As a follow up to Tuesday’s piece, “Economy on a Knife’s Edge,” we’re adding a couple more pessimistic pieces to the mosaic, one showing that real economic activity continues to fall deeper into recessionary territory, the other predicting a negative impact on GDP from fiscal retrenchment that begins now and extends through 2011. We then try to temper them with some more sanguine observations.
First is this dour picture painted by the Consumer Metric Institute’s Daily Growth Index, which has been indicating contraction in the U.S. since Q1 of this year:
Second is this chart from a recent Goldman Sachs piece (TOH PragCap), which echoes the concerns we’ve had since the beginning of 2010, when it appeared that additional fiscal stimulus was set to taper off:
Mike Darda of MKM Partners offered a more sanguine take on things recently by pointing out that credit market indicators have returned to very benign levels, and that there are important differences between the U.S.’s experience thus far and Japan’s in the 1990s. While those data points are reassuring, we have some concerns looking forward. For example:
- Treasury Yield Curve – We expect the Treasury yield curve to continue flattening in the coming years, due to dovish and possibly activist Fed policy, and to falling growth and inflation expectations. Thus, a steep yield curve will gradually come off the table. This implies lower nominal GDP and amounts to a diminishing subsidy for the banking sector. And flattening at low nominal levels also implies that yield curve signals might be less powerful or less reliable in the decade ahead than they were in the five or six decades just passed.
- Credit Risk Indicators – Interest rate and credit default swap spreads have been much tamer since the Greek debt crisis settled down. But upside (i.e., negative) movements in those indicators tend to be sudden and severe. The ECB and IMF have been very successful in buying time for troubled European governments. But there is still not a permanent solution in place, and it’s important to keep in mind that during the crises of 2007-2009, those same indicators were dovish until they suddenly weren’t. To us, they’re similar to the VIX, being more useful as ’buy’ indicators when they hit their upper extremes, rather than as a ‘hold’ indicator when they’re at lullaby levels.
- Industrial Commodity Prices - Industrial prices have been more buoyant during this crisis than they were in Yen terms during the 1990s. However, during the 1990s, slow to negative growth and financial crises in many emerging economies, plus a “strong dollar” policy, provided a stiff headwind to commodity prices generally. Growth in emerging economies, plus China’s concerted stimulus measures in 2009, are providing a tailwind to commodity prices this time around. As long as this continues, we admit that tradable goods will be more of a stagflationary force in the U.S. than a deflationary one. But that can’t continue indefinitely, especially if U.S. demand continues to retrench.
- Demographics – While cruder measures like fertility rates and dependency ratios support the idea that the U.S. should outperform Japan and Europe (and perhaps China) in the decades ahead, recent and current shifts in age structure in the U.S. clearly follow a pattern like Japan’s, with roughly a ten year lag. That implies falling rates of household formation, durables purchases, and overall demand, all else equal (for more on this topic, see our recent interview with labor economist Diane Macunovich).
- Public & Private Sector Balance Sheets - A critical theme in the current environment is that households are desperate to repair damaged balance sheets. While corporations may be levering up, money supply data still indicates falling levels of credit and money turnover. This is a situation that no developed countries, with the exception of Japan, have encountered since the 1930s (a period that also coincided with the type of age structure shifts mentioned above). The Fed is considering another round of quantitative easing, but as we recently pointed out, this is a very messy approach to monetary policy. The obvious choice under the conditions facing the developed world — aside from incurring the long term opportunity costs of letting a deflationary wash0ut follow its natural course – is for the federal government to continue engaging in fiscal expansion, until private sector credit growth recovers.*** But it seems crystal clear to us, as reflected in the Goldman chart above, that the public sector is headed in the opposite direction, and we look for PAYGO to be alive, well, and plenty harmful in 2011.
Corporate profits as a percentage of GDP continue to grind higher too, in what appears to be a secular trend. This is good insofar as it supports overall demand and/or saving desires in the private sector. But there are plenty of wrinkles to it, as a recent Economist article points out:
This focus on improved efficiency without investing in growth will last a while… In particular, the “bankruptcy bubble” of a year ago is only now starting to bear fruit. Compared with previous waves of restructuring, this one was more about generating operating efficiencies by cutting jobs and capacity than about restructuring balance-sheets.
There’s still a lot more juice to be squeezed from the lemon, says Hal Sirkin of Boston Consulting Group. One obvious area is procurement, where a growing number of firms are starting to “squeeze their suppliers a second time”, after realising that the first round of renegotiations following the financial crisis did not go far enough. Many of these suppliers have themselves reduced their costs in the past 18 months and have yet to pass those savings on. Mr Sirkin also expects merger activity to accelerate, which should release “another significant amount of juice”.
The great squeeze cannot go on forever, of course, but it shows no sign of slackening. And the great decoupling of profits from jobs could last for a long time. If so, successful American firms will remain uncharacteristically unpopular.
A first reaction might be that corporate management and shareholders have used productivity gains (and perhaps other factors) to garner a greater share of wealth for themselves, but we suspect, as the Economist article notes, that this dynamic has a lot to do with globalization. One has to wonder though if the distribution of income won’t become as serious an issue in the years ahead as it was at the turn of the 20th century.
*** The intersectoral balances approach is not an intuitive concept, as most of us are conditioned by culture and experience to think of debt as risky and originating outside of our own “economies”. We reflexively believe that money is created in the private sector (which it was, for the most part, when money was derived from precious metals), and taken away by the public sector via taxes and transfer payments. But in fact, the federal government (via the quasi-public Federal Reserve) is the only supplier of the money we use to save, invest, transact with each other, and pay taxes (and that it uses to service its debt and purchase goods and services from the private sector). But very few policymakers grasp this dynamic, much less have the courage to advocate expanded deficits in an election season dominated by misguided tea partiers and other deficit phobes (though as we have acknowledged previously, the belief that higher deficits now lead to higher taxes later is completely understandable, given how the left thinks and talks about these things; until more policymakers grasp intersectoral dynamics, the deficit phobes sort of have a point).
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