Carlson gets it right, and I don't mean Tucker.
Almost a year ago I stated that we had reached the "boom phase" of the current economic expansion - that point where growth is inflationary. Booms run until the pain from inflation gets to be more than the gain from go go expansion. Pain as measured by those actors who can do something about it. When central banks, where they have autonomy, feel pain, they make the economy take the medicine.
Right now the Federal Reserve is feeling some discomfort, but they aren't in pain yet. But the yield curve continues to march towards inversion, and we look back at something I've been writing about for some time: Greenspan's bet, what it is, and whether he has enough chips left as he hands over his seat to Cousin Ben - Ben Bernanke.
["In the year of storms" has been picked up for digital distribution by Music is here and should be available for download soon - Ask iTunes to carry it.]
Before I go any further it is important to make a clear distinction - there are two kinds of bearishness: absolute bearishness, and relative bearishness. Absolute bearishness is believing there is a decline in a stock, economy or other thing of value. Relative bearishness is believing that suboptimal choices are being made - that the opportunity cost of a decision is higher than the gain from that decision. That is, someone could be doing better, perhaps much better, than they are.
I have been a relative bear on this economy for some time, and I have been absolutely bearish on the prospects for labor, and to a lesser extent capital, relative to rent. This isn't the same thing as predicting a collapse. For a period of time in 2004 it seemed likely that the US was going to reach recession early, however, Europe saved us by going into an even deeper economic slide than they needed to. What was good for the US in 2004 and 2005, was very bad for German workers and French workers.
I have not been subscribing to a rapid energetic decline in the US dollar as the inevitable result of current policies. I say this as someone who has made a series of very good, and often contrarian, calls on currency movements over the years. The reasons for this are fairly simple - the US is paying higher interest rates on its securities than our competitors are for similar supply and risk. This means that the dollar may decline, but not substantially until US interest rates are lower than foreign interest rates. Bond holders go where the risk adjusted return is. The US can run a deficit, even a big one, so long as we are willing to shaft the future with the debt, and the rest of the world credibly believes the future won't be able to simply inflate or devalue that debt away.
So where are we? The next year is critical for this business cycle, but the decisions have already been made, what we are going to see is the playing out of those decisions. There is little any policy maker could do now that would substantially alter whether the US economy gets another landing/boom phase of this expansion, or we go into recession late in 2006 or in 2007. However, it isn't clear what the underlying economy is going to do yet.
The Bull Case Scenario
The bull case scenario runs this way: after years of having bad balance sheets loaded with non-performing assets - that's econospeak for "the money wasn't really there, we just all pretended together that it was" - companies are now loaded with real cash that they can spend. Because of the soft labor market - more on that later - they are taking the opportunity to slash benefits and harvest cash out of pension plans, or use bankruptcy in a friendly economic environment to dump long term committments.
There is then almost a trillion dollars of investment looking for a home.
On the Federal side, there is nearly 500 Billion of stimulus due this year in revenue reductions, Iraq and defense spending, Katrina rebuilding and other assorted pork projects in the transportation bill. While the government has signalled that the defense boom is at an end, and this is the last year for some of it, with reductions as far as the eye can see - the money is still coming on line.
This, plus the stimulus of foreign investment flowing here in search of higher low risk returns means that the United States has almost 1.75 trillion dollars of stimulus for the next year, minus the loss of the draw down of money from the housing sector. The American consumer bet that this would be a long economic cycle, and instead of the gloom of 1996, Americans borrowed optimistically, expecting at least 4 good years to pay down debt and sell off interest only mortgage properties. The higher interest rates are already reducing mortgage lending, so far by a total of 40 billion per month, which would mean that there would be some 500 billion less in the form of mortgage stimulus. Net of roughly 1.25 trillion in stimulus available this year. That's nominal, not real, and the difference is important.
This means, from the bull case scenario - that housing is going to give way to business investment and commercial construction. The optibulls of the far right are expecting a late 1920's burst of building and optimistic expansion of commercial capacity. The mere bulls are expecting that the stimulus will come in, that higher fed rates will keep real wages flat, and therefore inflation will be subdued. This means, from their perspective, that the stimulus will buy a great deal of real growth - that is, less will boil away as inflation, or as diminished return on investment.
The econospeak for this is that "the economy isn't going to overheat".
In this view, there will be somewhat lower growth than last year, but still very solid growth. The indicators are that there will be substantially more hiring, and that the Dow will break through its pre-crash highs, while the S&P will make substantial gains towards its all time peak. Even better will be the return of tech spending and the NASDAQ, as companies replace aging PCs and equipment with new equipment.
That's the bull case scenario, and some parts of it are correct. The hidden assumptions in it, however, bad for most people - real wages will not go up by much, percentage increases in payroll employment will stay low, benefits will erode, and home equity will fall in the bicoastal areas. In short, it might be a boom, but you aren't going to see much of it.
The Snake Case Scenario
Unlike the bulls, the snakes look at 2006, and see 2005 with the bottom falling out from under it. They don't see the business stimulus and federal stimulus as being effective because (1) it's going to end as soon as the Republicans win the election and have to hit the "austerity" button, (2) the global growth that is going to happen is going to push up energy prices farther than the Fed has planned for.
In this view a great deal more of the stimulus is going to show up as increased energy and materials costs. The snakes point to the recent gold rally as a sign that commodity inflation has spread out of energy and into everything, because gold is the pivot point for commodity speculation - a place to park gains while looking for the next opportunity.
They point to the probability of a European recovery, the continued Japanese recovery, and continued Chinese expansion as reasons why commodity inflation is going to continue. This inflation will force another round of Fed rate increases, and create the high probability of a fully inverted yield curve, signalling a probably recession late in the year or in 2007. George Soros is in this camp.
So, for the record, am I.
This scenario, in macroeconomic terms looks little different from the bull case scenario, with important twists. Where the bulls celebrate the low unemployment rate, the snakes point out that it means that the Fed's hands are tied - this is as close to "full employment" as we get for this economic cycle. If it is a lousy looking full employment, then it is because we've made lousy choices about where to put our effort. To give you an idea of how lousy our choices are, consider that raising CAFE standards for cars to 34.5 mpg would cost less than the amount of money we can't account for in Iraq every year, or has been misspent on DoD projects. That's right - we could slash oil imports for cost of the wastage of Iraq. (Cost estimates of CAFE standards from the Congressional Budget Office's 2003 study on gasoline taxes and Cafe standards, unaccounted for money in Iraq from the GAO).
According to the Snakes, housing was, and is, what is driving the US economy, and its collapse, like the collapse of the tech boom, is going to hobble employment, and therefore both demand and solvency of US consumers. The US consumer isn't going to "give out", but he and she are no longer going to put out for American companies.
The snakes also point to the very high structural risks in the current economy - with oil production just about at capacity, and growth straining that capacity, the world is one very large supply shock away from a very unpleasant bout of high inflation. Katrina was the model - a disruption of 1 mbpd of crude production and associated refining capacity created a short spike of double digit level inflation in the US. A spike that was evened out with the strategic petrolum and gas reserves, as they were intended to do, but which if sustained would require extremely high interest rates to slow the economy down to the available supply of oil.
This doesn't mean a recession is mandatory, but that a slow down in the US economy, rather than a popping the corks expansion like the late 1990's, is what is in the cards even if the current business cycle manages to hang on. The snakes point to the need for autos and other heavy industrial goods to slash prices, which will lead to lower wages and demand. The snakes see the end of construction demand as producing a great deal of unemployment, and leading to either dramatically reduced wages in large sections of the country, or a migration to cheap land areas as people cash out of the metro-economies. The first leads to a bust in "red zone" areas, the second in the "blue zone" areas. With job creation and growth flat in many blue states already, and construction falling, it could be both.
Instead the snakes see that there is still a bit of light between the bottom of the yield curve and the pivot point (more on this below), and believe that if the Fed can stop here, and we don't get a Katrina event, that we can sneak through this year, and perhaps get to better economic priorities. But one bad bounce is enough to send the snakes scurrying for their holes.
The Bear Case Scenario
The bear case scenario looks a the yield curve and says "there is less than one .25 basis point rise between the 1 month short yield, and the 6 month pivot - either ben stops cold, bond holders start dumping US long bonds, or we are going to get inversion by march and recession by mid year. This will lead to a collapse of housing values, a chain reaction of bankruptcies, or require Cousin Ben to drop interest rates faster than he drops his drawers at night - which leads to a meltdown of the US dollar." Several economists - Roach, Krugman, Feldstien - have outlined the possibility of a currency crisis that would dwarf anything seen in the 1990's - or even the 1970's.
Let me unpack this a bit, because there is some complex economic theory going on behind currency woes. While I don't subscribe to the idea of a currency meltdown - for those that want to make this bet, it is important to know what it is you are betting on, so you know when to double down, or throw in the hand.
A "Yield Curve" plots the cost of money against time. One takes a given kind of bond - or anything that yields a return - and one plots the interest rate vertically against the time to repay horizontally. The result is a "curve". If the curve is flat, it means that you don't get much more for being patient than for being impatient. If the curve is steep, it says that you get more for being willing to wait.
Now yield curves tend to have a "spread" between the top and the bottom. This is because the longer you wait to get your money back, the more happiness you are defering - so you want to get paid for that, and the more risk you take that inflation will happen, or that longer term risks will eat up your investment. Afterall, if you are investing for the long run, you might be dead before it gets here.
The spread between the "short end" of the yield curve, that is being paid back fast, and the "long end" of the yield curve, tells investors what the future prospects look like.
If the spread is big, it means that future prospects look bright - short term money is cheap, where as being able to invest for the long term has higher yields. Investors find ways of borrowing short term and getting long term returns. For example, start a company, pay short term interest rates, and get long term returns. Or find ways of borrowing money short term and buying long term bonds - that's "the carry trade".
If the spread is small, it means that while short term prospects might be quite good, longer term prospects are not so good. One will see a large number of bullshit explanations about bond holders locking in expectations and other nonsense. But if that were true, the yield curve would work in a closed US economy, instead, it has been predictive during the period of an open US economy. The real reason that spreads get smaller is this - as an economic expansion goes on, people make long term bets. They have to sit and wait for them to return. These long term bets show up, sooner or later, as the need to park money long term. That means that as the expansion goes on, more and more people have long term bets, and therefore long term rates can't go up.
Now we get to "inversion", that is when short term money is more expensive than long term money. When does this happen? Three things have to be true - one is the Federal Reserve has to be making short term money more expensive. And there have to be fewer and fewer people borrowing short term, the third thing that has to be true is that long term buyers can't have someplace else to go, otherwise, they would sell the long end, buy the short end, and then shift back to the long end later.
The claim that long term buyers are "locking in" long term rates doesn't hold up emprically - inverted yield curves have predicted recessions during times when long term rates actually went up soon afterwards. There's always been a chance to lock in rates once the Fed admits that the recession is on, there is no reason to do it until then.
When the yield curve inverts, there is a particular dance that it does. First, it flattens on the long end - from 2 years and up. This makes it develop a "knee" or a pivot point, below that point the yield curve is steeper than above it. As the Fed raises rates, that knee gets sooner and sooner - first the two year, then down to 6 months. Played as an animation, it looks like a door swinging shut.
That's what has been happening for almost two years now - the door on the expansion has been swinging shut. To stop a recession requires a burst of spending, and finding a way to make whatever is expensive in the economy cheaper. LBJ managed it in 1966-1967, but no one else has once the yield curve slams shut.
The bears argue that Greenspan's foot dragging on raising interest rates will only make the recession worse, and that Bernanke will get hit with a challenge to Fed authority, and he will have to raise rates even further. Sites such as bondtalk subscribe to the fed challenge theory - even though they aren't bears.
The bears believe that the fed will be challenged, that it will have to raise rates and choke the economy, or fail to raise rates and allow the dollar to cascade downward. Which means that either the fed funds rate should go above 5%, or CPI-U should crack 5% nominal with gasoline above $3/gallon for an extended period of time. In their view, the current breather is a respite bought by dumping the SPR and SGR, and will go away shortly.
Making Better Choices
Which ever view you subscribe to, wages and jobs are not going to grow robustly. Instead, this economy is as good as it can get given the choices we have made - bail out US corporations from their bad bets during the boom (the tax policies), war with Iraq, and a protectionist boom in health care and housing. These were all explicit choices, choices which could have gone in other directions. Americans repeatedly backed these choices by giving Bush high approval numbers, and accepting in three successive elections his party in power.
So what are better choices?
The worse choice is protectionism. We are in this mess because of protectionism. If you look at the choices made by Bush they amount to:
- Protectionism for big business.
- Protectionism for big military.
- Protectionism for doctors and red state contractors.
Imagine for a minute a perotista party took power, and slammed the doors shut and protected manufacturing workers - in 4 years, you can be sure that the red zoners would be screaming, as the price of their pick up trucks would be going up and up and up, while there would be no cheap chinese money to buy houses. Protectionism is one group of workers fighting another group of workers. If you look back on the "Gilded Age" of the late 19th century and Republican dominance of the Congress and the White House, you will see high protective tariffs from one side to the other. High tariffs benefit those accumulating capital, they can help industrial workers in the sectors that are being built out, but only to the extent that there is someplace to dump the results. Who, exactly, other than an American, is going to be buying Hummers that get 8 mpg?
It isn't that "American jobs are going to China". Because China turns around and lends all the money they make back here - what has happened instead is that civilian employment has gone down - and we have spent that money on "The War on Terror" and the War in Iraq, creating defense jobs. Virginia and Texas have gained, while Michigan and Pennsylvania have lost. But slamming the door shut won't create new jobs, but, instead, destroy them.
Instead, if you want to see where the missing jobs are, look again at the bull case scenario. Realize that corporations have cleaned up their balance sheets and are holding huge amounts of cash, cash that they haven't been taxed. That money isn't going any place, except to be parked in safe places. This has kept long term rates low, and therefore acted as a disincentive to long term investment - because there is less of a reward for it. Instead, it has been focused on soaking up the carry trade money.
Now businesses still aren't investing this in the US, or even as much overseas as you would think, if they were, prices would be dropping even faster on manufactured goods here. They are sitting on it. Good for the privileged, not so good for the rest of us. The famous line about banks applies to government - go where the money is. The money isn't in slamming the door shut on China - though we could definitely force the Chinese to play buy the (supposedly free trade) rules that everyone else (except the oilarchies) has to play by.
Instead, the money is in the trillions of parked money that is sitting around looking for free returns. Back in the days of gold standards, it would have sat in gold, with gold getting more valuable every year, and been used to create big factories with spectacular products, and vast human misery at the same time. Without gold, it has to be juggled carefully - and that has been the objective of the reactionary movement over the last 30 years - a gold standard, without the noxious limits of gold that stop them from bailing themselves out when they need to just print money. Soft money for the creditors, hard money for the borrowers.
Better decisions are not hard to make. Consider the CBO survey I mentioned earlier. Consider how cheap the increase in fuel standards is compared to the war in Iraq. This is merely one example. Given a period of borrowing to meet a recession - which is what you should do, have the government spend when prices are going down - we could have employed the 500K lost tech jobs to develop a great deal of a wireless/hybrid/telecommuting America - which would be one step more along the ultimate trail of a scaleable, sustainable and accessible America - reduced the price of oil, still had a substantial house build out, and had a lower federal budget deficit when it was all over anyway. It also would have been able to bail out pension funds and start us towards national health care. We chose to kill Iraqis rather than save children here, burn gas rather than save it, devote our research to domestic spying rather than cheaper wireless.
People have often asked me about solutions - here is the root of all solutions: change incentives. We created incentives to build houses and consume. People responded by following the jobs and the money. Why am I back in the private sector? Because they pay me a great deal more that the progressive political sphere can. What do I do here? Screw consumers out of money and help ship jobs to China and India. It isn't lack of protectionism that is shipping your jobs to China and India, and you can pass every "worker protection" law you want. The jobs that are going to China are nice jobs, in cubicles no different from yours - they would meet any "parity of worker standards" rule that you want to set, because the same jobs aren't unionized over here either.
Changing incentives means changing one's vision of society. It does not come from endless arguments over which technology will get you there - politics is about saying where we are going, and what we are willing to give up to get there. The "market place of ideas" and the free market will provide the solutions that the public - collectively as government and individually as consumers and producers - will choose.
The guy who did the best over the last five years - other than the big share holder - was the guy who followed the defense and housing boom, or the finance and health care boom, or is in the energy business making holes in the ground. He's what we incentivized, him and his SUV and mcmansion. He's happy. Happier than he has ever been in fact. He goes to his big bucket church, eats at his big bucket restaurant, votes for a big bucket of pork and corruption, and wants a big bucket of cheap money and oil out there for that taking.
The basic roots of the solution are to charge for unsustainability. Build the price of dismantling into the cost of anything, and prices snap into proportion. We've been doing the reverse - corporations want to get out of the costs of asbestos, pension plans and health plans. They want to leave broken down cities, broken down workers, broken down veterans from Iraq, and "move on". The China they are going to leave behind isn't going to be pretty looking either.
Over the Next Year
I am, as noted, a snake. I believe that next year is going to wiggle along like last year, even as the bottom erodes from beneath the economy. The dotconomy busted in early 2000, but it took another year for the economy to go into recession - and then only because Bush was intent on sending it there. The same thing is going to happen now in my view - it is going to take time for Americans to run out of borrowing, and for companies to realize that the easy profits are goin and start slashing prices, and workforces. This means that the recession is still off in the distance for the whole economy - but it is going to arrive in different places at different times. Many blue zones are going to feel it earlier, as the ability to suck money out of houses is going to end.
What people should do is realize that it takes strong nerves to hang in there - the time when people know there could be a big bust, but the panic hasn't started yet. It is easy to panic early. This is the best year to hang on to your job. The best year to switch to a job that is in a less recession prone industry. I get asked alot of questions about "where do I put my money?" the answer varies - close to retirement? young? with kids in college? one size doesn't fit all. The simple one size fits all answer is to stop wasting money - eat out less, pay down your credit cards, make sure you have the right amount of term life insurance, cancel entertainment expenses that you don't need - these will do you more good than timing the crash. When the crash is about to hit, we will know, they send big loud signals.
Most of all - invest in your relationship. A divorce does the same thing to your assets as a stock market crash - and worse, things aren't cheap on the other side. Economists talk about "opportunity costs" - spending an hour on your primary relationship is an hour better spent than trying to find the next hot stock.
For investing - invest in inflation that the fed thinks is good. For a long time that was housing inflation. Now it is energy inflation. In stocks - buy index funds of the major world indexes - US, France, Germany, UK, Tokyo - and in major oil companies. When the fed gets serious about energy inflation - it will be time to sell. But regardless of who takes power, the US is going to have to put huge amounts into electrical power generation and transportation generation - we are going to spend almost a trillion dollars a year on these projects. Invest in them for the long term.
There are three cases for the next year: the bulls think the money is coming raining down, and that the fed has stopped inflation. The snakes thing that interest rates are going to bleed the consumer, and that the stimulus is destined to produce inflation, that will be reigned in after the elections. The bears think that the conditions for a major disruption are in place, and that at some point during the year, there will be a shock that will send the economy spiralling down.
Regardless of your scenario - hiring is going to be slow, though not dead the way it was in 2002 and 2003 - and wages are going to be tough.
To me this means that the best strategy is to tend to ones own garden - work, retrench, invest in ones family, and put ones money to work in long term trends that will pay off regardless of the shape of the rest of the business cycle.