A Weakening Economy

More and more evidence is trickling in that shows that economic activity is softening considerably all over the world. Yesterday, US manufacturing ISM data vastly underwhelmed expectations as the headline number dropped to the lowest level in two years, to 50.9 from 55.3 the previous month and against an expected 54.5 (so much for the forecasting prowess of mainstream economists. We have argued all year long that the 'big surprise will be a weakening of the economy as the year goes on', based solely on deductive reasoning).

Bloomberg reports:


„Manufacturing in the U.S. almost stalled in July, threatening to deprive the two-year recovery of one of its main drivers.

The Institute for Supply Management’s factory index slumped to 50.9, the lowest since July 2009, from 55.3 a month earlier, the Tempe, Arizona-based group said today. Figures less than 50 signal contraction, and the July index was lower than the most pessimistic forecast in a Bloomberg News survey.

Stocks declined and Treasuries rallied as orders shrank for the first time since June 2009, indicating production and economic growth may be limited. Other reports today indicated a global slowdown as factory measures from Asia to Europe dropped.

“Businesses have cut back on orders and employment because they are just not seeing the demand that they expected,” said John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina. “The economy is just not picking up momentum in the second half.”

The median forecast in the Bloomberg survey of 80 economists called for a decline to 54.5. Estimates ranged from 51 to 56.“


We have frequently remarked on the tendency of economists to be overoptimistic, especially near economic turning points. As a forecasting tool, the current economic orthodoxy is completely useless.

The steepness of this drop in the ISM underscores something else that we have remarked upon in the past: during secular contractions, the onset of recessionary phases will usually be very sudden – businessmen will tend to say things like 'it was as if someone had suddenly thrown a light switch'.

We have heard remarks to this effect both at the beginning of the 2000 -2002 recession and the beginning of the 2007-2009 recession. We are observing such anecdotal evidence once again today, in earnings conference calls held by cyclical businesses (such as e.g. Emerson Electric's recent earnings conference call, which we have previously mentioned in this context). The tone of these earnings calls is generally somber, and it has been noted that 'there was a sudden and unexpected slowdown in June and July'.

 

Monetary Pumping and Deficit Spending – Can They Help the Economy?

When a secular contraction begins,  an enormous amount of unproductive debt  has usually been amassed during the preceding series of credit booms. These preceding booms not only leave the financial sector and the economy at large hopelessly overleveraged with unsound credit, they also tend to consume much of the real capital that is required to generate sustainable economic growth. This is to say the economy finds itself under pressure from two directions at once: the legacy of unsound credit that paralyzes both borrowers and creditors and the fact that wealth generation has become far more difficult to achieve due to the sheer amount of capital malinvestment that has accumulated during the credit boom phases of the secular expansion.

 


 

Total credit market debt owed in the US economy. This debt expansion has gone hand in hand with the introduction of an unfettered fiat money system – click for higher resolution.

 


 

Total credit market debt divided by nominal GDP. More and more debt has been accumulated relative to economic output (note that GDP is a very flawed measure of economic activity, but it suffices to illustrate this particular point) – click for higher resolution.

 


 

Cyclical expansions during a secular contraction are largely driven by monetary pumping, deficit spending and the inventory cycle (see also 'Short and Long Term Cycles' for more details). This actually explains why the contraction tends to be 'secular', i.e., a long-lasting, drawn out affair that never seems to end.

The sine qua non for laying the foundation for sustainable growth is the reconfiguration of the economy's production structure away from the false activities of the boom to activities that reflect the actual demands of consumers. This requires the transformation and transference (where possible) and/or liquidation of malinvested capital, the accumulation of new savings as well as catching up with capital maintenance, which as a rule is neglected during the boom. This process of reconfiguring the economy to a sustainable production/consumption balance that is in accordance with reality rather than the inflationary illusions of the boom registers as a bust phase. Note here one of the portions of Bloomberg's report on the ISM data we highlighted above:

“Businesses have cut back on orders and employment because they are just not seeing the demand that they expected.”

Why were businesses once again led astray? The answer is that policymakers, i.e., the government and the central bank, don't leave economic busts alone.

While the process of reconfiguring the production structure goes on, fewer workers are needed than were needed during the artificial boom –  capital liquidation and capital maintenance are not as labor-intensive as the activities of the boom have been. In addition, it takes time for people who lost their jobs in the business lines where the boom's capital malinvestment was concentrated (e.g. construction work during the housing boom) to find jobs in different branches. They may need to accept lower wages, they may need to move to new locations, they may need to retrain and in many cases may need to wait until the reconfiguration of the capital structure has been largely accomplished and it becomes clear which new business lines actually require more workers. Obviously, one can not expect all these things to be accomplished overnight.

It should be equally obvious that the bust phase will to some extent be a mirror image of the preceding boom – simply put, the bigger the boom, the bigger the bust. It takes time to accumulate new savings, liquidate unsound credit and unsound investments and reconfigure the production structure, and the weaker the economy happens to be on a structural level on the eve of the bust, the more time it will take.

Politicians and policymakers believe they do not have the time. After all, there are elections and reappointment hearings they have to think of. In addition, the current Keynesian orthodoxy – which is widely thought by policymakers to hold the correct answers to the vexing question of how to combat economic recessions – prescribes the implementation of policies that are supposed to ensure an 'eternal boom'. Thus the same policies that were at the root of the previous credit boom are applied all over again. This tends to arrest and reverse the above discussed process of the reconfiguration of the capital structure. This restructuring process is however absolutely necessary to once again create a solid foundation for economic growth. Obviously, a 'zero interest rate policy' such as currently practiced by the Federal Reserve will also tend to discourage the accumulation of new savings.

Below is a chart we have shown before. It gives us a crude illustration of the imbalances that have accumulated in the economy as a result of current monetary and fiscal policies:

  


 

The ratio of production of business equipment (durable capital goods) to non-durable consumer goods since 1971. As can be seen, this ratio is way above its historical average. The historical highs in this ratio have generally coincided with the tops of credit and asset booms – this is no coincidence – click for higher resolution.

 


 

A long term chart of the same ratio shows that the extreme imbalance began to become manifest after the monetary system had been changed to a pure fiat money system in the early 1970's. Again, this is no coincidence, as this makeover of the monetary system is what made an extreme credit expansion possible – click for higher resolution.

 


 

The increase in the ratio of the production of business equipment (durable capital goods ex buildings) versus the production of non-durable consumer goods shows us that the Fed's monetary pumping effort has arrested and reversed the economy's attempt to bring this production ratio back into balance and closer to its historical average.

Loose monetary and fiscal policies have once again drawn investment increasingly toward the higher order goods production stages. The problem with this is that the major driver of this shift in production has been an increase in the broad true money supply (TMS-2) of 45% combined with a vast increase in deficit spending since the beginning of 2008.

It has not been supported by a commensurate increase in real savings, and thus will once again prove unsustainable. This will in turn necessitate another round of liquidation of malinvested capital down the road – and this process may in fact be about to begin.

A further problem is that one can not start such artificial booms too often. It  appears that the economy's pool of real funding has suffered grave damage in the last boom, which is evidenced by the fact that in spite of the herculean monetary pumping and deficit spending efforts since 2008, the economy has failed to recover to the extent that has usually been observed in post WW2 recoveries.

While scarce capital tends to be consumed during a boom, there is always a certain degree of true wealth creation going on in the market economy, in spite of all the obstacles it faces. As long as such wealth generation exceeds the consumption of capital, monetary pumping can always recreate an illusion of growing prosperity by shifting more resources into ultimately unprofitable or unrealizable investment projects.

It becomes however impossible to maintain such an illusion of prosperity once capital consumption exceeds the creation of new wealth and accumulation of new capital. We may well have arrived at that point, as the Federal Reserve's 'quantitative easing' programs appear to have less and less effect. This has left the Fed chairman 'puzzled' as he recently admitted, but it probably does not mean that he is about to abandon his cherished theories.

We should therefore expect that even more monetary pumping is going to be foisted on the economy – with the attendant negative repercussions on the generation of true wealth.

Similar views as Bernanke's are held by many prominent economists on the subject of deficit spending. For instance, on occasion of the debt ceiling debate,  Paul Krugman writes in the NYT:

 

“Start with the economics. We currently have a deeply depressed economy. We will almost certainly continue to have a depressed economy all through next year. And we will probably have a depressed economy through 2013 as well, if not beyond.

The worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further. Pay no attention to those who invoke the confidence fairy, claiming that tough action on the budget will reassure businesses and consumers, leading them to spend more. It doesn’t work that way, a fact confirmed by many studies of the historical record.

Indeed, slashing spending while the economy is depressed won’t even help the budget situation much, and might well make it worse. On one side, interest rates on federal borrowing are currently very low, so spending cuts now will do little to reduce future interest costs. On the other side, making the economy weaker now will also hurt its long-run prospects, which will in turn reduce future revenue. So those demanding spending cuts now are like medieval doctors who treated the sick by bleeding them, and thereby made them even sicker.”

 

If is true, as Krugman asserts, that it is a mistake to cut government spending during a recession, then one must ask: why hasn't the vast deficit spending exercise helped thus far?

 


 

Paul Krugman complains that the president has 'capitulated' on the debt ceiling debate – alas, the president sure has followed Krugman's deficit spending advice thus far. Why hasn't it worked? – click for higher resolution.

 


 

Krugman wisely neglects to name the 'many studies of the historical record' that allegedly prove that the 'worst thing one can do is to cut deficit spending' when the economy is weak. To this it should be noted that historical economic statistics can not really be used to prove a theoretical argument. This is because there are too many dynamic factors influencing the economy at any given point in time – they can not be quantified and cause and effect can not be objectively assigned.

Alas, what studies there do exist, actually support the opposite claim – as e.g. Robert Barro's empirical research has shown, the so-called 'multiplier' of deficit spending is very likely less than one – this is to say, deficit spending actually lowers economic growth. (see the two WSJ articles 'Stimulus Spending Doesn't Work' and 'Government Spending is no Free Lunch').

So we can in fact name a few empirical studies that are buttressing our contentions, and they directly contradict Krugman's assertions. This should be no surprise. We can arrive at the same conclusion without relying on empirical studies by the application of logic. The government does not possess any resources of its own – every dollar it spends must be taken from the private sector in some shape or form (either by taxation, borrowing or inflation). So to the same extent that the government increases its spending, the private sector is forced to reduce its spending and investment activities. This leaves only one question to be answered: what is more likely to generate wealth? The answer to this question should be obvious.

The decisive point about the efficacy of both monetary pumping and fiscal deficit spending is this: neither can in fact increase the economy's pool of real funding. They can only redistribute the already existing pool of real resources.

Real funding is what actually funds production – money does not ''fund' anything, it is merely a medium of exchange. We can not get richer by creating more of it and we can not get any richer by government amassing large additional debts. Deficit spending merely channels resources along the lines preferred by politicians and bureaucrats – and this is hardly a viable road to sustainable economic growth.

As an interesting aside to the above – we have previously discussed the often mentioned alleged 'mistake of 1937', where a slight tightening of fiscal and monetary policies are held to have been instrumental in creating the 'depression within the depression'. As we have argued, all that has likely happened was that the inflationary mini-boom of 1933-1937 was unmasked as unsustainable. However, we have recently come across a quote by Benjamin Anderson that suggests that an additional factor worsened the situation considerably – the passage of the 'Wagner act'. Anderson states that:


A main factor on the industrial side in bringing the revival of 1935-37 to a close was this startling increase in wages arising not from scarcity of labor, because unemployment remained at 6.25 million for the year 1937, but from a tremendous burst of activity by trade unions under the Wagner Act – a rise in wages unmatched by a corresponding rise in the productivity of labor."


It should be noted to this that a strong rebound in economic activity in the post-war period began as soon as the most injurious policies of the 'New Deal' were repealed by Congress in 1946.

 

Addendum:

Further proof that the economic slowdown is beginning to be felt all over the world has surfaced. Russia has just released very disappointing manufacturing data as well – manufacturing activity in Russia has in fact shrunk for the first time in 19 months. Due to Russia's export dependency, a contraction in its manufacturing sector does tell us a bit about economic activity elsewhere in the world. As Bloomberg reports:

 

Russian manufacturing contracted in July for the first time since December 2009 as slowing growth in China and the euro area damped demand for the country’s exports.

The Purchasing Managers’ Index fell to a seasonally adjusted 49.8 from 50.6 in June, HSBC Holdings Plc said in a report today, citing data compiled by London-based Markit Economics. A reading below 50 indicates contraction.

Russia, the world’s biggest energy exporter, is lagging behind growth in emerging-market peers Brazil, India and China. Gross domestic product expanded 3.7 percent from a year earlier in the second quarter, less than the 4.1 percent increase in the first three months of 2011, according to the Economy Ministry.

“The Russian manufacturing sector appeared to enter the summer recess in July,” Alexander Morozov, HSBC’s chief economist for Russia and the Commonwealth of Independent States, said in the report. The weak reading “clearly demonstrates the strong dependence of Russian manufacturing growth on the global economic cycle through Russian exports.”

 

(emphasis added).

Well, it is all happening just in time for the annual central banker pow-wow in Jackson Hole. Last year, Fed chief Bernanke used the occasion to give the markets a strong hint that 'QE 2' was imminent. We wouldn't be surprised if similar hints were to emerge this year.

 

 Charts by: Ferderal Reserve of Saint Louis Research


 

 

 

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4 Responses to “Secular Contractions And Interventionism”

  • I don’t believe what Bernanke is doing is having any effect other than speculation. Banks don’t need capital reserves to hold government debt, thus they can create the money themselves. Instead, it is depriving the system of the return on the money that would otherwise be paid. Money in banks don’t exist except for the purpose of cashing checks deposited in other banks. Bernanke is instead hiding the insolvency of the system, sort of like rather than default, Obama merely asks for a rise in the debt ceiling so he can borrow more money. You might note the bond market charts, where there wasn’t a worry in the world about a default. Federal debt is free income for banks. That is unless it happens to be Greek debt in a European bank.

    As for the durable capital goods spending opposed to the non durable consumer goods spending? What I believe Pater is saying is that we have had a continual crack up boom for going on 40 years now, fed by leverage. The point of this is that once the bill comes due, the debt will consume the capital position and it will all freeze in place. No real capital means that companies go bankrupt and lay off employees and there is a lack of real capital to liquidate the assets in the system. The situation in China is even more extreme, as the banking there provides evergreen notes for expansion. Can they make the transition? Probably not, because their economy depends on exports to keep it humming. The Joe Biden quote that we must spend money to keep from going broke is more like the heroin addict who takes the 1000th shot to get high. It merely keeps him from getting sick at best and eventually kills him. It is no longer getting him high because that stage is behind him. We have juiced our economy for so long the juice don’t work any more. Bernanke is merely stealing from savers to bail out bankers. As the savers get poorer, there will be less to pay the bankers, less to put up as venture capital and so forth.

    Another note. I heard the pent up demand story in relation to automobiles again. They were talking about the age of the fleet. Well, they count the cars that were parked out back to have an extra car that people acquired during the boom. For over a decade, there wasn’t a dip of any significance in new car sales from boom levels. Modern autos can run a hell of a long time and I am sure that by the time this game is done, the average auto will get a lot older. So will the PC’s on the desks of US business, the buildings and all the other prime investments that have been so casually made over the past few decades.

  • The ratio of production of business equipment (durable capital goods) to non-durable consumer goods since 1971. As can be seen, this ratio is way above its historical average. The historical highs in this ratio have generally coincided with the tops of credit and asset booms – this is no coincidence – click for higher resolution.

    So does this mean that this ratio has to eventually work its way down to more normal levels (as the time structure of production realigns to people’s preferences)? Because, if that’s right and I’m not misunderstanding this ratio, then that is an alarming prospect indeed!

    • Yes, that is what it implies. We must of course also consider that nowadays, the global division of labor has moved a lot of final goods production overseas, but even so this ratio is likely extremely out of whack with the production system actual time preferences would indicate as being healthy. One must suspect – although it can not be proved, except by logical deduction – that the monetary pumping of recent years has drawn too much capital toward higher order goods production, and the pool of real savings is actually not large enough to support that amount of investment in the early stages. Of course when this is being addressed, it will likely involve another severe recession.

  • amun1:

    The bond market seems to believe that more money printing is headed our way, as does gold. It’s a good indicator that the misallocation will continue. Governments will borrow massive sums of free money, citizens will get a minimal return on their savings, investors will misjudge the availability of capital and make poor decisions.

    The solutions are always the same; destroy the incentive for saving, now extending out decades into the future. Japan seems to be the model, but the odds of that happening under this scenario of global rampant deficit spending and debt monetization, are almost zero. At these bond prices, we’ve almost guaranteed a debt catastrophe.

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