Point one. Weak economy no longer papered over by housing bubble.
Point two. Weakness in the financial sector exacerbated by Fed and Treasury malfeasance.
Now Point three. The commodities bubble.
Remember with me. The first half of this year, when oil kept climbing, climbing, climbing. Will it really break $100? And it did, all the way to $147. "Better get used to it," we were told. Insatiable world demand, isn't it obvious? A great opportunity in alternative energy products. Priuses sold like hotcakes to the economically sophisticated.
But the fall of commodities does not leave us in the same economic world as we left when it rose. Ford, GM, Chrysler and the other auto makers got sliced and diced like a subprime mortgage by the bubble. It left them worth just about as much as a CDO.
Things don't pencil out at $55 oil the same way they did at $120 oil. Consumers were hammered on the front end, and producers on the back end. Maybe the ex-Enron traders on the Goldman Sachs floor did well, but not many others.
First a note.
"Since 1929, Republicans and Democrats have each controlled the presidency for nearly 40 years. So which party has been better for American pocketbooks and capitalism as a whole? Well, here’s an experiment: imagine that during these years you had to invest exclusively under either Democratic or Republican administrations. How would you have fared?
As of Friday, a $10,000 investment in the S.& P. stock market index* would have grown to $11,733 if invested under Republican presidents only, although that would be $51,211 if we exclude Herbert Hoover’s presidency during the Great Depression. Invested under Democratic presidents only, $10,000 would have grown to $300,671 at a compound rate of 8.9 percent over nearly 40 years."
This from Tommy McCall, formerly of Money magazine, and appearing in the New York Times
This has gotten the supercilious treatment common to the economic blogs. They will not pick the low hanging fruit for fear of being seen as lacking objectivity. Our own research shows the Republicans performance on the S&P outstrips their performance on corporate profits, and the statistic should be worse. At a minimum it should be acknowledged that making life nice for investors is a primary purpose for Republican supply side economic strategy.
There is no reason to change prior forecasts until the dimensions of the financial sector's meltdown become more clear, particularly when we are still fairly accurate. When we do our adjustments, they will be even more down than last time, but for the same reason -- mismanagement and incompetence at the Fed and Treasury.
Ours has been the most pessimistic on the block until recently. The consensus seems to be rushing toward us, so we'll have to run further into the gloom to keep leverage. And gloomy will be the new rosy unless there is widespread acceptance of and willingness to act on three facts:
1. The financial system is broken. Here we mean the banks, shadow banks, hedge funds, private equity firms, and so on.
2. The financial system will not be able to resist being reformed -- that is, the megabanks that have just been put on the Big Nine, need to be restructured and downsized.
3. The failure of supply side free market laissez faire will remove it as a voice from the table of responsible policy makers. Its failure will be understood widely and its return from the dead delayed at least until we ensure the survival of the planet.
Perhaps these are obvious to you. I hope so. If as we suspect, the remedies being imposed by the Fed actually do significant harm or create zombie Goliaths that never come down, we will have incomplete reform. The financial sector will not be able to function efficiently. Free marketeers, ever supplied with funding by the Right Wing think tanks, will continue to horn in on policy debates. We will need ever more, ever more complete meltdown to disprove their yammering.
The more we listen to these guys, the more we approach a Japanese style no-growth scenario, because the more we have shackled ourselves to failure.
Now. The Real Economy.
We issued a forecast of recession and deep recession in October 2007. That forecast was not based on any credit crunch continuing for more than a year, doing increasing damage and ultimately providing federal money to private banks. That forecast was based instead on the disappearance of housing as an engine for the economy.
Our diagnosis then was as it is now. The US economy is fundamentally weak. Absent a bubble and the tremendous stimulus of debt both federally and at the household level, there was no growth, unless you want to count negative growth. Incomes and employment levels were stagnant in the jobless recovery subsequent to the 2001 recession. There was no growth because there was only very weak productive investment, either in private plant and equipment, public infrastructure, or human capital of any source.
Residential and commercial real estate boomed, but that is passive investment for the most part. And we see now that the valuations put in place have not stood very strong.
Without housing construction with its jobs, without rising home equity as easy funding for consumer extravagance and retirement security, and without prospect of it returning soon, the economy was obviously weak in the fall of 2007. But that turned out to be only the tip of the iceberg.
Housing weakness has collapsed some delicate inventions of the financial engineers, carrying the housing demise into an enormously big pit of financial losses. Still opaque banks and bank holding companies are providing only destabilizing uncertainty to the financial sector. These financial houses are very likely beyond saving in their current form, but by damn, we're going to do whatever it takes to save them. More about that later.
So. Point one. Weak economy no longer papered over by housing bubble.
Point two. Weakness in the financial sector exacerbated by Fed and Treasury malfeasance.
Now Point three. The commodities bubble.
Remember with me. The first half of this year, when oil kept climbing, climbing, climbing. Will it really break $100? And it did, all the way to $147. "Better get used to it," we were told. Insatiable world demand, isn't it obvious? A great opportunity in alternative energy products. Priuses sold like hotcakes to the economically sophisticated.
One of us said it was an asset bubble. More than one of us, actually. We played some Senate hearings where the economic price was described as $55. But one of us more loudly than the others. You don't hear much about oil and commodities any more. When you do, it is with surprise, and always with the double comment: This is good, consumers will have more to spend, and "It's because of decreasing demand." Just as demand did not double to push oil to $147, so demand did not collapse to half to drive the price below $70.
But the fall of commodities does not leave us in the same economic world as we left when it rose. Ford, GM, Chrysler and the other auto makers got sliced and diced like a subprime mortgage by the bubble. It left them worth just about as much as a CDO.
I will depend on the listeners memory to testify to how we thought these auto makers were out of touch and unworthy capitalists. The financial media, of course, led the way. Auto makers didn't have the product for the new world.
Oops. The new world is the old world now, at least in terms of oil prices. But it is too late for auto makers, and as well for many farmers, a whole line-up of alternative energy projects, and the commodity dependent nations around the world. Things don't pencil out at $55 oil the same way they did at $120 oil. Consumers were hammered on the front end, and producers on the back end. Maybe the ex-Enron traders on the Goldman Sachs floor did well, but not many others.
Don't look for Middle East sovereign wealth funds to be rushing in with cash any time soon. Don't look for booming exports to developing economies.
Cheap money and easy terms from the Fed, an asset price booming out of all common sense. It's a bubble. Proof. The price did not go up and stabilize at a high level, even for a week. When the price stopped rising and drawing in other bidders, it had to fall. It's a cousin to a Ponzi scheme.
So that was an elaborate point three.
The good news is that falling and low commodity prices may allow room for action without inflation, and worse, inflation remedies from the Fed.
But there is bad news.
The Fed and Bernanke are wrong in their solutions
Let's go there by way of J. Bradford DeLong, an economist and historian and professor at the University of California at Berkeley.
DeLong abbreviates the competing explanations and remedies for the Great Depression to three.
- The Depression was caused by the Fed constricting the supply of money, the Milton Friedman Monetarist theory. Bernanke has been shoveling cheap money as fast as he can. No resolution to the crisis after one year. Friedman goes down in flames.
- Larry Summers and DeLong himself proposed that expected deflation was the culprit. Today there is no expected deflation, according to DeLong. So much for that explanation.
- Leaving the last one standing: Ben Bernanke, whose academic work propounds the theory that it was the collapse of the banks that initiated the Depression.
Demand Side not as certain that Bernanke IS left standing. At minimum, it is a proposition left to be proven. And DeLong acknowledges this point in a recent Guardian piece, when he says, "the theory that recapitalising the banking system will cure what ails the global economy is, at the moment, only a theory. It could be wrong." DeLong goes on to say, "If Plan F fails, we move to Plan G: we pull the Keynesian fire alarm and begin an enormous government infrastructure building program in the whole North Atlantic to keep away depression."
It does not seem to us that any of the Bernanke bailout efforts have succeeded, including the extraordinary efforts and massive bailouts of the past month. We remember fondly the Paulson Plan, vitally necessary before passage, causing great consternation among all on Wall Street that Congress could not get its act together. After the passage it turns out that plan will take months to put in effect, and by the way here's a different approach we can do now. Nor does it seem to us that building the physical elements of a successful economy is a "fire alarm."
BUT
DeLong is missing one explanation in his count:
- The Depression was caused by a dearth of aggregate demand. This is, in fact, more commonly accepted than any of the others he mentions. You may be familiar with the end of the argument, that it was the Second World War that finally ended the Depression. It put the dot on the aye and the cross on the tee with regard to the aggregate demand explanation. This is, of course, why stimulus and recovery plans that involve jobs and infrastructure and education is the way forward. It is why putting a floor under home prices by stabilizing foreclosures and preventing the very untimely contraction of state and local governments is the way of keeping from going backward.
It's not a fire alarm, its just that, paraphrasing Winston Churchill, "Americans always come to the right conclusion, after they have exhausted all alternatives."
It is one thing to say a financial collapse precipitated the Great Depression and this year's sequel, but quite another to say financial engineering can put it back together again. If Bernanke's idea of preventing a Depression is to save the banks in their current forms at all costs, he is saddling the economy with a rider who is too heavy, doesn't know which way to go and is most interested in using the horse to slake his appetite. A ruthlessness in dealing with Wall Street commensurate with their ruthlessness in dealing with us is quite appropriate.
Even the banks can go nowhere without the demand. They may get the facilities to borrow and lend, but where is the growth without growing demand? Demand growth from the consumer sector is just not in the cards.
Cheer up. If, God willing, we get to an Obama administration, and it makes the right calls, there is plenty of reason to expect the Democrats to continue their string with the S&P index.