THE BEAR'S LAIR Combining the worst By Martin Hutchinson
Federal Reserve chairman Ben Bernanke loses sleep over the possibility that the
United States may suffer a repeat of the 1930s' Great Depression. Inflation
hawks and opponents of President Barack Obama's Keynesian "stimulus" warn
continually of a possible repeat of the 1970s' stagflation. Yet recent data is
beginning to suggest a more unpleasant possibility still: that the United
States could suffer both traumas simultaneously - a prolonged period of
pathologically high unemployment combined with vicious and unrelenting
This grim prognostication results from recent developments that have eliminated
some economic possibilities but boosted the probability of others, including
the apparently unlikely outcome
outlined above. The possibility I thought most likely a year ago, of a
relatively strong recovery accompanied by rising inflation (which might then
require a Paul Volcker-style remedy to combat it, so pushing the economy into a
double-dip similar to that of 1980-82) now seems relatively unlikely.
Likewise, the possibility feared above all others by Bernanke, of a bout of
savage deflation sufficiently severe to choke off economic recovery, is also
off the table - although in my view it was never truly on it.
The first development that has changed the picture is the renewed downturn in
the housing market. It was always likely that once the artificial stimulus of
the US$8,000 first-time buyer credit was exhausted at the end of April, home
sales would drop. However, both new home sales and existing home sales for July
dropped by double-digit percentages to levels never seen in the history of the
series. (While for existing homes the series dates back only to 1999, for new
homes it dates back to 1959, so the decline in new homes sales tells us that 50
years of growth has been wiped out in that market.)
With the Case-Shiller 20-city house price index still 47% above its value in
January 2000, just about matching the consumer price rise during the period,
house prices are still about 5-8% above their long-term average in terms of
incomes (the recession, reducing incomes, has not helped here, of course).
Dean Baker of the Center for Economic Policy Research estimated recently that
house prices had another 15% to fall. I would regard that 15% figure as about
right, maybe a little low. However in certain areas such as New York, Boston,
the Washington DC suburbs and coastal California, house prices remain far above
their historical norms, even though they have already fallen a long way.
(Suburban Washington is a special case; there the market has been propped up
for the past decade by the explosion in the number of federal bureaucrats and
especially lobbyists; there must be some hope that recession will shortly hit
even this pampered sector of the economy.)
Meanwhile mortgage originations and particularly re-financings have continued
at a rapid clip, with individual homeowners continuing to use re-financings as
ATMs and banks comforted by the current ability to get a federal government
guarantee on everything. Thus there remains a large volume of home mortgages,
both recent re-financings and those carried out in 2003-05, which have not yet
suffered from negative equity but are about to do so. After all, in a house
price decline of 40-50% from the peak, as will be seen in some areas, home
mortgages no longer need to have been "subprime" to go horribly wrong.
As house prices decline further therefore, the volume of mortgage defaults and
foreclosures will once again explode upwards, with the main losses now being
borne by taxpayers rather than by the banking system.
As it did in 2008-09, this will produce a further economic downdraft.
Unemployment, already close to post-war records (and well above previous
records when long-term unemployment is considered) will soar further as
consumption is depressed by the mass of losses and financial traumas among even
the wealthier segments of the middle class. Unemployment is unlikely to reach
25% as it did in 1933, but a prolonged period of 12-15% unemployment, more than
half of which is long-term, is entirely possible.
On the inflation side, the Fed has now kept interest rates well below the level
of inflation for two years. Savers are venturing into ever more speculative
investments in order to avoid the gradual erosion of their capital. Meanwhile
international cost pressures are intensifying. In China and India, price
pressures are building up fast, with real estate in China and food and fuel
prices in India providing particular upward momentum, while wages in both
countries are rising at double-digit rates.
Global commodity prices are rising inexorably, driven partly by rapidly rising
demand in relatively poor countries that consume a large proportion of "drop it
on your foot" products (rather than services), but also by persistent negative
global real interest rates.
Gold prices, once again nearing a record, are only a symptom of this; the World
Gold Council recently reported that global demand for gold increased by 40% in
the second quarter of 2010 and is running far ahead of supply. Needless to say,
the immense liquidity among central banks, increasingly finding gold a better
investment than each others' currencies, and hedge funds and corporations in
general, is feeding this bubble. While little of the global inflation has yet
affected US prices (which are in any case carefully "managed" by the Bureau of
Labor Statistics) its force cannot be denied much longer; even by the end of
the year US inflation figures are likely to look considerably less benign than
they do at present.
This combination of inflation and recession will produce multiple feedback
loops. Recession, depressing wage costs and making retailers compete more
aggressively, will tend to depress inflation, but will in the end prove unable
to overcome the twin forces of soaring commodity prices and rising emerging
market labor costs.
Eventually, retailers who cut prices aggressively to try and recapture lost
sales volume will go bankrupt, freeing the market for their remaining
competitors but allowing prices to rise.
On the other side, inflation will cushion somewhat the loss of wealth from
declining house prices, as the real value of home mortgages also declines, but
it will at some stage cause an almighty and very expensive bursting of the
current bubble in US Treasuries. Once consumer price inflation rises
definitively above 3%, investors will cease to accept less than 5% on 10-year
Treasuries - and that implies a substantial price loss of 19.3% from their
current level yielding 2.5%. Needless to say, the price losses in Treasuries
will cause the collapse of various institutions, the further insolvency of
numerous public and private sector pension funds and a substantial further
decline in the stock market.
This combination of deep recession and inflation is supposed theoretically to
be impossible but can exist perfectly comfortably in a world that is not all in
recession. Argentina in particular has suffered a combination of inflation and
a sharp decline in living standards for much the period since 1945. Russia and
much of eastern Europe suffered both declining gross domestic product and
rising inflation during the 1990s, and Venezuela is suffering it currently. It
generally occurs when there is either an economically inept government (as now
in Venezuela) or a massive deterioration in the terms of trade for the country
concerned. Inflation, by eroding the value of incomes and savings, allows the
adjustment to much lower living standards to occur with less disruption than if
the burden were borne entirely by soaring unemployment and bankruptcies.
That is what is now happening to the United States. While the government is
generally fairly competent (though the generation of presidents George W Bush
and Obama and Fed chairmen Allan Greenspan and Bernanke has not excelled in
this respect) the massively improved ease of outsourcing has permanently
worsened the terms of trade for rich countries with only moderate endowments of
natural resources. During the 2000s, this reality was disguised by the housing
and financial bubbles and by the massive US balance of payments deficit; now
its reality is becoming clear to all.
US labor is now worth less relative to emerging market labor because the
logistical costs of manufacturing and much service provision in emerging
markets have greatly declined - and the "outsourcing" process itself has
increased the capability of emerging markets workforces. This process has been
exacerbated by low global interest rates, which collapsed the capital cost
premium emerging markets needed to pay to attract investment, and by the US
balance of payments deficit, which has allowed the capital positions of the
United States and emerging markets to be further equalized.
The period of inflationary recession will thus resemble neither the 1930s, in
which those who kept their jobs found their living standards improving, nor the
1970s, where lack of competition allowed powerful unions to extract rents for
their members. Job holders will find themselves receiving little or nothing in
pay increases because the labor market will be slack, while unions that attempt
to keep up their members' living standards by industrial action will find their
employers locking them out to avoid bankruptcy, their bargaining position
improved by the pool of available unemployed labor. As for the public sector,
we are already seeing a massive political backlash against automatic public
sector pay and pension increases, which is likely to intensify as inflation
Policy will determine how long this utterly miserable period lasts. Optimists
can imagine a near-term correction in US fiscal and monetary policy, producing
interest rates high enough to stem inflation's rise and a public sector deficit
shrinking rapidly back to normal levels. That would allow the US capital base
to rebuild while avoiding burdening the economy with excessive public sector
bloat. In that case, the natural competitiveness and capability of the US
workforce would reassert itself within a few years and growth would resume.
For pessimists, the Fed will keep interest rates far too low because of the
recession, allowing inflation to soar and shrinking the real value of the US
capital base, while mammoth public sector deficits crowd out private sector
investment. In that case, apart from the very real possibility of a US Treasury
default, the US downturn would intensify, as its capital endowment was hollowed
out by inflation and public borrowing, while its competitiveness was reduced by
a bloated public sector. We might then see a downturn lasting a decade and a
reduction of 30% or even 40% in median real US wages. The US might also, like
Argentina, suffer a period of hyperinflation.
The prospect ahead is thus uniquely gloomy. Part of the gloom is caused by a
natural and unavoidable change in the terms of trade, making a reduction in US
living standards inevitable. However, most of it can be ascribed to
wrong-headed policies pursued by the four horsemen of the financial apocalypse,
Messrs Bush, Obama, Greenspan and Bernanke.
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.)