If a Boom Is Coming, Will a Bust Follow?

Back in February, I asked you if we were experiencing a recession or depression. A plurality said it was a depression with a small ’d.’ I agreed and went on to explain why. Since then, things have changed and we seem to be on the verge of what I call a technical recovery (or a fake recovery – take your pick). We may even be on the verge of a multi-year economic expansion – something bears like David Rosenberg should not rule out. But vigilance is still required. I will explain why.

Since the recovery talk has gathered steam, a lot of well-respected economists and policy makers have begun to construct what I consider a revisionist history of events. It goes something like this:

We have just experienced a major economic downturn. Coupled with a financial panic of major proportions, the global economy suffered a severe shock. However, we have learnt how to deal with such crises due to our experiences during the Great Depression. The liquidity crisis was overcome through deft monetary policy. And fiscal expansionary policy aided a return to business as usual much sooner than many would have believed.

As a result, it is quite obvious we have been through a severe contraction, but nothing more than a garden-variety recession complicated – of course – by a financial panic. Back in February, a lot of economists made alarmist predictions of woe, foretelling a global Depression. This was wrong-headed and reckless as we see today. GDP has likely turned up in this third quarter and will continue rising for the foreseeable future. With the worst of things behind us, we can normalize monetary and fiscal policy and return to a more robust economic path.

On the surface, this narrative is compelling. But, I believe it is based on a flawed analysis. I would like to present a different narrative here for you to dissect.

GDP is a poor measure of growth

As Joseph Stiglitz recently wrote, GDP is a very poor measure of growth and economic health. And he is right. There are many questions of statistical accuracy in its measurement. But, more than quantity, I have problems with GDP as a measure because of quality. Robust 4% growth that is underpinned by savings and capital investment is not the same as robust 4% growth underpinned by debt and consumption.

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings. As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsdayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe. Knowing this shapes the psychology of economic forecasting and is why missing the turn is disastrous for one’s career. Efforts to avoid missing the turn are also part of a very large pro-cyclical psychological force underpinning a cyclical bull market.

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Marc Faber: “Don’t underestimate the power of printing money”

You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, “Don’t underestimate the power of printing money.” This quote has stuck with me as asset markets have soared in the intervening time. What Faber was alluding to was the fact that printing money works. It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China. Are you telling me stimulus is not working? It most certainly is.

In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. it is doing just that. In response to a Spanish-language article on just this topic, I wrote in today’s links:

Europeans are abandoning savings accounts in favour of riskier assets as low interest rates have created a liquidity-seeking-return dynamic. This is true as much in the US as it is in Europe and it proves that a wall of liquidity can induce a cyclical recovery based on asset price inflation aka the fake recovery. The question is what comes next?

Liquidity is seeking return. It is pure speculation whether the upturn that underpins this dynamic has legs. I see an even chance that it does, which is why, despite my recent mild bearishness, I am a lot more upbeat about the economy and markets than a lot of others in the blogosphere.

So where does that leave us?

The outlook is unclear. The Obama Administration looks ready to take a victory lap judging from recent statements. Officials say they are also withdrawing liquidity in anticipation of an upturn in the economy (though some believe these claims exaggerated). So, that is the one side – which Goldman’s Jim O’Neill takes.

On the other side of the argument is the fact that employment is still weak and incomes are down – the most since the Great Depression. After a decade with no income gains and still weak employment prospects, the ability of households to refuel a debt-induced upturn seems limited – as the recent data on consumer credit demonstrates. This is the side that David Rosenberg takes.

I take neither side. I am just not that clairvoyant. Both scenarios are plausible outcomes. But, I am still very worried about the low quality of any growth we will get in an upturn and the widening gulf of economic fortunes that result. I am equally worried about how even a low quality upturn will sap the will for reform in the financial arena. Mostly, I am worried that the eventual collapse – if it doesn’t happen now – will be much worse when it does happen.

Background

Please listen to the half-hour audio clip with Marc Faber from yesterday. He does an excellent job of giving voice to some of the ideas I just laid out in his usual semi-apocalyptic style. The clip comes via Bloomberg’s On the Economy podcast, a show I recommend highly. Click here for the show’s webpage and instructions on how to listen to broadcasts.

(mp3 Audio embedded below)

Comments

[Graham and Dodd Investor]

There is no basis for a boom, meaning that if one is manufactured artificially, a bust is going to follow.

2009 Sep 11 03:10 PM

[Fighting Yoda]

Ponzi schemes work but only for so long, bubbles also can grow very large but they all, without exception, always burst. It would not be different this time. Lot of people continue to have faith in the market - 'markets are right - they are telling something', when they fully well know markets are always wrong. In the current episode the markets were at all time high 2 months before the biggest recession since the great depression. So much for market signals and wisdom

Wall Street is simply capable of extraordinary delusions, euphoria and panics.

With Fed printing and stimulus etc - the pain of the crisis is being cushioned - but no problem is getting solved. More debt is being accumulated, foreclosures and delinquencies keep soaring, of course there is no end to job losses. The confidence game that the Govt is trying to play will ultimately fail - with terrible consequences - debt will have to be repaid with much higher taxes and/or huge inflation.

2009 Sep 11 03:15 PM

[Pat C]

Very well written. I just don't think monetary policy and the financial sector is going to be able to mask this horrible employment and lack of meaningful investment and productivity. I'm not optimistic.

2009 Sep 11 07:00 PM

[Roger Knights]

"As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth."

This dichotomy of underlying rot and superficial health is what I alluded to a few days back in my comment, "Lookin' good, Dorian Grey. (How's that portrait doin'?"

2009 Sep 11 08:14 PM

[Nick36]

So far the boom has been in stocks and some commodity prices and not in the real economy.

Consumer spending is still down a lot from last year, the unemployment is up a lot. Company earnings are lot lower than they were last year. And foreclosures and defaults are still going at full speed even more than before.

This doesn't look like an economic boom to me. It's more like a speculative boom and not an economic boom. And speculative booms seem to happen every year nowdays.

In 2007, the stock market soared to record highs in October after the sub-prime housing disaster started in the summer. In 2008, oil and commodity prices soared despite a deepening recession in USA and continuing financial crisis. And this year the stock market has soared again despite soaring unemployment and poor company earnings in terms of the reported P/E ratios.

The last too times such speculation ended in a bad way for many of those who bought the optimistic story. And it's hard to see how the present speculative bubble is going to end any differently.

Many investors are now pretending that there is an economic recovery when there isn't one. And sooner or later the reality will become obvious to them. Nobody can ignore the reality forever.

Perhaps China is good at cooking its books. They book an increase in GDP as soon as their banks loan out the money as ordered by their government. But whether that money goes into speculation in real estate, commodities, and the stock market or into the real economy their GDP doesn't say.

Just because a lot of people are saying that the economy is recovering doesn't mean that it's true. You have to look and judge for yourself. Or else you will end up joining the herd in the speculative bubbles and running together with the herd off the cliff every time the bubble bursts.

2009 Sep 12 10:41 AM

[Jimbo]

Mr. Harrison's views make sense to me. The government seems to be trying to freeze the ball, hoping that somehow, someway, a new dawn will appear. We don't seem to have the political will to tackle the fundamental flaws in the system.

2009 Sep 12 10:44 AM

[Asbytec]

Good points, one and all...

2009 Sep 12 11:03 AM

[E Nuff Sed]

Well written. It is trite wisdom that boom is inevitably followed by a bust. We are still in a secular bear market which started in 2000 and may well last till the middle of the next decade (secular cycles are around 16 years).

However cyclical bull and bear markets within a secular trend come and go with the waning and waxing of investor's animal spirits. Most of the capital gains come with expansion of P/E ratio's as risk appetite increases and vice versa.

The difficult trick is to get out when everyone is getting in - but not get out too soon. I think we are good for the next couple of years and we can expect 15% growth p.a. The next crisis will come in 2012 - 2013 (presidential cycle). I hope I have the guts to get out by then.

"Moreover, it is good business to take chances when the possible
profit is big enough. The top is never in sight when the vision is vitiated by hope. The average man sees a stock that nobody wanted at twelve dollars or fourteen dollars a share suddenly advance to thirty which surely is the top until it rises to fifty. That is
absolutely the end of the rise. Then it goes to sixty; to seventy; to seventy-five. It then becomes a certainty that this stock, which a few weeks ago was selling for less than fifteen, can't go any higher. But it goes to eighty; and to eighty-five. Whereupon the
average man, who never thinks of values but of prices, and is not governed in his actions by conditions but by fears, takes the easiest way he stops thinking that there must be a limit to the advances. That is why those outsiders who are wise enough not to buy at the top make up for it by not taking profits. The big money in booms is always made first by the public on paper. And it remains on paper."
from - Reminiscences of a Stock Operator

2009 Sep 12 11:18 AM

[RickRussellTX]

It's refreshing to see a cogent analysis that doesn't beat the neo-Keynesian drum of spend, consume, debt over and over again.

2009 Sep 12 11:20 AM

[bluesky123]

Thanks to the author for his excellent observations on the huge difference between high quality growth vs. low quality growth. I listened to the Marc Faber interview twice and thought it to be a very important interview. The disturbing observation is that Bernanke believes EVERY recession can be avoided by printing money and that nobody in the Fed ever speaks or writes about the destabilizing influence of too much debt (this includes Greenspan). This aspect of the Feb is a very important point.

So we have the tech market crash in 2001. What did the Fed do in the aftermath? Flood the system with liquidity, and drop the interest rates to zero (just like today). What happened? There was the housing market bubble, the refi bubble, the asset bubble of all types and that set us up perfectly for the crash we're in right now. How is the Fed tackling this downturn? By doing the same thing all over again. We keep solving asset bubbles by creating more assets bubbles. Some other notable points that Marc Faber mentions:

1) US debt = 375% of GDP not including the $59billion in unfunded Medicare and Medicaid liabilities

2) There is less employment in the US today than in 1999 even though the population has grown by 30m people in the meantime

3) In the Hong Kong property crash of 1997, property prices dropped 70% (and people are calling the US housing market at a "bottom" when 2/3 of the homes which have already been foreclosed upon have deliberately not been put by the banks on to the market)

4) He mentions Asian companies which by and large have either no debt or negligible debt and are financing their activities from cash flow. If the cash flow is not there, they wait until it is there before embarking on the next capital project. Compare that to US leverage.

5) Faber mentions a very important point which is that we in the US constantly seek to solve recessionary problems through Fed measures to boost consumption - consumer tax rebates, cash for clunkers etc. We do not invest enough in our infrastructure, R&D etc. As he says, if you use up the country's money to prop up consumer consumption, you eat the piece of cake and at the end of the day have nothing.

I found the interview to be very enlightening. My thanks to the author for providing the weblink.

2009 Sep 12 11:27 AM

[Dave Wrixon]

You already had your boom.

The bust has been delayed but the chances are that it is going to be much deeper than it would have been, due to clueless intervention from the Obama administration. Cash for Clunkers was this biggest fiasco of all.

Hitting China with this stupid tax of tires when they are only competing with other imports may be the final folly. If China decides to take revenge then a Dollar crisis may well ensue which will suck the US Economy into a Black Hole.

2009 Sep 12 12:30 PM

[jimboy]

Great article. Even fake recoveries can have legs and look pretty good for a long time. But for the really indebted countries you have singled out (UK, US, Spain and Ireland) no amount of monetary and fiscal boosting will be enough to paper over all the cracks. Another lurch down in 2010.

2009 Sep 12 01:19 PM

[Jim in Virginia]

I think that until we start seeing job growth we will have to rely on the crystal ball. If the health care bill passes, how many employers will elect to drop their support for health care coverage in favor of the cheaper 8% penalty? How many employers will elect to purchase automation which is subsidized by the government in tax law rather than rehire the old employees back under as yet unknown penalties? What effect will the cap and tax bill have on job growth. I think in some situations there are just too many varibles to make a good judgment call.

2009 Sep 12 03:56 PM

[Kimball Corson]

"If a Boom is Coming, Will a Bust Follow?"

Does night follow day? The only question is timing.

2009 Sep 12 04:43 PM

[max12345]

I think it's a very good article but I didn't see anything mentioned in it about global warming and climate change. (the next major world crisis coming up in just a few more years)

Though the number of dramatic examples of climate change from all over the globe is getting larger and their impact more significant by the day, the bulk of the world seems still to be in denial. (or in some form or another of "I couldn't care less-'ism' " because "I am far too busy making money")

There will be yet another big global conference about this issue (of ever more hot air) this December in Copenhagen featuring the usual even bigger doses of "hot air" . That is, the most likely outcome of that meeting will be more of the four D's. (denial, deception, dissembling and delaying) Perhaps with some minor shift in emphasis this time towards some of the latter "D's";
(the final three of which I had omitted so as not to appear to be "too pessimistic".....i.e. Disaster, Destruction and Death)

And this since "the political economy" of the issue (both nationally and globally) is such that we obviously "just can't" do anything about it. (much better instead to destroy the planet's assorted delicate balances irreversibly....while at the same time of course leveraging, selling short, buying long, and buying up and down tons of derivatives....and derivatives of derivatives... and (authentic) "default" swaps... on gold and all other commodities.... including also on the planet as a whole)

But it should be very clear to anyone who is also a physical scientist (and not only one or another of the abundant so called "social scientists") (which of course includes economists) that reverting to "3% economic growth forever" simply will not work on a planet with limited resources and limited "environmental sinks".
Isn't it time to start to think seriously and long and deep and wide about what to do about this? Maybe we need a different world "economic development" model than the current one?

At some point "physics" is going to force humanity to listen. Though of course by then it will very likely be too late; and the price to pay next time will undoubtedly dwarf the few trillions that this last debacle cost.

I see remarkably little being written on "Seeking Alpha" about this next major world crisis and "hot topic". (even if only about its impacts on the global economy and the financial markets) A crisis which -if not properly addressed- and it almost surely will NOT be- is going to make the current one look like child's play.

Fasten your seat belts folks -and in particular all of you Alpha Seekers out there-....somewhere, somehow there probably still will be LOTS OF MONEY to be made!

And may all the loonie "tree huggers" and Oracles of Doom and Cassandras out there like me move to Mars if they don't like it here on Planet Earth. ...(or better yet, may they all go to burn in hell) (instead of here)

2009 Sep 13 03:52 AM

[buyitcheap]

I think the post above has a point, specifically related to the economic impact of global warming policies that are being implemented, cap and trade, etc. That will be felt far more quickly than the whole "warming thing" (and isn't it a dry heat anyway? Is that so bad?)

2009 Sep 15 07:50 AM