THE BEAR'S LAIR V-shaped explosion
By Martin Hutchinson
Commentators, including the egregious Federal Reserve chairman Ben Bernanke,
are increasingly claiming that the United States is in the process of a
V-shaped recovery from the Great Recession. Certainly first-quarter gross
domestic product (GDP), to be announced next week, is likely to show a
substantial bounce, albeit not quite the inventory-driven 5.6% annualized
growth of the fourth quarter. Yet commentators should be careful what they wish
for: a V-shaped recovery is likely to lead not to a prolonged period of healthy
growth, but to an economic explosion and collapse.
This may seem counter-intuitive. You would normally expect a period of
above-normal growth after such a deep recession, whatever the political
environment. After all, even in 1934, a year in which the federal government
was taking a hatchet to the
banking system and capital markets through the Glass-Steagall Act and was
micro-managing wages, prices and product specifications through the National
Recovery Administration, US GDP, it is now estimated, rose by an extremely
healthy 10.9%. Indeed, 1933-34 form the principal supporting evidence for the
efficacy of Keynesian "stimulus" - real federal expenditure rose by 23.7% in
1933 and no less than 34.2% in 1934, a public sector bloat rate of which even
President Barack Obama might be proud.
In the very short run, intuition may be right. Manufacturing numbers for the
last couple of months have been good, while surging retail sales and the
plunging savings rate suggested that the US consumer has discovered yet another
credit card in an old jacket pocket that he had forgotten about. Automobile
sales too have rebounded nicely, and Ford in particular is looking more solid
than it has for several years. Tech sector profits seem to be "surprising on
the upside" as they say, with Google reporting sharply rebounding ad sales.
With such growth, even the projected federal deficit may decline by US$50
billion or so, still not quite a rounding error.
The recovery may be V-shaped in the next quarter or two, but it is very
doubtful indeed whether it can continue to be so for long enough to define
itself as a true recovery rather than merely an intermediate bump in a
"double-dip" recession. On unemployment, for example, since 8.4 million jobs
have been lost in the recession, a US recovery that lasted two years from now
would have to create 350,000 jobs per month to restore the jobs lost, and that
would still leave unemployment much higher than in December 2007, at 6.5-7%,
because over 5 million more people would have been added to the labor force
between December 2007 and April 2012.
With an employed US labor force of 139 million at present, job creation at
350,000 per month implies an increase in the work available of 0.252% per month
or 3.02% per annum. Add the 2% trend growth in productivity, and you're talking
more than 5% GDP growth for two full years. A lovely V-shaped recovery if you
could get it, but in terms of duration and extent, the bare minimum necessary
for the recovery to qualify as a true economic expansion and not simply a bump
in a prolonged recession.
So what are the chances of 5% US annual GDP growth for the next two years and
commensurate growth in international markets? To see the problems involved,
consider the question of commodity and energy prices. In the last 12 months,
while the global economy has been operating far below capacity, the
Organization for Petroleum Exporting Countries benchmark crude oil price has
risen from $50.20 to $81.52 per barrel, a 62.4% increase. Yet US GDP, which
bottomed out last April/May, has risen no more than 5% in the last 12 months,
probably less. Thus two years of 5% GDP growth would imply energy prices rising
at least as quickly as in the last 12 months, as Chinese and Indian growth
continued rapid and US oil consumption rebounded towards historic trends.
Two more years of 62.4% price rises would take oil prices to $215 per barrel.
Given that $147 per barrel oil was a major contributor to the 2008 crisis, do
we really think the US economy capable of bearing $215 oil in 2012 without
caving in on itself? I don't think so. At least, not unless the dollar has
collapsed and inflation has taken off to a level of perhaps 20-25% per annum,
which is certainly a possibility.
Then there's iron ore. The annual contract system appears to have broken down,
with contracts settled at 100% above last year's prices and the spot price
running 50% higher still. Given the assumption of robust global growth and thus
maintenance of this rate of increase, iron ore prices by April 2012 could thus
be quadruple their current level, or $600 per tonne. Automobile production
would have to shift entirely to plastic - except that being derived from
petroleum, plastics prices would also have grown exponentially.
Then there's copper. That's also up more than 60% over the past year and on the
London Metal Exchange is closing in on its all-time record price, set in April
2008, around $9,000 per tonne. Existing copper mines deplete rapidly unless
capital is invested in them, and with new investment having ceased for a year
in 2008-09 there is now a serious supply shortage, not expected to be
alleviated until major new capacity comes on stream in 2014-15. Again, if
economic recovery is robust for the next two years, copper prices will continue
rising at the same rate as in the last year, reaching $21,000 per tonne by
2012. Any bets on what that will do to the economy, or to inflation?
In short, rapid expansion at 5% per annum for the next two years, the minimum
necessary for this to be termed a true V-shaped recovery and not just a blip,
will run into one of two constraints. Either inflation will take off, reaching
an annual rate of at least 20% by 2012 as commodity and energy prices continue
their inexorable climb, so forming a larger and larger part of the consumer's
purchase basket. Or a collapse in the government bond market, panicking at the
rapid acceleration in inflation, will choke off economic recovery, plunging
asset prices including housing back into the depths of gloom and sparking off
another banking crisis caused by yet another wave of home mortgage defaults.
In other words, a true V-shaped recovery is impossible, at least without some
very unpleasant consequences indeed. Presumably in the latter stages of a rise
in inflation towards 20-25%, even Bernanke would be forced to recognize its
existence and raise short-term interest rates from their present derisory
levels - which would itself cause a crisis in the financial and housing
sectors.
When considering the recovery's future trajectory, there is another fairly
benign possibility, that of a gamma-shaped recovery (the English language has
no appropriate letters!) in which growth starts off at the V-shaped rate of 5%
or so, but within a quarter or two from now slows down to a "soft landing" pace
of 1-1.5%, at which the commodity price explosion levels out, inflation remains
a potential problem but not an immediate danger and the global economic
imbalances are allowed to work themselves out over time..
However, that would not allow US unemployment to decline much - once the slow
recovery had set in, productivity growth would prevent net job creation and so
with the workforce expanding steadily, unemployment would remain stubbornly
high, probably around 9%.
To achieve the optimal gamma shaped recovery, however, one policy change is
absolutely necessary: the Fed must increase forthwith its federal funds target
and other short-term interest rates from zero to a level slightly above the
rate of inflation, perhaps in the 3-4% range, increasing them further if, as is
likely, inflation trended upwards. That would remove the incentive for banks
and hedge funds to borrow at negative real interest rates and invest in
anything, such as commodities and energy, which seemed likely to maintain its
value.
It would also remove two anomalies in the present market that make healthy and
sustained recovery impossible. First, it would remove the subsidy for banks to
"borrow short and lend long" by investing their balance sheets in Treasury
securities and housing bonds, thus starving small business of funding. With
commercial and industrial loans now down 25% from their October 2008 peak,
small business is starving for working capital at the same time as the banks
make record profits.
Second, it would remove the disincentive to saving that is driving the US
savings rate back down to the near-zero levels of 2005-07, making the US
financial system in the long run unsustainable. Japan can sustain public debt
of 200% of GDP because of its enormous savings pool; blowout is likely in the
US at much lower levels because no such savings pool is available.
Higher interest rates would also reduce stock market speculation, returning the
market to its sustainable level of around 8,000 or below on the Dow. It would
also, by reducing bank enthusiasm for housing bonds, begin to remove the
excessive subsidization of housing, diverting capital back into more productive
channels.
A gamma-shaped recovery may look fairly unattractive, but it's a lot better
than the alternative of rapid recovery followed by blowout. It could also be
engineered so that the gamma-ization of 5% growth into 1.5% growth did not
become apparent until after November's midterm elections, thus allowing the
Obama administration to present simple folk in the electorate with the
impression of a vigorous and sustainable recovery.
However, with Bernanke at the Fed, the necessary rise in interest rates is
unlikely to happen. So the wise investor will remain long commodities and
energy -and brace himself for eventual inflationary collapse into a
"double-dip" Greater Recession.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-10 David W Tice & Associates.)
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