Dr. Strangelove Economics: or how I learned to stop worrying and love the crash is a ten-part economic essay — the result of a six-month labor of love (or insanity, still not sure which), during which I did a deep-dive into the economics of America. What I found wasn’t pretty and certainly wasn’t reassuring. I concluded back in October that we were headed for a market crash — long before coronavirus first arrived in Wuhan, China. I call my chapters scenes because each one has a movie-theme.
There are three scenes in today’s installment. Read all of them, or skip to the parts that catch your fancy.
Field of Dreams is about the catastrophe that is American farming. Mr. Blandings Builds His Dream House discusses the housing building that has yet to pop — but will.
And the final chapter is a bit of an odd thing called Knowing, which will help you understand the whackiness going on in currency markets, ETF Funds and other problems yet to hit the news. Such as the massive amounts of “cash” held by Apple and other corporations that actually isn’t cash at all, but risky corporate bonds.
Scene 6: Field of Dreams
Remember Field of Dreams, the 1989 fantasy sports movie with Kevin Costner? The opening reminds me of what has happened to the American farmer, except there is no happy ending waiting in real life corn and soybean fields.
”If you build it they will come” was the promise given to farmers by the companies pushing Big Ag — especially the Big Ag behind GMO herbicide resistant corn and soybean. ”They” was all the countries in the world lining up to buy America’s agricultural bounties. Increased yields were to lead to increased markets because the world wanted cheap food and everyone would get rich. It worked right up to 2013, but farm income is now 35.5% below what it was then. Everyone thinks it’s just the farmer’s loss of the Chinese market in the trade war that’s at fault. But there’s a deeper problem of over-production and rising input costs, especially for GMO seed, which for corn has increased over 100% in the last decade.
I was in Iowa talking to farmers in May of 2019; one woman told me about her family farm where the yield per acre was 330 bushels of corn. That’s great, five years ago it was 230 bushels. The increased productivity came from improvements in GMO seeds. But now they had a problem with falling prices because everyone was growing more corn. During this same time, GMO related costs were rising. Five years ago they made $8 per bushel on corn. Now it was $2. Total profits were less than five years ago despite increased yields.
I learned something else in Iowa. Hedge funds are buying up farmland as a hedge against inflation. A farmer told me about it; he was a paid consultant to one of these hedge funds. Perhaps this explains why the USDA has discovered a strange disconnect in the value of farmland. Agricultural land values used to closely correlate to the net cash income of farmers. When their profits increased, so did the value of their land. When profits went down, so did land. But land values kept increasing in 2014, just as farm profits were dropping. A quick google search shows it isn’t just hedge funds. A wide range of institutional investors from pension funds to university endowments are also buying farmland. Along with banks and insurance companies. This started to become a big thing around 2013.
Farming has entered what will likely be a long-term decline. There’s overproduction, the disruption of climate change and the tariff war that killed agricultural markets and put farmers out of business.
A recent Reuters interview with Iowa corn and soybean farmer Mitchell Hora sums up the situation:
The agricultural system is completely broken” because of the trade war, severe weather and mounting farm debt, Hora said. “We have to farm smarter.
With farm incomes dropping, debt loads are increasing which are seen as sustainable only because farmland is now a valuable asset. The land is the bank’s collateral; if it declines in value, it will play hell with the rural banking system that Congress just deregulated.
Maybe the price of farmland will never decline despite dropping farm income. That’s the bet made by the bankers, hedge funds and a lot institutional investors on Wall Street. But I’ll bet you don’t get anything like the feel-good ghostly ending of Field of Dreams when Ray, played by Kevin Kostner, gets a reunion with his dead Father — reincarnated as a young baseball catcher:
There was a time quite a few folks thought Iowa was the next best thing. A time before bankers and Wall Street invented Big Ag.
Scene 7: Mr. Blandings Builds His Dream House
Mr. Blandings Builds His Dream House is a 1948 comedy about an American longing — that wish for a home of your own. Cary Grant as the main character Bill shows how people get in-over-their-heads on a house:
A second motive for buying more house than you can afford is the belief that your house will always be more valuable in the future than the day you bought it — meaning no price is ever too high. This thinking persists despite the popping of several housing bubbles over the last fifty years. I still remember the sound of that pop when the bubble burst in early 80s California housing. I was listening to Don Regan on NPR back in 1982. Regan was a former Merrill Lynch CEO from the days when banking was boring and safe. At the time he was Ronald Reagan’s Treasury Secretary. His interview was in a news report about a crash in California real estate. Regan was mystified as to why anyone would speculate on housing in the first place:
”A house isn’t an investment. A house is where you live.”
It’s an old fashioned view, long ago replaced with the idea that the middle class should build wealth through buying houses. Many continue to espouse it. Here’s a 2018 essay from the George W. Bush Institute saying, ”home and asset ownership is a solid bet to generate and protect middle-class families’ wealth.” The essay — without shame — even boasts about George W. Bush’s “Ownership Society” policies that went a long way toward creating the last housing bubble. People should really think harder about how that ended.
Some are. For example this Brookings report saying that federal policy shouldn’t tilt toward owners over renters. But the owner versus renter argument bypasses a key point. Housing has gotten expensive again, not because a mix of home owners and house flippers are bidding up prices. It’s gotten expensive because owning homes to rent has become a business strategy, with a lot of different players in the game. The most visible face is private equity. Steve Schwarzman of Blackstone, the private equity behemoth, boasted to Business Insider: “We’re now, we believe, the largest owner of real estate in the world.” He’s right. They manage $100 billion worth of property across the globe. Blackstone’s role in the high cost of housing caught the eye of the United Nations Special Rapporteur on the Right to Housing, Leilani Farha. The gifted Swedish documentary filmmaker Fredrik Gertten made a film about her work, called Push. You can view a short preview here on the film’s website.
But it’s more than Blackstone. This is a big subject and you can write a book about it. In fact someone has. So rather than say more I’ll simply recommend Homewreckers: How a Gang of Wall Street Kingpins, Hedge Fund Magnates, Crooked Banks, and Vulture Capitalists Suckered Millions Out of Their Homes and Demolished the American Dream. It’s written by Aaron Glantz and the title is the story.
It’s not just banks and private equity companies driving up the cost of housing, in fact they may not even be the biggest culprit. There is also an army of small investors buying houses, people who’ve decided owning homes as rental property is a better way to earn a buck than working nine to five. In 2019 one-third of all homes were bought by these investors. House flipping is back in vogue and it’s pushing up rents as well.
We’re just playing a different version of the same game that created the last crash. The real estate market has recovered to a record $15.8 trillion in home equity nationally. In 2009 just after the crash, it was $6.1 trillion. In the years since the Great Recession house prices have increased faster than income growth. Here’s the $64,000 question: are we in another housing bubble? Some say yes. Some say no. The housing market slowed in 2019 largely because it’s no longer affordable. We’ve reached peak housing prices again and Zillow, the online real estate data company, predicts a housing recession in 2020. Rather than guess at the timing of a recession, I have just two questions about what happens when it comes:
· How does a recession affect the millions of small-time investors who thought home values would never go down?
· Will private equity and other corporate owners dump their holdings?
In 1986 Hollywood remade Mr. Blandings Builds His Dream House with Tom Hanks taking on Cary Grant’s old role. The new title may be a more appropriate expression of my worries. The film is called The Money Pit.
Scene 8: Knowing
Knowing is a 2009 film that was a modest box office success but critical disaster starring Nicholas Cage. Little more than silly science fiction, Knowing features some mysterious numbers whose secret is discovered by Professor John Koestler. The numbers, it turns out, predict a string of disasters, including the end of the world. I chose Knowing as the theme here because of its premise that knowing the meaning of numbers is important, hard work. Then there is this line, delivered by Nicholas Cage with his trademarked breathy weightiness.
Unlike my other scenes, I don’t have a single point to make here, I’ve got several different things to say. Each is obscure, you likely haven’t even heard of it before. Each is potentially significant. Unlike the movie, it’s hard to know what the numbers are telling us. What’s in common is that each of these things deserves more knowing.
Jobs and unemployment numbers
Knowing about jobs is the first and simplest of the things I want to bring to your attention. Specifically how many jobs did the economy really create in 2019? Would you be surprised if I said we won’t know for sure until August of 2020? Because we won’t.
Before I explain, I want to point out how much money Wall Street bets every month on the employment numbers put out by the Labor Department. The December jobs report surprised everyone with the very good news that we added 266,000 new jobs. The Dow immediately went on a 861 point tear, reaching 28,538 on December 31. (the Phase One trade deal with China also helped).
But what if we didn’t actually have 266,000 new jobs in November? This question shouldn’t be a big deal because the Bureau of Labor Statistics is very clear that these numbers are estimates, meant to be good enough for understanding long-term economic trends. But that isn’t how jobs numbers are used anymore; think how many times the President has tweeted about jobs. (Out of curiosity I googled ”president trump tweets jobs” and got 243 million hits). Investors ignore other worrisome data and are throwing money into markets because of that jobs number. The Fed sat tight in December on further interest rate cuts because of that jobs number. People were even being encouraged to buy houses because of it. MoneyWise had this quote from real estate executive Corey Burr:
”Buying real estate is as much about confidence in the future as it is about the current financial strength of a buyer, and Friday’s strong jobs report adds to the confidence about the future.”
If you didn’t know that 266,000 jobs was only a preliminary estimate, it’s probably because business writers seldom mention it. Perhaps they don’t want the potential unreliability of data messing with their story. Perhaps they don’t know how BLS does their work. It’s not simple, it took me weeks of ploughing through research to get it. The fact is, there is dissonance in Bureau of Labor job numbers — for instance the two key employment surveys don’t yield the same result. BLS quaintly calls it occasional trend divergences. In the fine print of Comparing employment from the BLS household and payroll surveys, they point out both job numbers are ”estimates”. The employment numbers (i.e. jobs added or lost) is done by the Bureau of Labor Statistics through a payroll survey, a sample of 142,000 employers with 560,000 different worksites. The employers report how many employees they have and if they have cut or added jobs. Only 73.1% of employers respond in time for the monthly jobs number release (as of 2013, I couldn’t find more recent data). BLS uses the data it does have to make an educated guess about what was in the missing 26.9%. BLS does two further revisions to this initial jobs numbers and an additional 20% of employers send their data in time to be included for the final revision. But 5.4% of the employers never respond and so the data in that third and final jobs report is still only 94.6% complete. You would think this would be important information to include with the monthly report, but it’s never mentioned. Never fear, BLS does an extremely accurate revision once a year, using a totally different data set: the tax records of ten million businesses. Politifact’s Revisions to jobs data: What you need to know has a good graph showing the annual BLS revisions for the last twenty years.
The 2019 yearly revision had an unusually large boo-boo: it found there were 501,000 fewer jobs created from March 2018 to March 2019 than claimed by the monthly reports. Let me put that into context. The Payroll survey over-counted new jobs by an average of 42,000 a month for an entire year. The last time a downward revision this big happened was in 2009, in the middle of the Great Recession when jobs were disappearing so fast the data couldn’t keep up. Surprisingly, the 501,000 disappearing jobs got relatively little press, likely thanks to the unintelligible press release put out by the Labor Department. It’s not just me that’s skeptical of these jobs numbers, the data website FiveThirtyEight.com also thinks they are ”overhyped”.
I also recommend this nifty FiveThirtyEight primer explaining all about the jobs numbers. It describes exactly who is and isn’t counted in our super-low unemployment numbers. Because that second important number — the unemployment rate — is also iffy. The ”headline unemployment rate” is the number everyone makes hay over. That’s U3, which is now 3.5%, the lowest in fifty years. Except it’s not. We can’t compare today’s numbers with the old ones because in 1994 BLS stopped counting ”discouraged workers”, meaning people who haven’t looked for work in over a year. But they were being counted in 1969. We also don’t count prisoners. In 1969 this was a statistically insignificant 200,000. Now we have 2.1 million people in federal and state prison. Sixty to seventy-five percent of these folks can’t read, which would definitely boost the unemployment rate if we didn’t have them locked up. There’s more, but this should be enough to show why comparing 1969 with 2019 is apples to oranges. U3 unemployment also doesn’t count anyone who didn’t actively look for work in the previous four weeks. But it does count part-time workers, even if they only worked a few hours a week and want a full-time position instead.
U6 on the other hand, is a different BLS unemployment number which does count these two categories as unemployed, which is why the U6 number for January 2020 is quite a bit higher than U3 at 6.9% unemployed. U6 briefly hit a historic low of 6.7% in December but it’s not that exceptional. During Bill Clinton’s last year in office U6 dropped to 6.8%.
Unemployment data comes from an entirely different survey and methodology. Both the U3 and U6 numbers are collected by the Census Bureau through their Current Population Survey (methodology explained here). Using phone and in-person interviews, they contact a sample 60,000 households every month and ask who is working. This kind of systematic counting of employment didn’t begin until the 1940 census, but has been the norm since. I suggest it might be time to update this eighty-year-old method of counting unemployment.
The Federal Reserve Foreign RRP Facility
Wow. Bet you never heard of this thing. I hadn’t either before taking this half-year dive into economics. I debated about including it at all, but idea that a Sagittarius-A* supermassive black hole may occupy the center of world dollar markets seems worth knowing; right now only central bankers know about the existence of the RRP — and no one talks about its dollar-zapping potential. No one, that is, except Zoltan Pozsar, an analyst at Credit Suisse. It’s not just the Fed Repo Rate that I mentioned in the It’s a Wonderful Life scene that’s a problem — there’s trouble brewing as well at this obscure financial entity operated by the Federal Reserve.
Last summer, the Financial Times had a good write-up about Zoltan’s work and the Fed’s ”Foreign RRP Facility”. RRP stands for reverse repurchase agreements, or reverse repo. Foreign central banks do a two-step dance when they need to weaken their currency against the dollar in order to stabilize it. First they buy dollars, second they sink those dollars in U.S. Treasuries. This sort of tinkering inside the world’s financial plumbing goes on everywhere by all central banks, all the time. But the U.S. Federal Reserve has a one-step alternative to buying treasuries that has become popular. Instead of the two-step Treasury dance, the foreign central bank can just park their dollars in the Fed’s foreign RRP facility. Pozsar says there’s a problem with that now, that so many dollars are going into the foreign RRP facility that it’s creating a dollar liquidity crisis because — unlike buying Treasuries — the dollars no longer circulate once they hit the foreign RRP. He calls this problem ”Sagittarius-A* — the supermassive black hole at the center of global dollar funding markets”; and recommends capping the facility and lowering the fed rate, something the Fed has now done three times. Problem solved? Who knows? I’ve been unable to find updates to the story.
When is high-tech cash not cash
Through the years corporations have discovered many different ways to make money; the oldest being the business of loaning money at interest. We once called this banking, and our governments took a keen interest in oversight, because when banking went bad it meant financial misery for everyone. Would it be worth knowing that a bank no longer has to be a bank? That the same company that makes your iPhone is also a bank? And an unregulated one at that?
High-tech firms hold huge amounts of cash. Apple leads the pack with $205.9 billion in ”short-term and long-term cash holdings”. Long-term cash holdings? What does that even mean? Isn’t cash liquid and immediate? Turns out this cash isn’t cash — it’s debt in the form of bonds. Some of it very safe, such as T-Bills. And some not-so-safe, such as corporate bonds. Apple is merely the visible tip of this iceberg. All Big Tech plays this game, along with Big Pharma and a lot of other companies too. Zoltan Pozsar, the Credit Suisse analyst looking at the Sagittarius-A* black hole in dollar funding has also been studying corporate cash. In 2018 he found 150 companies in the S&P 500 with $1.1 trillion in savings that was called cash but it is actually corporate bonds. The top ten companies held $600 billion of this pile. His report has the off-putting title, Global Money Notes #11 Repatriation, the Echo-Taper and the €/$ Basis, which probably explains why I only found one business writer who reported the findings: Rana Foroohar of the Financial Times. Zoltan Pozsar’s focus wasn’t bonds per se, but rather dollar repatriation effects after the 2017 GOP tax cut bill. But along the way he shows that corporations are defacto banks — Apple and Oracle even went so far as to create asset management subsidiaries that issue their own high-grade corporate bonds — which they use to buy higher return/lower quality bonds. It’s this statement from Pozsar that I find most concerning:
The top ten [corporations] disclose neither the sectors nor the names of the corporate bonds they buy, so the riskiness [of] their corporate holdings is a bit of a mystery. But, anecdotally, debt issued by foreign banks accounts for a big share.
ETF contagion risk
What if you had a melt-down on Wall Street in a pile of money twice the size of the CDO debt that went bad in 2008. Worth knowing about?
Exchange traded funds — known on Wall Street as EFTs — have been around for three decades. But they only reached their current $4 trillion since the Great Recession. They have never been tested in this quantity in a down market. In theory they are a liquid assets that both tracks — and outperforms — the S&P 500. There are many, many different types of ETFs but all track an underlying market index. Their liquidity isn’t in doubt in a bull market, but there are questions about how they would work with a bear market. The ESRB — European Systemic Risk Board — produced a June 2019 report about exchange traded funds: Can ETFs contribute to systemic risk? They identified three ”channels” of systemic risk that are a consequence of ETF trading: a decrease in market stability, increased price volatility, and a potential liquidity crisis in ETF funds if the market enters ”periods of financial stress”. The European Central Bank has imposed some restrictions on ETFs as a result of these concerns. The European Fund and Asset Management Association disagrees, and wrote a paper responding to the European Central Bank. They want to avoid further regulation of ETF.
Moody’s Investor Service also sees risk, pointing out that the market makers for these funds (liquidity providers in the language of the report) are themselves ”exposed to market, liquidity and operational risks. These risks, when coupled with an exogenous systemwide shock, could in turn amplify systemic risk …”
Knowing about cyclical markets
What goes up, goes down. It’s the rule governing both gravity and Wall Street. To conclude this chapter, I’m choosing something written just before the last good market turned bad. It’s worth knowing what that felt like.
Lots of people are asking whether this is going to get ugly. Is this the beginning of a credit crunch? Will it lead to a recession? How bad will it get? When will the bottom be reached? How long will the recovery take? The answer’s simple: no one knows.
This was written by the investor Howard Marks on the 10th of September 2007. The start of the recession was three months away and most everyone was saying all would be fine — five months later Bernanke would tell the Senate ”don’t worry, we got this”. (And it did look okay, much like today’s economic outlook looked okay until it suddenly didn't). But credit was drying up, the repo market was haywire and the inverted yield curve had only just straightened out that summer. Wall Street was begging the Fed to lower the interest rate, which they did the following week. In October the Dow jumped to a new high, passing 14,000 for the first time ever. A year-and-a-half on, it lay in ruins at 7000.
I highly recommend Howard Marks’ musings on the cyclical nature of markets: Now It’s All Bad?
Written by Kent Moorhead © 2020 by Passage Film, Inc.
Don’t want to wait for the next scene? The entire essay is available on Medium. Spoiler: it’s a damn long read and you might prefer reading the installments on KOS.
Coming tomorrow: Scene 9: On the Waterfront
Scene 1: Twister was published on Kos on March 16, 2020.
Scene 2: It’s a Wonderful Life was published on Kos on March 17, 2020
Scene 3: Back to the Future was published on Kos on March 18, 2020
Scene 4: 9 to 5 was published on Kos on March 19, 2020
Scene 5: Wall Street was published on Kos on March 20, 2020