Thanks to the invaluable work of modern financial writers and economists, conservatives have found it easier to defend capitalism against the salacious charge that markets were responsible for the enduring unemployment seen during the Great Depression. Amity Shlaes’ The Forgotten Man and the work of Lee Ohanian and Harold Cole, of UCLA and the University of Rochester respectively, have made a compelling case that the Great Depression resulted from the failure of wages, in real terms, to adjust to macroeconomic deflation. This failure could have a benign cause, a result of imperfect information and the inability of business to properly assess the productivity shock that resulted from the crash of 1929. This theory would certainly explain why a severe recession could turn into a prolonged recession. It remains suspect that poor economic decision making could last for over a decade.
In fact, if the labor force was not reduced dramatically by our first ever peace time draft and the ramp up in preparation for World War II we do not know when the Depression would have ended. The true culprit was policy from Washington as pointed out by the Secretary of the Treasury Henry Morganthau who wrote in May of 1939, “We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!” Policies aimed at wage stabilization were begun under President Hoover and accelerated under FDR. As a result of the National Recovery Act, industries were forced to submit Codes of Fair Competition. In essence, each industry’s Code was a legalized cartel with output, productivity and wages all strictly regulated and backed by the authority of the Federal Government. The tragic story of the Schechters is a haunting embodiment of this control. The Schechters owned a small poultry business and allowed customers to choose which chickens they wish to purchase. This small example of independence earned the Schechters jail terms. Farm controls resulted in slaughtered livestock left to rot in the sunshine and dairy products dumped at the side of the road as millions went hungry.
The NRA, along with much of the original New Deal, was tossed by the Supreme Court. Government power needed to be consolidated though, and Congress remained undeterred by judicial rebuke. In 1935, the Wagner Act was passed allowing for collective bargaining by employees through unions. Previously, this had been prosecuted under antitrust legislation. The National Labor Relations Board was created to mediate negotiations between business and unions. Although it has become popular through photos of sit-ins by the UAW against GM in Flint, among many other examples, to cloak early unions as knights crusading for “fair” wages it was, in essence, a continuation of the NRA administration of wage protection. People were paid more to do less. The result was massive underemployment among the economy at large. Rates touched as high as 30% despite numerous government work programs. The swelled ranks of the unemployed ensured that demand for final products could never recover. Without pricing power and rising costs businesses retrenched and curried favor with politicians rather than creating the conditions for economic recovery.
This recession has seen wages decline, both real and nominally, the average work week reach record lows, and productivity rise sharply. Companies cut workers quickly as the unemployment rate is now at 17% according to recent U6 statistics. It would stand to reason that our current troubles could never morph into a prolonged depression. Unfortunately that is not the case and, logically, government is the reason why the macroeconomic performance will continue below trend for years to come. The United States government has not just guaranteed losses in money market funds in the past year, it has, through the Federal Reserve, propped up failing financial institutions, doubled the money supply by dumping cash out of its discount window in exchange for evermore questionable collateral, and has bought nearly $300 billion of its own Treasury debt and nearly $1 trillion of agency debt. The government has done everything it can short of ad hoc devaluation of our currency to increase the amount of money in the system and create a resultant increase in asset prices.
The government has rationalized that its unprecedented steps have staved off deflation. This is only partly true. It has staved off asset deflation, it has not ended the threat of demand pull deflation. Since the lows of last winter, commodities and financial assets have rallied seemingly without interruption. Oil has doubled from the low thirties to nearly seventy dollars a barrel, copper has doubled in price, silver has recently exploded as high as seventeen dollars, and gold now stands north of one thousand dollars per ounce. The stock market has increased nearly sixty percent with the S&P now around 1,020, a far cry from the ominous intraday low of 666. The Nasdaq has proven even more resistant to sluggish fundamentals and the Dow Jones Average has also yielded healthy six month returns. Equity strength should portend bond weakness but that has not been the case. Bonds also remain highly priced pushing the 30 year yield to below four percent.
This remarkable equity and commodity performance has come even though the economy at large has shed over 2.5 million new jobs without one month of employment growth. Initial claims remain in the mid-500,000s, continuing claims remain near record highs, and emergency claims continue to set monthly records. Employment is not the only indicator of continued economic weakness. Car sales remain poor except when government finances short term programs such as cash for clunkers. Realtors are already asking for an expansion of the first time home buyer tax credit to keep housing sales from retreating further, pulling prices with them. Popular industries such as video games are even feeling the pinch. Game sales are down several months running and console prices have been slashed. The Sony PlayStation 3 is now less than half of its initial retail price, less than three years after its initial launch. The Nintendo Wii, the best selling of the latest generation consoles, will see a price reduction of 20% for the holiday season. Gasoline prices have decoupled from oil with per gallon prices in the Michigan area now standing at $2.30 and falling. Refiners are one of the worst performing industries as they cannot add margins sufficient to cover costs. Our refinery capacity continues to shrink, down to just 84%. It is expected that natural gas supplies will reach storage capacity by the end of November while the excess is dumped onto the market forcing down spot rates. Because of operation flow orders mandating only 80% capacity as of Labor Day, we saw this phenomenon a month ago driving spot prices below $2 per million cubic feet. Even with expansionary prints, regional surveys, from Dallas to Chicago, Richmond to Kansas City, have shown contractionary readings for prices received. Much like Depression era work programs failed to create permanent employment, short sighted fiscal programs cannot create permanent product demand.
By now, the problem should be obvious. As pricing power declines, raw materials costs are rising (highlighted by the 65 prices paid number in the August ISM and 63 in September). This should erode margins which were the source of the earnings beats of the 2nd quarter. As prices fall, total revenue will continue to miss expectations. Credit is contracting at historical rates with commercial real estate and option ARM resets looming. Record foreclosures portend future losses and the shutdown of banks at an escalating rate. Credit will not expand soon increasing the likelihood of further price decreases as consumers increase personal savings rates.
The government reflation experiment has ensured that company costs cannot reach equilibrium with weak final goods markets. This is similar to the Great Depression except that artificial wage inflation has been replaced by artificial commodity inflation to create the disequlibrium. To cut rising costs, the only option is to reduce salaried employees, or shut down completely due to losses in core operations. Rising unemployment will create further weakness in final goods. This portends continued macroeconomic performance below trend for a length of time not seen since the Depression. Asset prices will eventually fall to the market solution, government intervention aimed at avoiding this harsh reality will only delay the inevitable and probably assure a more painful destination in the process.