Steven Hansen's  Instablog

I continue ponder the possibility of a quantum shift in the economic fabric which is causing our economic and financial indicators to display incorrectly.  I believe there is a fundamental and significant change in the dynamics which drive our economy.

What the punters are telling us that once we shift our personal wealth engines into high gear by talking up the equities markets and we get housing to stabilize or even creep up a little – we are going back to our old ways of spending.  They see a direct correlation between wealth and spending.

This is all based on the premise that the higher current consumer savings rate is transient because wealth is down.  The punters also see a direct correlation between wealth and savings rates.   You see, for consumers to spend as before – they cannot save. We need to spend to drive our consumption based economy back to our past levels.

Most economic bears rightly use the argument that the existing debt burden will restrain our ability to achieve past spending levels.  Let us save this argument for another day.

There is old research which offers an explanation of what we might be seeing.  This paper explores baby boomers and their effect on asset prices.

Some of the dialogue in the paper:

A young population has many savers which generates a high total demand for assets, but an old population has many dissavers [dissavers in this instance means people who dispose of assets] so total demand for assets is low.

Asset prices clearly respond to a baby boom. Initially, the baby boom has little effect on the growth of asset prices. The simulation shows that asset prices grow 19 percent during the first 15 years (the years of high population growth), a rate near the steady state growth rate of 1 percent per year. This small initial effect reflects the relatively small size of the baby boomers and the small savings of young individuals. The growth of asset prices then accelerates to 73 percent during the next 30 years as the baby boomers mature and increase their savings. The year 2010 marks the retirement of the first baby boomer which reduces the demand for assets as the baby boomers begin to consume some of their wealth. 

The net effect slows the growth of asset prices and eventually the large numbers of baby boomers consuming their wealth causes asset prices to fall. The decline starts in 2018 and continues for 9 years beyond the death of the first baby boomer in 2020. This fall in asset prices supports Schieber and Shoven’s [1994] speculation that the retirement of baby boomers will be a net drain on pension plans, thereby place a downward pressure on asset prices.

So this paper is telling us that there are new forces at work to depress housing prices.  Their study has a caveat that the dates are only guesses – and therefore it is indeed possible that this could have been a contributing factor in our housing price decline as the demand would have fallen.  I suspect the effects of the boomers “dissaving” will prevent any sort of significant recovery of asset value.

On the subject of consumer spending, I can cite many studies which draw the same conclusion as the 2005 Case, Quigley, and Shiller study Comparing Wealth Effects: The Stock market versus the Housing Market.

The evidence for a stock market wealth effect on consumption is, at best weak ......[and  there is] strong evidence for a significant housing market wealth effect on consumption

Without a return to our old spending ways we will have an “L” shaped recession / recovery.  Housing is the key to normal recovery as economists believe there is a direct correlation between housing prices and consumer spending.  The boomers life cycle may prevent the housing market recovery – therefore no consumer spending like the past.

Many of our economic theories and beliefs are based on data developed since WWII while the boomers were climbing to their financial peak.  Now their positive roles in our economy are reversing.  Can we rely on our economic forecasting techniques which are based on historical data when the boomers are changing roles?

The boomers may have created the quantum shift. 

This brings me to the issue of recovery.  In any company, when you overrun revenue – it is considered a loss.  Consider America as a company.  Let’s say you overspend by $500 billion which is roughly 3% of GDP.  This is not the type of overspending that will create jobs or income in the future so it is a true loss.  GDP growth needs to overcome this loss to be gaining ground – either today or in the near future. 

Now let’s say the overspending is in the trillions, and the population is growing by over 1%.  Now GDP growth needs to be in double digits to move forward.  It is impossible for a mature economy to achieve double digit growth.

Consider now that this overspending will happen every year into the foreseeable future.  Massive overspending can be tolerated in short bursts, but only a die-hard Keynesian would argue that excessive overspending can go on indefinitely.  The effects will eventually tip the economic balance, causing economic crisis.

My definition of recovery is moving forward economically.  With the quantity of deficit spending, our recovery will be backward steps.  There appears to be no forward thinking.  We are being sucked into a black hole.  As things are relative, there will be an initial illusion that things will be getting better. 

We are about to experience a “black hole” recovery or “●” recovery.  So forget about “v”, “L”, or “W”.

Welcome to the new normal.

Additional Economic Data from this Past Week

Headline: Consumer Credit falls over 7%, Markets falls.  News at 11.

Reality: Forget percentages.  This is April 2009 data which actually is telling me that things are remaining almost static – after all, the consumer credit debit level is still higher than 2007 when the recession began while overall credit has fallen.  

Consumer credit is important as it has been fueling the economy.  The truth, however, is not in these numbers.  It is the soaring default rate on credit cards, and the lack of transparency into the bank’s books which would tell us the complete story.  Another part of the story is that debit cards are the majority plastic transaction vehicle now – a general trend away from credit cards no doubt inspired by a pullback in credit lines by the banks.

The banks are treating their problems like a small child taking off a Band-aid.  They are doing it little by little prolonging the pain over an extended period of time.  We have no accurate way to judge current consumer credit situation using this data.

After my rail job I did last week on the Institute of Supply Management’s Manufacturing Index, there is no reason to repeat my sentiment on their June 2009 non-manufacturing index which incidentally was less bad.   The last time it was at this less bad level was before the economy hit the fan last year.  In any event, it does appear things are less bad.  Concentrating on only one element of their report – new orders, you can get a feel of what is going on:

The seven industries reporting growth of new orders in June — listed in order — are: Real Estate, Rental & Leasing; Arts, Entertainment & Recreation; Educational Services; Accommodation & Food Services; Construction; Information; and Finance & Insurance. The eight industries reporting contraction of new orders in June — listed in order — are: Mining; Agriculture, Forestry, Fishing & Hunting; Wholesale Trade; Transportation & Warehousing; Professional, Scientific & Technical Services; Health Care & Social Assistance; Public Administration; and Other Services.

Mortgage applications continue to fall.  The four week moving average of mortgage loan application volume decreased 6.5% and increased 11% compared with the same week one year earlier.  Please note that this was the shortened July 4^th week, and even though the data was adjusted it should be viewed as suspect. The refinance share of mortgage activity increased slightly to 48% of applications.  The average interest rate for 30-year fixed-rate mortgage remained unchanged at 5.34%.  The point in providing this data is to demonstrate that the volume of home sales are not increasing on a real time basis – and therefore housing remains a negative force for economic recovery.

The Conference Board’s employment index rate of fall moderated in June 2009.  This index aggregates 8 indexes, and thankfully does not use the data from the BLS’s Non-Farm employment report which has provided so much discussion relative to its accuracy [they do however compare their results to this report].   I believe this index properly quantifies the current employment situation.

Because unemployment is so severe today, jobs at this point are the primary economic drag.  The problem is our data when we try to quantify the problem.  The collection methodology has changed though the years.  Nothing better illustrates this than a comparison between an unemployment graph which has been circulating through the blogs this past week to an employment table – both are correctly analyzing published information and both use the same agencies data.

If the graph on the left is correct, please let’s stop talking about stimulus as things are not that bad.  If the table on the right is correct, we are in the worst recession since WWII.  As other data, such as manufacturing has fallen off more severely than any other recession since WWII – logic tells me that the table on the right more closely resembles the true state of employment / unemployment.

Just one more kick at the unemployment cat.  As the data does not seem to correlate in one way or another, I have estimated the true official unemployment rate at 10.5% using the Clinton era adjustments in the methodology.  I would be interesting to have a contest for all punters to think through unemployment – and derive unemployment using various methods.  I do agree with the bear punters who think the real unemployment rate is over 12% using the 1970’s methodology.  While we continue to lie to ourselves, we will continue to underestimate this Great Recession – and continue to make stupid decisions.

The 4 week moving average of initial unemployment claims decreased to 606,000.  This data is for the July 4^th holiday period and this data should be viewed skeptically.  Also, it was inconsistent that the total of persons receiving unemployment actually increased.  There was no explanation given whether this resulted from a change in the benefits programs or reporting methodology. In fact, if you just stare at the data – it does not add up at all when you compare initial claims seasonally adjusted to non-seasonally adjusted. I will just ignore this week’s data.  Pretend I did not bring it up this week.

Filing for Bankruptcy: Lear Corporation (LEA) ,   Bank failures this week: Bank of Wyoming, Thermopolis, WY

Economic Forecasts Published this Past Week

Nouriel Roubini’s RGE Monitor provided a mid-2009 economic outlook.  Here are some selected excerpts:

On the end of the recession: We forecast negative real GDP growth in Q2 2009 and Q3 2009, and for real GDP to remain flat in Q4…… growth will reenter positive territory only in 2010, and then at a very sluggish rate, well below potential….. Recessions are not measured exclusively by GDP contractions. Unemployment,  industrial production, real manufacturing, wholesale retail trade sales and real personal income (less transfer) are all considered when it is time for the National Bureau of Economic Research (NBER) to put dates around recession periods…… but it is likely that many of the above indicators will not bottom out (or peak, in the case of unemployment) before mid-2010. 

On Employment: ……average weekly hours in private nonfarm payrolls are at the lowest since 1964, as employers have cut employees’ hours. Job openings and turnover openings continue to fall and are at the lowest levels since 2000, indicating continued weakness in the economy. 

On Housing: …..housing demand is not yet improving at a pace that can guarantee that the lingering inventory overhang will dissipate. This implies that home prices will continue to fall. RGE Monitor expects home prices to continue to fall through mid-2010. 

On Banks: Increases in the unemployment rate, well beyond the rates envisioned by the adverse scenario of the recent bank stress tests, imply that recapitalization needs are larger than what the too-lenient stress test prescribed. The U.S financial system – in spite of the massive policy backstop – thus remains severely damaged, and the credit crunch remains unlikely to ease very fast. 

On Industrial Production:  While the index probably found its bottom back in December 2008--at depression levels of 32.9--industrial production remains in a mode of contraction that started in January 2008. 

On Public Debt: ….. the U.S. Congressional Budget Office estimates that the public-debt-to-GDP ratio will rise from 40% to 80% (in the next decade), or about $9 trillion – will also put a dent on growth. If long-term rates were to increase to 5%, the resulting increase in the interest rate bill alone would be about $450 billion, or 3% of GDP. The implication is that the fiscal primary surplus will have to be permanently increased by 3% of GDP, which could constitute further pressure on the disposable income of the U.S. consumer. 

On Inflation: Deflationary pressures are still present in the U.S. economy. Demand is falling relative to supply and excess capacity is still promoting slack in the goods markets. Moreover, the rising slack in labor markets, which is pushing down wages and labor costs, implies that deflationary pressures are going to be dominant this year and next year. 

On a Double Dip Recession: There are also signs that a double-dip recession could materialize toward the second half of next year, or in 2011. If oil prices rise too much, too fast, too soon, that’s going to have a negative effect in terms of trade and real disposable income in oil-importing countries. Also, concerns about unsustainable budget deficits are high and are pushing long-term interest rates higher. If these budget deficits are going to continue to be monetized, eventually, toward the end of next year, there is a risk of a sharp increase in expected inflation that could push interest rates even higher. Together with higher oil prices, driven up in part by this wall of liquidity rather than fundamentals alone, this could be a double whammy that would push the economy into a double-dip or W-shaped recession by late 2010 or 2011. 

The WLI from ECRI is continuing to show improvement in economic conditions six months from now.  The current reading is a two year high.  In their statement last Friday, they said:

It is increasingly evident that, despite widespread misgivings based on backward-looking economic data, the end of recession is at hand,

You will note on the ECRI graph, a backdated revision in the blue colored Weekly Coincident Index (WCI) line.  Lakshman Achuthan provided the following explanation:

The upward revision had to do with an actual increase in personal income.  Also, the chart shown is of WCI GROWTH, which has certainly turned up, indicating a growth rate cycle upturn (followed, at least in every recession in the last 75 years, by an end to recession within 4 months).  We are still waiting for a clear upturn in the LEVEL of the WCI, which would indicate an end to the recession.

This economic wrap has turned out sounding too negative.  The economy, baring another kick in the stomach, is at the bottom or nearly there.  Expect the bottom (NBER end of recession) in 3Q 2009.  You will not know it happened because there will be no big indicator which jumps up and says we are there.  The word “recovery” should be banned from describing the bumpy economic conditions which will follow.

What will be going on for the rest of the year is business and consumers adjusting to the new normal.  There will be continuing weakness in manufacturing and services as companies adjust inventories, logistics, and processes.  Consumers have a long road ahead of them to adjust their personal balance sheets.  And my belief remains that the boomers are nearly finished fueling the economy.

Our future, however, is really in the hands of Washington and to the degree they can put America on the path to fiscal responsibility.

There is enough data out there to prove any point you would like to prove by careful connection of dots.  The economy has billions of forces or dots.  They interact, and it is that interaction that creates the dynamics.  I am not out to prove anything except to challenge your beliefs.  There is no absolute truth, only things relatively truer than other things.  

Instablogs Published this week:

Economic Predictions by Automotive Manufacturers

Commercial Real Estate and the Fed

Leashing the Fed

Disclosures: long MMF's, PYEMX, EWZ, TBT, PGJ, EWY, DBC, EWA, EWC, EWT, PIN,  Physical Gold