What If the Great Depression Analogy Is Wrong? 18 comments
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I say this with no exaggeration: The picture painted by the data flow of the past two weeks is deep into the left tail of any of my reasonable distribution of probable economic outcomes. The die is now cast – fiscal stimulus will be too late to prevent the snowballing that will occur throughout the first half of next year. In this environment, policymaking will become increasingly desperate.
The free fall in economic activity reported by the ISM in both the manufacturing and nonmanufacturing sectors yielded the worst for the labor market. There is no way to candy coat the November employment report. It was simply dismal; downward revisions to the previous month boosted the sense of dread that emanated from the BLS release. And the damage to labor markets appears to be accelerating, with the rise in initial jobless claims last week pointing toward a December job loss of 600k or more. Expectations of rising headline unemployment rates can be tempered only by defections from the labor force; I would not be surprised to see the broad U-6 measure of unemployment coast through 15% before the first quarter is over.
With the labor market in disarray, the Fed will feel compelled to do more, as only they can deliver stimulus in the near term. The FOMC begins a two day meeting tomorrow, with a further 50bp of rate cutting almost certain. Also almost certain is that no one believes that the last 100bp has much stimulative power to offer. The rate cut itself, thus, is largely irrelevant. What is relevant is the statement – will the Fed more explicitly define their apparent policy of quantitative easing? Federal Reserve Chairman Ben Bernanke’s recent speech set up expectations that such a shift was coming. Failure to follow through would be yet another communication failure.
I am torn on the wisdom of this move. On one hand, using the Great Depression as a guide, the appropriate policy direction appears clear – flood the markets with liquidity, coupled with massive fiscal stimulus. This is the track the policy train is on. I completely understand this policy in a closed economy suffering from insufficient demand relative to supply. But when faced with a large open economy with a substantial current account deficit, the back of my mind screams “caution.” It is an itch I can’t scratch.
In my view, policymakers tend to see the current account deficit as almost an unimportant residual, something that just falls out of the global economy, but tells you little about the economy itself. I tend to view it as representing a fundamental imbalance. I believed that as part of the adjustment of the past year, a combination of import compression and export expansion would eliminate the imbalance, and that the appropriate role of policy was to facilitate and cushion that imbalance.
In nominal terms, high oil prices in the first half of the year stalled that adjustment and forced an intensification of import compression by undermining consumer spending. This triggered a more intense adjustment than I would prefer (obviously), but I could see that the expected improvement of the current account deficit would provide room for aggressive policy response. This was especially the case given collapsing oil prices. And if domestic saving rose enough as households and firms restrained spending, the federal government could have a very significant gap to fill.
But then a funny thing happened…global trade appears to be collapsing, undermining US exports and leaving the nominal current account deficit stable, meaning that the US still remains very dependent on capital inflows. Brad Setser scared me straight last week on this topic:
The US trade data surprised on the downside — and while it is far too soon for the dollar’s recent rise to really have an impact on the trade data, the rise in the deficit perhaps did remind the market that over time a rising dollar would tend to maintain the still large trade deficit not bring it down. Macro Man was far more surprised by the rise in the non-oil deficit than I was; it was always going to be race down between imports and exports.
Simply a race down, or a race to the bottom? My challenge is that lacking an adjustment of the external imbalance, I can easily see that the current policy path becomes a dead end. Emphasis on “dead.” Yves Smith lays out an alternative scenario that reminded me of old concerns:
Now to my doubts about the proposed remedies, namely monster stimulus and monetary easing. First, as mentioned before, the analogy is to the US in the Depression, which we have said repeatedly before is questionable. The US in the 1920s was the world's biggest creditor, exporter, and manufacturer. Our position then is analogous to China's now. Indeed, Keynes in the 1930s urged America to take even more aggressive measures, and argued that it was not reasonable for the US to expect over-consuming, debt-burdened countries like the UK and France to take up the demand slack. So even though most economists are invoking Keynes, it isn't clear he'd prescribe such aggressive stimulus for the US and UK now.
If Yves is correct, the coming massive US policy response is a desperate attempt to maintain a global economic structure that is fundamentally broken. This is a story I have long championed, but, in recent months, one I was willing to discount given my expectations of an improvement in the current account. Indeed, this seemed consistent with the strengthening of the dollar. But recent trade data suggests I may have become too complacent with regards to the external dynamic.
The threat, of course, is that the Fed and Treasury are setting the stage for a disorderly adjustment of the dollar by ignoring the imbalance. Without the external adjustment in place, pushing rates to zero, flooding the economy with money, and pumping out hundreds of billions of new debt threatens to pull the rug out from under the dollar. Even more worrisome, however, is that surplus nations respond with competitive depreciations as they also seek to maintain the fundamental imbalance. We all race to the bottom together.
The recent stability of the US dollar has almost certainly put to rest any worries on the part of policymakers. But it is looking like the dollar has peaked. From Bloomberg:
Speculation that the dollar has peaked gained steam last week as the currency plunged 4.9 percent against the euro to $1.3369, its biggest drop since Europe’s common currency was created in 1999. It weakened 1.75 percent versus the yen.
“We’re at a turning point in terms of dollar dynamics,” said Jens Nordvig, a New York-based strategist at Goldman Sachs (GS), the biggest U.S. securities firm to convert to a bank. “The dollar shortage has been addressed and we’ll see people start to focus on other things and those are all dollar negative.”
With delivering induced flight to quality largely complete, the stage is set for underlying factors to come into play. And those factors do not appear to be supportive of dollar denominated assets. One would think that near zero rates would stem the allure of the dollar (one would also think that domestic savers rethink keeping their money anywhere but a safe deposit box). Indeed, that appears to be the case versus the yen.
But to be a real dollar rout, we would expect to see Treasuries come under severe pressure, which has not exactly been a recent trend. So perhaps there really is nothing to fear. Indeed, I have argued that if the stimulus is too excessive, that excess should reveal itself in the Treasury market, and policymakers can simply back off. No problem – ease away. Build those bridges.
This assumes that policymakers back off. What if rising Treasury rates encourage the Fed to double down, expanding quantitative easing to hold rates low and stimulative. What if years of research on the Great Depression have left even the best and the brightest with tunnel vision such that they could not accept that they were wrong?
Bottom Line: The Fed is headed to the zero mark, with another 50bp almost certain this week. It is widely expected that they will give some guidance as to their next steps, pointing us in the direction of an explicit policy of quantitative easing. Fed policy, as well as fiscal policy, assumes that the Great Depression is the most accurate analogy. This assumption ignores the external position of the US, which stubbornly refuses to adjust. If that failure to adjust is relevant, then recent dollar stability was simply a head-fake.
We should see pressure on the dollar and, ultimately, Treasuries. Policymakers could adjust, but would they? With pursuit of the Great Depression case as the baseline scenario, it seems prudent to keep in mind the risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility.
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This article has 18 comments:
If you were a sales manager would you tell you sales people to go out there and tell their prospects the economy is going to get worse.
What the Fed should do is RAISED the Fed Fund Rate, considering that virtually zero rates have had no positive economic income, and tell the world that everything is great in the U.S. It may not be true but it will cause no harm.
IMHO, the new administration (which i did not vote for) is trying to heal one of the contagions in effect at present: investor confidence (IC). Since there is a high probability of the economy getting worse, the last thing IC needs right now is for more Kool-Aide talk. Do you really think that telling them the worst is over, go buy 'stuff', is the correct road to recovery? Do you really think that will cause no harm? wow.
All the world's ideologues think they can make their hyperinflation bets come right in the end after all, if they just screech loud enough that it is all some con. Well, boys and girls, they are epicly wrong and busted. Fact.
As a Brazilian whether 2.5% in dollars sounds like a good return.
The US economy bottomed in *May*, measured in Euros.
The personal savings rate has already risen to over 5%. It might go as far again in a single quarter. Companies are reporting losses, many of them non-cash, while forcing an epic cash flow in their favor from loan runoffs and stimulus actions received.
The balance sheet of all US sectors other than government are improving dramatically and nothing can stop that process from completing itself and having its natural effect.
Final demand hasn't dropped at all yet, in nominal terms. In 6-9 months when all the balance sheet repair has happened and the stimulus fuel remains lying around, it will pop upward.
And it will be real. Not a mere currency adjustment.
Until everyone gets the inflationary brainstorm out of their system, they will continue to be ground to atoms. Lots of money will be made in corporate loans and in equities, none of it by betting that the dollar goes to zero.
The Fed held M1 *constant* for 3 straight years, spring 2005 to spring 2008. Currencies willing to do that, and take this kind of epic asset-smash pain, do *not* go to zero, they are *not* soft currencies.
Policymaking will BECOME desperate? What would you call what has already happened, if not desperate? And I disagree that the fiscal stimulus will be too late...it won't work...but not because it was too late...but because it was the WRONG stimulus. Pouring bailout cash into the banks and picking winners...often shoring up unwise and foolish companies at the expense of those of us who have been prudent and wise...at taxpayer expense...will not save anything, EVER...neither late nor early...but NEVER. Wrong policies hurt, not help...no matter when implemented.
What was needed was to let what was rotten fail; and to have across the board, large, tax cuts to both corporations and individuals -- with the effect of stimulating both businesses and allowing personal balance sheets to be cleaned up with the additional cash flow that we'd be allowed to keep (our OWN money, after all!)
We're still sinking...and that's the ONE measure that has not yet been tried. Why? It is the one measure that allows RELINQUISHMENT of CONTROL AND POWER from the Government back to the People. That was at the heart of the problem (e.g. socialist housing --> subprime meltdown; excessive and onerous tax code --> high first hurdle for capital for biz and personal use & entrepreneurship).
We in Europe have been disagreeing with the US policy and way of doing business since many years, but always are being told that we are to stupid to understand big business.
( in fact we stupid Austrians have some historical knowledge of greed combined with capitalism - study the Vienna economic school - en.wikipedia.org/wiki/... )
If now is not the time to tell the people of the US the the ship is going down when is it?
If you where a true democracy and not a major corrupt military system, the people would have known about their situation some time ago, and maybe, maybe people in the states would not have been to arrogant and wreck less.
Do it now, and this time please, do it good. We have been through it !!!
On Dec 15 01:39 PM PrudentMan, CFA wrote:
I believe we are experiencing the consequences of a certain culture of hyper-consumerism, which is playing itself out, at the same time that we are making very significant moves from the manufacturing to the knowledge economy, experiencing incredible volatility with the world's most vital commodities including food and fuel, living in a truly global economy, and doing it all in a world where communications (and the creation of new structures of "communities") is full time and real time and spans geography, time and language and the media is no longer owned.
If my premise is correct, the changes that we are about to see will be cultural and political in nature as well as economic. I have been writing about this from my perspective with about 40 years of experience in the communications business at deathoftime.com.
I believe we can see an important initial sign: the bifurcation of the communications industry. Messages that say "buy this" have dominated the American consciousness since the post WW II expansion. We are beginning to see the greater emergence of messages that say "support this." The hyper-consumer society is about to be moderated by a surge in "supporterism." Watch your TVs and all other messages that are getting to you. You can see this trend for yourself. This is an important cultural sign.
Politically, we are also seeing other major changes, including the phenomenon of capitalists throughout the world applauding -- urging-on -- more involvement by the state. The process of Hegelian shifts is not confined between a Tuesday and a Thursday, but takes generations. Moves are usually subtle. But I think we have just seen a pretty big benchmark in the process.
For those worried about hyperinflation, the interesting period to study is not the depression, but the successful post-WW2 adjustment of money supply and velocity and the reprivatization of industry. It is crucial that this transition is done right in order to avoid hyperinflation. Hopefully Mr. Bernake studied this period as well as he studied the depression.
As for arguments that wars are automatically good for the economy because the depression ended after WW2 and the mild recession of the early 90's ended after the Gulf War, hopefully the Iraq debacle will be the end of that.
On Dec 15 08:14 PM dw57 wrote:
> I wonder about some of these folks who say we are doing the wrong
> thing. like what would they have us do? Nothing. that has been tried
> right before that last great depression. and we saw what that got
> us. 10 years of disastrous economy. and we even tried to balance
> the budget in the middle of it, and fell back and it then took WW2
> to right every thing back up again. so doing nothing has been a proven
> failure. doing some thing works but you do have to make sure the
> economy has really turned before dialing back. so far i have seen
> nothing from the business leaders that will address the problem.
> it has all been window dressing with no effect other than being good
> PR.
> jack
We need to recognize that:
* The export of heavy industry from the U.S. to other nations is a key factor in the present trade imbalance, and in the terminal dependency upon monetary manipulation and, more benignly, the service economy, which are dysfunctional and unsustainable, respectively.
* A large part of what remains of U.S. industry is dedicated to military production, which is a net negative for the real economy, and that dependence upon the external projection of power has destroyed the integrity of the U.S. economy, while building a fifth column in the form of a military-industrial complex that tends to lock the U.S. in to this destabilizing policy.
* Other centers of power have emerged as the internal decay of the U.S. through militarism and other corruption has undermined U.S. economic power and military alliances.
We need some truly creative ways of addressing these problems, such as:
* Making deals with nations with net surplus reserves that have grown tired of financing U.S. overspending, to obtain additional investment in exchange for the U.S. (and its clients) drawing back from present aggressive policies, and also by using these funds for a massive conversion of the military industry to civilian productive purposes (e.g., green technology) that the world needs and that can therefore ultimately correct the trade imbalance.
* Cutting the military budget and using the proceeds for part of the required stimulus.
* Including as part of the stimulus package Federal grants for worker-run cooperatives to take over idled manufacturing facilities, as happened during the recent Argentinian crisis.
* Putting zombie banks out of their misery and dealing with the chain reaction of failures by replacing these failed institutions with direct public investment, instead of pouring TARP funds down a bottomless pit of financial chicanery.
* Tight regulation of what remains of the financial sector.
Can we do it? It comes down to our will to survive.
We need to recognize that:
* The export of heavy industry from the U.S. to other nations is a key factor in the present trade imbalance, and in the terminal dependency upon monetary manipulation and, more benignly, the service economy, which are dysfunctional and unsustainable, respectively.
* A large part of what remains of U.S. industry is dedicated to military production, which is a net negative for the real economy, and that dependence upon the external projection of power has destroyed the integrity of the U.S. economy, while building a fifth column in the form of a military-industrial complex that tends to lock the U.S. in to this destabilizing policy.
* Other centers of power have emerged as the internal decay of the U.S. through militarism and other corruption has undermined U.S. economic power and military alliances.
We need some truly creative ways of addressing these problems, such as:
* Making deals with nations with net surplus reserves that have grown tired of financing U.S. overspending, to obtain additional investment in exchange for the U.S. (and its clients) drawing back from present aggressive policies, and also by using these funds for a massive conversion of the military industry to civilian productive purposes (e.g., green technology) that the world needs and that can therefore ultimately correct the trade imbalance.
* Cutting the military budget and using the proceeds for part of the required stimulus.
* Including as part of the stimulus package Federal grants for worker-run cooperatives to take over idled manufacturing facilities, as happened during the recent Argentinian crisis.
* Putting zombie banks out of their misery and dealing with the chain reaction of failures by replacing these failed institutions with direct public investment, instead of pouring TARP funds down a bottomless pit of financial chicanery.
* Tight regulation of what remains of the financial sector.
Can we do it? It comes down to our will to survive.