Neither makes debt instruments particularly palatable. However, rather than expecting rates to rise (as seems to be the consensus) we expect that rates will remain low – because monetary authorities want them so – and that most future financing will be through equity investment (shares or direct ownership.) This argues for greater market concentration and control of capital, like in the 1950s or during the deflationary boom after the Civil War – consistent with a decrease in capital efficiency until the invisible hand balances the current excess supply of capital with (hopefully, growing) demand.