ISM Drops Into Contraction Territory

by: Acting Man

PMI Closing in on "Recession Warning" Levels

It was already clear from the various regional surveys that have been published recently that US manufacturing industries have been weakening (a notable exception was the Chicago PMI, which was such a big outlier that one wonders if there was perhaps a data error). The overall ISM PMI index fell to 49, into contraction territory and recording a multi-year low. The details included fairly sharp declines in new orders (-3.5 to 48.8), order backlogs (-5 to 48) and production (-4.9 to 48.6).

It should be noted that in spite of the fact that all of these are now in indicating contraction, the numbers are not yet signaling a recession. However, if a recession were on its way, then such ISM readings would certainly be a way station. In fact, the current numbers are almost precisely identical to those that were recorded at the beginning of the last recession. The main difference is that last time around, the stock market was already looking somewhat wobbly when the ISM components dropped to similar levels. Note however that the generally accepted view at the time was that there would be no recession although it had already begun - a view that continued to prevail for another 8 or 9 months (!).

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The PMI composite index and the SPX (scale adjusted for easier comparison).

The stock market in fact decided to embark on a rally shortly after the release of the data - presumably on the idea that they ensure that the Fed's money printing will continue unabated (which it likely would have done regardless of the number). This was in contrast to Japan, where news that corporate capital spending declined sharply was greeted with yet another sell-off on Monday (we want to stress again that the data are only incidental - whether the market reacts by rising or falling merely tells us something about market sentiment).

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ISM new orders index.

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ISM production index.

The Importance of the Manufacturing Sector

Since GDP accounting leaves out almost the entire production structure of the economy (except fixed capital goods investment), the idea has taken hold that "consumer spending is 70% of the economy." That is however incorrect. When studying the gross domestic output accounts, it becomes clear that the largest portion of economic activity by far is actually represented by the manufacturing sector. Consumer spending amounts at most to about 35% of total economic activity. As George Reisman once argued, it would be better to call GDP net domestic product, rather than gross domestic product.

The idea of GDP accounting is that all the raw and intermediate type goods that are produced in the early and middle stages of the capital structure are 'contained' in the final goods they help to produce. It should be clear however that this is not only very odd from a mathematical and logical point of view, but also that it creates a wildly distorted view of the economy as a whole. This is not the only problem with GDP. For instance, GDP needs to be adjusted for the devaluation of money - but to do so, one needs to employ price indexes that purport to measure something that is inherently unmeasurable. Moreover, government expenditure is added to GDP, although it certainly doesn't add to our standard of living (Rothbard therefore created the measure private GDP remaining).

We don't want to belabor the point more than is necessary (interested readers can check out George Reisman's paper on the subject or look at this interview of Jeffrey Herbener by Tom Woods for more color and details). The main point we wish to make is that a plethora of production processes are not captured by GDP and most of those can probably be assigned to the category manufacturing. They employ countless people and pay their wages, absorb enormous capital investment, and so forth. If one believes, as GDP accounting indicates, that manufacturing is only 12% of the economy, one is seriously misled about the actual importance of manufacturing to the economy.

The health of the manufacturing sector is therefore of decisive importance to the economy. When we see a sharp deterioration in manufacturing PMI, it is actually quite meaningful. It is amusing that the stock market as a rule reacts far more forcefully to the monthly payrolls report, which is not only a lagging indicator, but has such a large margin of error as to be practically meaningless on the day of its release. However, employment data are of course a declared focus of the Fed, and hence they are also a focus of the market. The quintessential feature of a market economy, the stock market, thus ironically cares more about the perceived future actions of a socialist central planning agency than about the actual state of the economy.

Money Printing has Undermined the Economy

Many observers are prone to arguing that it is a hallmark of the economy's underlying weakness that the data continue to be so dismal in spite of the heavy monetary pumping that is taking place. They rarely stop to consider that the weakness may actually be a result of said monetary pumping.

The confusion stems from the fact that aggregate economic data will often show that an artificial lowering of interest rates and expansion of money and credit from thin air seemingly have positive effects. For example, during the entire housing boom prior to the 2008 crash, aggregate economic statistics suggested that a healthy economic expansion was underway. Today even the densest observers have probably realized that all the investment in residential structures and related spending was a giant waste of scarce capital. And yet, while it took place, very few mainstream economists (and not a single person at the Fed) recognized that something untoward might be happening.

If you think about economic activity a bit, it should be clear that printing money cannot possibly create any wealth. Imagine that instead of the Fed doing the printing, Tony Soprano would be doing it in his cellar. No-one would entertain the absurd idea that he is about to help the economy. It would be immediately clear that he would merely be defrauding someone, by means of appropriating real goods for himself by spending money he has created ex nihilo with his spiffy color copier.

However, when the Fed and/or commercial banks are doing the same thing, the main difference is that when they are doing it, it is not illegal. From a purely economic point of view there is no difference - only the names of those that profit from being the first receivers of the new money are different (it won't be Tony). Such exchanges of nothing (money from thin air) for something (real goods and services) may for a time create the illusion that the economy is reviving - after all there is spending, and that spending is counted by the government's statistics minions. And yet, underneath the activity, the economy becomes structurally weaker the more often this process is repeated. This is so because money as such is only the medium of exchange - it does not really fund economic activity (the process is nicely explained and summarized by Frank Shostak here).

The more often the cycle of monetary inflation repeats, the more likely it becomes that negative effects begin to predominate, as one set of balance sheets in the economy after another ends up ravaged by the boom-bust cycle. At some point then, additional inflation no longer even has a positive effect on macro-economic aggregates; instead, they may begin to mysteriously deteriorate. This is the possibility most observers do not have on their radar when contemplating the weakness of the recovery.

One way of measuring the imbalances in the economy (only a very rough guide to be sure) is to compare the production of capital goods to the production of consumer goods. A too low interest rate will tend to draw investment and factors toward the higher order stages of production, as businessmen will find a lengthening of the production structure profitable - projects that may not have been regarded as profitable at a 3% interest rate may well appear to be so at a 1% rate. However, if the production structure 'ties up' more consumer goods than it releases, an inherently unsustainable situation results.

The process will be reversed during the bust, as the economy adjusts to reality and the production structure is shortened again in reflection of the fact that society-wide time preferences were actually higher than the artificially lowered interest rate indicated (and hence, real savings were smaller and the demand for present consumption greater than assumed). A long term chart of the ratio illustrates this nicely (as an aside, the longer term uptrend of the ratio can be partly explained by the accumulation of capital and the expansion of trade, but the un-anchoring of the monetary system in the early 1970s and the subsequent huge expansion in money and credit no doubt played a major role as well; within the longer term uptrend we can recognize the short term cycles that tend to coincide with the boom-bust cycles induced by Fed policy).

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The ratio of the production of business equipment ('fixed' capital goods) and consumer goods.


It is possible that the manufacturing sector is lately weakening not in spite, but because of the Fed's ministrations. There are certainly other influences that need to be considered as well, such as the recession in Europe and the economic weakness in China and Japan (all of which may however ultimately be traceable to a similar origin). Any sustained deterioration in manufacturing would be a far more serious problem for the economy than the sector's ranking in terms of GDP accounting would indicate.

We would argue that this is further evidence that risks for the stock market and the corporate debt markets are markedly increasing, in spite of the market's benign initial reaction to the data release (it is also strongly recommended not to wait for chairman Bernanke or his fellow monetary bureaucrats to tell us that something might be going wrong).

That said, the historical record shows that similar ISM/PMI data have in the past not always led to recessions. However, we can add this data release to the ever longer list of warning signs.

Charts by Federal Reserve of Saint Louis Research.