Seeking Alpha
Research analyst, macro, deep value
Profile| Send Message|
( followers)  

The thesis of this new economic paradigm discussion is that our rapidly evolving world is rendering a large percentage of our work force population obsolete. The question we seek to answer is the economic impact of this paradigm shift.

There are two subsets to the discussion:

  1. Can we determine if fiscal and monetary policy are dealing effectively with this new paradigm?
  2. Can we propose an effective monetary and fiscal policy solution going forward?

The assumption is that in the high tech, robotic world we are evolving into it is going to be increasingly difficult for the unskilled or those with obsolete skills to find employment. The hard truth is that we may not need as many workers in today's world. Computers are taking over and doing tasks that heretofore people did and computers are both better at these tasks and more cost effective.

The economic consequence of this shift will take a huge toll on global economies as it becomes more apparent that we don't have the fiscal or monetary tools to deal with the matter. The truth is we have implemented unprecedented fiscal and monetary stimulus measures in an effort to bring unemployment down over the last 4 years and to no avail.

We will use the U.S. as an example of this phenomenon. Our current unemployment rate is 8.3% but that number is a distortion of reality. It reports those currently out of work and looking for employment. U6 employment numbers measure a broader segment of the population.

It includes a more transient group of people who are out of work and not looking; out of work and looking; and employed part time or in work well under their qualification level. U6 unemployment as of April, 2012 was 14.5%.

John Williams, author of the book "Shadow Government Statistics," estimates that as of January, 2012 the real unemployment rate after adding in long term discouraged workers who are no longer seeking employment to the Bureau of Labor Statistics U6 number leaves us with a number of 22.5%.

By comparison the depression era unemployment rate peaked at 24.7% in 1933. If we are to accept William's number and measure depression by unemployment numbers only, we are currently in a depression now. We don't define depression by unemployment data though. In the U.S the term depression is not specifically defined. The following excerpt from the online encyclopedia Wikipedia states:

In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions. Generally, periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology (potential output).

If we use the definition of depression as "periods marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology," then we are in a depression now as the underutilization of resources, i.e., labor force, is on a scale that is equal to the period in our history that no one disputes as a depression - the Great Depression of the 30s.

Unemployment's impact on economic growth

The chart below shows the persistent nature of our unemployment problem since the 2008-2009 recession:

U6 unemployment Rate

U6 Unemployment

Unemployment using the U6 figure has remained above 150% of the 2008 levels for 4 years despite massive monetary and fiscal stimulus. It seems logical to assume the displacement of workers has more to do with the new economic paradigm than the slow growth economy.

One can effectively argue that Federal Reserve policy has been modestly effective up to this point. It is hard to be too critical of fiscal policy as well. A combination of dramatically expanded government spending to extend entitlements has managed to support GDP since the recession officially ended in the 3rd quarter of 2009.

The chart below uses the 1st quarter of 2008 as a base year and calculates the percentage change from the base for each of 5 separate economic metrics. The increase in Fed assets starting with QE1 is in excess of 300% - a massive effort at stimulus to induce monetary expansion and job growth.

Following close behind is the 50% growth in our national debt. Notwithstanding the combination of quantative easing and fiscal stimulus of such dramatic proportions, unemployment remains at 150% of pre-recession levels.

Only the S&P 500 is trending in the direction we would like to see and that trend is unsustainable without job growth. John Maynard Keynes observed that markets can act irrational longer than many investors can remain solvent and that seems to be the case here.

5 Economic Metrics Reflected as a % of Base Yr 2008

To suggest that monetary or fiscal policy has solved the problem would be deceptive. On the other hand, as Ben Bernanke states, Fed policy has certainly mitigated the damage caused by the bank crisis. For the moment at least it is also reasonable to say that the fiscal policy that extended and increased entitlement spending aided in the trends reflected above.

Since GDP growth drives employment the rather flat performance in GDP growth also poses a serious problem going forward. There is very little reason to assume that companies will increase hiring absent an increase in demand. In fact we are not sure that companies will increase hiring even if GDP were to accelerate to the upside. It is entirely possible that the work force currently in place is not operating at full capacity.

As Bernanke stated to Darrell Issa, Fed actions to date have managed to "forestall deflation". The truth is that is all that has been accomplished. His use of the word "forestall" seems appropriate considering the facts and seems to strongly imply that avoidance of a deflationary spiral through Fed action is only temporary.

Fiscal and monetary policy going forward

So what should we do going forward? The looming fiscal cliff issue sets up this discussion. The Congressional Budget Office Report released August 22, 2012 provides two scenarios for consideration. The first is that Congress does not deal with the fiscal cliff and allows spending cuts to go into effect and tax increases to kick in. The second scenario is that the tax cuts are extended and the spending cuts are deferred.

Under the first scenario we go back into a recession with GDP contracting by .5% from the 4th quarter of 2012 to the 4th quarter of 2013. Unemployment will move back to 9% if we are to accept the CBO's conclusions and the budget deficit will shrink by approximately $500 billion.

Under the second scenario the budget deficit would be $1 trillion in 2013 and GDP would expand by 1.7%. Unemployment under this scenario would be 8% at the end of 2013 but these unemployment levels would only be sustainable with a continuation of two very disconcerting trends -the first being a continuation of massive deficit spending and the second would be substantial additions to the national debt.

Looking forward under the first scenario GDP growth would average 4.3% from 2014 through 2017 according to the CBO. Unemployment at the end of 2017 would be 5.7%. The CBO states that the second scenario, although reflecting a modest positive effect in the short run is fully unsustainable in the long run. The following statement appears at the end of the report on the CBO website:

Ultimately, the policies assumed in the alternative fiscal scenario would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective.

It's clear where the CBO stands on the matter. As far as the CBO is concerned the only viable solution is to simply go over the fiscal cliff. Given the 2 scenarios they outline it is hard to argue that they aren't right. Of course this is predicated on their conclusions being correct.

The consequence of going over the fiscal cliff could be much worse. The CBO states that the budget deficit will shrink by $500 billion and that GDP will contract by .5%. The deficit reduction will be the result of increased tax revenues and reduced spending. Those tax dollars are coming out of the economy and therefore are dollars that will not be spent boosting GDP. Likewise, the spending cuts are monies that will not flow into the economy and therefore will not boost GDP. The total $500 billion represents approximately 3% of GDP, not .5%.

If GDP contraction were to hit 3% in 2013 it is not likely that unemployment would stabilize at 9%. Companies fighting to maintain profitability will be forced to search out more ways to cut costs to maintain profit margins. Certain corporate costs are fixed - for example plant and equipment costs. The area where cost cutting would likely occur would be in the area of employee costs. Affordable Care Act costs will also be a game changer in that the added burden to companies will give them further incentive to reduce payrolls.

Then there is the issue of deflation. Ben Bernanke's concerns over the possibility of a deflationary spiral are real and justified. If deflation were to surface and become an economic reality further GDP contraction would occur as a result of falling prices. GDP growth from 2008 through the 2nd quarter of 2012 can be fully accounted for by inflation. Absent inflation GDP growth would be virtually flat for the period. A look at the current inflation trend is particularly disturbing.

Inflation

Bernanke rightfully states in numerous communications that deflation was and remains a real threat to the economy. His response to Chairman of the House Oversight Committe Darrell Issa's letter of August 1, 2012 mentioned his concern about deflation in his answers to Issa's questions 2, 3 and 4. Bernanke also expressed concern about deflation in his Jackson Hole Speech last week. A deflationary spiral is a real and legitimate threat.

A deflationary spiral is the worst of all possible scenarios in that it feeds on itself making the situation progressively worse as companies attempt to respond to falling sales with cost cuts. The majority of those cost cuts in dollar terms will be payroll cuts that simply exacerbate the problem.

Generally speaking politicians, central bankers and government economists don't release worst case scenarios. It would be wholly irresponsible of them to do so and risk inciting panic. Assuming that we are being fed a steady dose of half truths and the magnitude of the problem is even more severe than we are being led to believe investors should be taking a particularly cautious stance.

A double dip recession seems a certainty. The risk/reward in stocks is just not very attractive when one considers the upside potential relative to the downside risk. We are within a stone's throw of post recession highs and in many stocks at all time highs and the headwinds we are facing are not going to be resolved with more stimulus. The problem is rooted in the persistently stubborn lack of job growth.

From a macro perspective GDP can't grow absent a build up of the consumer pool through the creation of new jobs and new jobs will not increase in a contracting economy.

Conclusions

There is really nothing further that the Fed can do but the perception that they may do something is serving the purpose for now. Markets are moving solely on rhetoric and promises of future action.

On the other hand private investors are buying intermediate and long term bonds assuming they are front running QE 3. The facts are they are accomplishing for Bernanke what he would be trying to accomplish with Fed action if QE 3 became reality and that is to put downward pressure on the long end of the yield curve.

As far as bank liquidity, the system liquidity already in place is severely underutilized at the present. Making asset purchases to inject liquidity into the banking system is like trying to add water to a glass that is already full to the brim. If I am not thirsty I am not going to take a drink even if you fill the glass to overflow. Banks are reluctant to lend and borrowers are just as reluctant. Without a net positive gain in bank loans money supply doesn't expand. (See QE3 is no substitute for leadership vacuum).

Bernanke knows these things and is going to stand pat for the balance of the year. QE3 has a really weak risk/reward. The Fed has almost nothing to gain and everything to lose by more QE.

It is a foregone conclusion that we are going off the fiscal cliff. The CBO has assumed responsibility for that decision with their recommendation. Beyond that, each side can blame the other as we fall off the fiscal cliff and into recession.

Two questions were posed at the start of this article:

  1. Can we determine if fiscal and monetary policy are dealing effectively with this new paradigm?
  2. Can we propose an effective monetary and fiscal policy solution going forward?

The evidence seems compelling and the answer is no to both questions. Neither monetary or fiscal policy has had any impact at all as far as job creation is concerned and absent job growth we are in for a long and protracted economic contraction.

Disclosure: No stocks are mentioned in this article but the article is strongly biased to the short side. I am heavily short a broad group of tech sector stocks and also short the crude oil market. These positions were all put in place in the last few weeks. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: High Unemployment: The New Economic Paradigm