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Let's De-Stimulate!

Way back in June I called for recalling the Stimulus. It was poorly designed, and probably worse than just flushing the money down the toilet. Since then nothing good has come of it. Larry Kudlow today revives this notion, saying we should De-Stimulate. We've all had more than enough government intervention and taxes and wasteful spending. And who is Obama to decide that having the federal government spend $2.3 on Green Energy programs is better than letting the private sector do it? If it were so profitable and job-creating, surely some enterprising firm out there would already be pursuing this. Here's a slightly edited version of Larry's column:


After the arrival of a disappointing December jobs report, my thought on putting America back to work is simple: de-stimulate. Get rid of the Obama stimulus monster, including the government takeover of health care, cap-and-trade, and all this nonsensical talk of creating green jobs. Get rid of the increase in marginal personal tax rates and capital-gains tax rates. Get rid of the payroll tax hike from the health-care talks. Get rid of the spending that is a counterweight to growth. It’s creating so much uncertainty that even profitable businesses are afraid to hire new workers and expand.

On Friday, the day of the sub-par jobs release, President Obama comes out with a new green-jobs program that will cost taxpayers $2.3 billion. He predicts targeted tax credits for all of his faddish “energy savers” -- presumably determined by hoards of EPA bureaucrats -- will create 17,000 new jobs. This is out of a total workforce of 153 million.

And wait, it gets better. The average cost of these alleged new green jobs will be $135,000 per job. It’s sorta like the $780 billion stimulus plan, half of which has supposedly saved 1 million jobs at roughly $200,000 per job.

And on the subject of energy-related jobs, the EPA is now going to penalize manufacturing America -- or what’s left of it -- with tougher standards to reduce smog. Of course, smog has already fallen 25 percent in the last three decades. And the EPA’s projected smog savings are so miniscule compared to the new costs for business that the National Association of Manufacturers, the petrochemical makers, and others are screaming bloody murder.

Interior Secretary Ken Salazar recently announced that he is closing down federal lands for oil and gas drilling. This with the price of oil hovering around $83 a barrel and retail gas at the pump moving in the direction of $3 per gallon. Does anybody in Washington have any common sense at all?

Steve Moore of the Wall Street Journal just wrote a good column about tax chaos in the new year, with small-business write-offs for capital purchases expiring, the alternative minimum tax (AMT) un-indexed for inflation, and no fix in place for the estate tax, which is set to rocket from zero back to 55 percent.

So my point is this: Get rid of all this government spending, taxing, regulating, and meddling. De-stimulate. Let us keep our own money as workers, small-business owners, and corporate employees. Stop any future tax hikes. Stop them. And bring down business tax rates for large and small companies, from 40 percent (federal, state, and local) to something around 25 percent. And take a cue from FedEx CEO Fred Smith, who wants to revive the manufacturing and transportation industries with immediate cash-expensing tax write-offs for investment in new equipment.

President Obama has talked about a zero cap-gains tax for small investors. But why not provide more capital access for everybody, small- and large-business investors?

In light of all the tax-and-regulatory threats, it’s too expensive to hire right now. So get rid of all the so-called stimulus plans and social policies to transform the government’s relation to the private economy. Remove these obstacles.

The economy has more than enough monetary stimulus, and corporations are profitable. The stock market rose nearly 3 percent in the first week of the new year, and is up 70 percent from the March 2009 low. The recession is over. But America must go back to work to truly get the country moving again. Unfortunately, Washington is standing in the way.

There’s a populist wave coming, but it’s from the right, not the left. Free-market populism emanating from the tea-party movement wants government out of our businesses and out of our pockets. These folks are right.

Right now, Washington is completely wrong.

Employment update (2)



Here's a chart which expands on the one in my previous post. It shows the 6-mo. annualized change in private sector jobs. I focus on private sector jobs in both posts, because the private sector is the more important one. Public sector jobs are going to be very weak for quite some time, given all the budget woes at the state and local level. Private sector jobs are the ones likely to turn up first. I note that private sector jobs actually increased slightly in November, and clearly the rate of decline has improved rather dramatically.


Employment update



I don't have much in the way of insights into today's employment report, but this chart is interesting. According to the establishment survey we are very close to a bottom. The household survey continues to decline, however, but the gap between the two surveys has narrowed considerably; if all goes well the household survey should show some bottoming action in coming months.

Regardless, it remains the case that the improvement in the labor market is gradual, and we are unlikely to see any dramatic decline in unemployment before the November elections. This all but ensures that the economy will be a major focus for the election, and Democrats are going to take a huge beating. Republicans will be successful to the extent they regroup and focus on the urgent need to rein in the explosive growth of spending, to avoid tax increases, and to lower and flatten the tax structure.

While the news continues to be rather grim, the prospects for the future are brighter.

The confusing connection between M2 and inflation (2)



This post is a follow-up to a post of mine last month, and to a recent post by Mark Perry questioning whether it is reasonable to expect a pickup in inflation given the big slowdown in M2 growth over the past year. The short answer to his question is yes, it is reasonable to expect inflation to pick up despite the big slowdown in M2 growth. Indeed, an inflation pickup is made more likely by the fact that M2 growth has slowed sharply, after rising sharply in late 2008.

To begin with, the chart above tells us two things: 1) the connection between M2 and inflation is not always consistent, and 2) M2 growth and inflation often (but not always) move in different directions, contrary to what a standard monetarist framework might predict (e.g., faster money growth should lead to more inflation according to standard monetary theory).

For example: Consider the huge pickup in M2 growth from 1970 to 1972, followed by a significant slowdown in inflation from 1972 to 1974. M2 then decelerated sharply in late 1973, only to be followed by a huge pickup in inflation in 1974-75. M2 decelerated in 1978, and was followed by surging inflation in 1979-80. On a more modest scale, M2 decelerated sharply in 2003, and was followed by rising inflation in 2004-5.

The explanation for this, I believe, can be found in the confusing nature of M2. We've all been taught over the years that M2 is arguably the best measure of money supply. I would argue instead that it is one of the best measures of money demand. After all, the Fed only supplies reserves and currency to the world, and currency makes up only 10% of M2. The other 90% of M2 exists because people want to hold money in the form of checking accounts (10%), retail money market funds (10%), small time deposits (13%), and savings deposits (57%).

This distinction—whether M2 represents money demand or money supply—makes a world of difference. When M2 growth slows sharply, I think it usually means that money demand has collapsed; people want less money, so they take it out of their savings account and spend it. That's equivalent to saying that the velocity of money has turned up. Rising money velocity means that a given amount of money can support a greater volume of transactions and/or a higher price level. This follows from the classic equation M*V = P*T.

What we have seen over the past 18 months is this: in Sept. '08 the Lehman bankruptcy sparked a global panic over the imminent collapse of the banking system; this in turn caused money demand to surge as a precautionary measure; rising money demand showed up in a big increase in M2; rising money demand meant a huge decline in money velocity, and that is what caused spending to plunge, economies and industries to shut down, and inflation to fall. Since late March we have been on the positive side of this process: confidence has returned, money demand has declined, M2 growth has slowed to a crawl, the economy has picked up, and inflation has picked up.

I think it is reasonable to expect this process to continue, especially given the 1-2 year lags that we see in this chart. Plus, the inflationary potential of falling money demand is likely to be boosted by the Fed's willingness to keep interest rates very low for an extended period. The evidence of the commodities market and the gold market tells us that people already are actively trying to reduce their money balances in favor of more exposure to commodities and hard assets. And the dollar has fallen very close to its lowest levels ever; dollar demand is clearly weak.

Let me be quick to add that I don't see the seeds of a huge increase in inflation (yet). But I think there's enough monetary fuel out there to push inflation higher over the next year, to 3-4% or more. That might not sound like a lot, but it's above the upper limit of the Fed's 2% target, and it's a lot more than the bond market and the Fed are currently expecting. And that can make for very interesting markets.

Credit spread update





Credit spreads continue to decline, and that is very good news. As both charts show, spreads have reversed all of the rise that occurred in 2008; in that sense, the Panic Recession of 2008 is now a distant memory. But as the second chart shows, spreads are still at levels that prevailed prior to and during the 2001 recession. So things have improved dramatically, but the market is still priced to some grim expectations.

The fact that credit spreads are still historically high tells me that the U.S. capital market is still a long way from being overly exuberant. In the past year the market has gone from anticipating a record-breaking depression and deflation, to now anticipating a run-of-the-mill recession. Nothing out there is priced to anything like a goldilocks scenario. Take the Treasury market, where 3-mo. T-bill yields are almost zero: that can only mean that people are still deeply distrustful of the future. Or consider eurodollar futures that reflect the expectation that the Fed funds rate will rise from 0.25% today to a mere 1.0% by the end of the year. If the market had any confidence in a V-shaped recovery, expectations for the Fed funds rate at year end would be much higher.

Bottom line: if you believe as I do that the economy can manage to grow 3-4% or perhaps a bit more this year—which would amount to a fairly anemic recovery given the severity of the recent recession—then equities, corporate bonds and emerging market bonds are still offering some very attractive valuations.

Fear subsides, prices rise (15)



Yet another update in a long-running series. The VIX index is a good proxy for the level of uncertainty, fear and doubt in the market. As FUD declines, prices should rise, and that has been the story ever since last March. This is a variation on the larger theme of confidence; confidence in the banking system almost collapsed just over a year ago, and it has been gradually rebuilding ever since. With greater confidence, money that was essentially stuffed under mattresses is getting spent, and the wheels of commerce are spinning back up as a result. It's only natural that equity prices should move up as confidence returns. This process has a ways to go, in any event, since a "normal" level of the VIX would be in the range of 10-15.

Commodities update





The extreme volatility of industrial metals prices in the past two years compels me to feature this chart, which shows the metals subindex of the Journal of Commerce commodity index. Since the end of the 2001 recession, industrial metals prices have risen fully 250%, yet they are still 23% below their high of April '08. 

Other important observations: It cannot be a coincidence that the long slide in commodity prices which started in 1996 and ended in Nov. '01 occurred during a period in which U.S. monetary policy was unusually tight. This shows up in the second chart as a real Federal funds rate that averaged about 4%. During this same period, the U.S. economy was for the most part unusually strong. Since 2001, monetary policy has been erratic but generally accomodative, while the economy has not been particularly strong, and in fact suffered one of its most painful recessions. Yet commodity prices have surged.

The conclusion I draw from this is that monetary policy has had a very important influence on commodity prices. As long as monetary policy remains accommodative, commodity prices are likely to continue to rise, especially if the U.S. and global economies continue to gain strength. Commodity prices are not yet in bubble territory, by my estimation, but they could well be the next bubble to form.


The people are starting to get upset

I'd like to think we'll see more of this kind of anger between now and the November elections.

UPDATE: The video that accompanied this post has been removed by its creator apparently. I'm leaving the post so that the comments remain. 

The problem with state and local budgets



There's been a lot of hand-wringing and angst over the deteriorating finances of many of our state and local governments. Commonly discussed solutions include budget cuts, tax increases or another "stimulus" package giving federal aid to states. What's missing is more discussion of why state and local budgets are in trouble. The recession has caused tax revenues to drop, of course, but spending and state and local payrolls just keep going up. The chart that follows shows how government employment is much more stable (and ever-rising) than private sector employment. The chart above, which comes from the Cato Institute, shows that state and local compensation policies are another major source of out-of-control spending; state and local employees on average make about 45% more than their private sector counterparts. Job security and fabulous pay and benefits, courtesy of taxpayers.


Service sector slowly improving



An update to this chart that measures the percentage of service sector businesses reporting improving activity. The improvement in the manufacturing sector has been much more dramatic than this, but still, things are getting better in both major sectors of the economy.

Corporate layoffs have all but vanished (7)



Another update in a long-running series. Announced corporate layoffs are now down to levels that in the past have been consistent with healthy economic growth, according to the folks at Challenger, Gray & Christmas. The firing storm has passed. Of course, we are still waiting for the other shoe to drop. Now that layoffs are back to normal, when will firms start hiring? With confidence returning and demand picking up, it's only a matter of time.



As this next chart suggests, it might be only a month or so until firms begin adding to payrolls instead of subtracting.

The fatal flaws in healthcare reform (5)

A few weeks ago I posted a list of four fatal flaws in healthcare reform.

The fourth flaw is so gigantic and obvious that it promises to be the driving force behind a new political movement that is already expressing itself via Tea Parties. It could well prove to be The End of Big Government As We Know It. It is this: our economy is now so large and complex that it is impossible for government planning to reform any industry for the better. 

Eric Raymond has written a very good essay on this subject ("Escalating Complexity and the Collapse of Elite Authority") which complements Don Boudreaux's essay that I linked to and cited in my post. Here are some excerpts, but please read the whole thing:

Our “educated classes” ... have run the economy onto recessionary rocks with overly-clever financial speculation and ham-handed political interventions. Republicans have been scarcely less guilty than Democrats.

When I look at the pattern of failures, I am reminded of something I learned from software engineering: planning fails when the complexity of the problem exceeds the capacity of the planners to reason about it. And the complexity of real-world planning problems almost never rises linearly; it tends to go up at least quadratically in the number of independent variables or problem elements.

I think the complexifying financial and political environment of the last few decades has simply outstripped the capacity of our “educated classes”, our cognitive elite, to cope with it. The “wizards” in our financial system couldn’t reason effectively about derivatives risk and oversimplified their way into meltdown; [and] regulators failed to foresee the consequences of requiring a quota of mortgage loans to insolvent minority customers ...

The “educated classes” are adrift, lurching from blunder to blunder in a world that has out-complexified their ability to impose a unifying narrative on it, or even a small collection of rival but commensurable narratives. They’re in the exact position of old Soviet central planners ...

What do we do next?

The answer is, I think implied by three words: adapt, decentralize, and harden. Levels of environmental complexity that defeat planning are readily handled by complex adaptive systems. A CAS doesn’t try to plan against the future; instead, the agents in it try lots of adaptive strategies and the successful ones propagate. This is true whether the CAS we’re speaking of is a human immune system, a free market, or an ecology.

Since we can no longer count on being able to plan, we must adapt. When planning doesn’t work, centralization of authority is at best useless and usually harmful. And we must harden: that is, we need to build robustness and the capacity to self-heal and self-defend at every level of the system.

... the elite planner’s response to threats like underwear bombs is to build elaborate but increasingly brittle security systems in which airline passengers are involved only as victims. The CAS response would be to arm the passengers, concentrate on fielding bomb-sniffers so cheap that hundreds of thousands of civilians can carry one, and pay bounties on dead terrorists.
As I and many others have said before, the only real solution to our healthcare problem must begin with steps designed to reintroduce competitive, market forces to the healthcare industry. That includes fixing the tax code so that employer-provided health care is no longer tax-advantaged over individually-funded healthcare, removing interstate barriers to selling healthcare insurance, and eliminating government-imposed mandates on healthcare insurance, among others. Only market forces are capable of improving the healthcare industry, but we've got to give them a chance.

HT: Glenn Reynolds

Auto sales: another V-shaped recovery



Just by eyeballing this chart you can see that there has been a huge rebound in auto sales since they hit bottom last February. Sales had fallen so far for so long that "pent-up demand" almost had to show up at some point. The catalyst for the sales upturn was not the "cash for clunkers" program, it was simply a) time, which heals all wounds, even the economic ones, and b) a return of consumer confidence driven by the growing realization that the world was not coming to an end as so many had thought at the end of last year.

Why a double-dip recession is extremely unlikely





It seems like every day I read about some economist or pundit predicting another recession, an economic slump, or another market crash. This undoubtedly sends chills up the spine of most investors, especially those who are "once burned, twice shy." The past year and a half have been so traumatic that it's only natural to worry that the future holds more nasty surprises. And for those who worry, there is no shortage of bad news. We've known for months that the unemployment rate is extremely high, that the housing market is facing another wave of foreclosure sales, that hotel occupancy rates are dismally low, that layoffs are continuing, that oil prices are rising again, that deflation threatens, that construction spending is very weak, that California is on the verge of bankruptcy, that the federal deficit is gargantuan, etc.

Fortunately, there is some very good news out there that doesn't get much air time. These two charts contain extremely valuable information about the future of the economy that is supplied in real-time, courtesy of the highly liquid U.S. bond market.

The top chart is the spread between the yield on 2- and 10-year Treasury bonds. When the spread is high, the yield curve is very steep, and a steep yield curve is a classic sign of easy money. When the spread is low or negative, the yield curve is flat or inverted, and that is a classic sign of very tight money. All of the post-war recessions in the U.S. have been preceded by one or more years of very tight monetary policy, and an inverted yield curve. All of the post-war recoveries from recessions have been accompanied by easy money, and a steep yield curve. Since the curve is steeper now than it has ever been, we can assume that monetary policy has never been so accommodative, and the likelihood of recovery has never been so high.

The second chart plots the spread on 5-year swaps. (See here for a basic primer on swap spreads.) This spread tells us a lot about how liquid the market is (low spreads = high liquidity), how risk-averse the market is (low spreads = low risk aversion), and what the generic risk of AA credit defaults is (low spreads = low default risk). Swap spreads have had an uncanny ability to foresee the economic health of the economy. They tend to rise well in advance of recessions, and they tend to decline well in advance of recoveries. (I first began forecasting an end to the recession in late 2008 because of the huge drop in swap spreads.) With swap spreads today trading at very low levels, the market is telling us that credit risk is very low, economic stress is very low, risk-aversion is very low, and default risk is very low. You couldn't ask for anything better.

Taken together, these two charts send a powerful and very reassuring message: the economic fundamentals have improved dramatically, and augur strongly for recovery.

Commodities update



Here's a long-term look at spot commodity prices. They have risen 38% from their lows of early last year, and are only 10% below their all-time high in mid-2008. Note the huge gain in prices which occurred in the inflationary 1970s, followed by the flat trading range that lasted from 1980 through 2006, a period characterized by relative low and stable inflation. Commodities now appear to be moving in a new, higher trading range, which in turn was ushered in by the Fed's accommodative monetary policy which began in the mid-2000s. The apparently permanent rise in virtually all commodity prices that began in 2007 is one of the reasons I look for inflation to continue to rise in coming years.

Dr. Copper says the patient has recovered



Since last February I've been noting the recovery in copper prices and arguing that this was a sign of recovery. Copper prices are now 172% above their lows of Dec. '08, and only 15% below their all-time highs. Not only has the economy's "fever" broken, but it appears to be regaining its former health quite rapidly, to judge by the huge recovery in copper prices.

Construction spending still weak



Not wanting to gloss over bad news, I post this chart of construction spending (both public and private). Although it appears the residential construction sector has hit bottom, nonresidential construction is now clearly declining, and the total of the two is also declining. It's going to be awhile before construction spending stops subtracting from GDP growth. Not all is rosy out there, but I think the list of positives clearly outweighs the negatives.

ISM: what deflation?



This charts shows the results of a survey of purchasing managers from manufacturing and service sector industries regarding how the prices they are paying compare to the prior month's prices. Today's reading of 61.5 for the prices paid by manufacturing industries implies that 61.5% of those surveyed reported paying higher prices in December.

This is most definitely not the stuff of which deflations are made. Despite the huge amount of "slack" that supposedly exists in the manufacturing sector (capacity utilization rates, according to the Fed, are only 71.3%, a level that was exceeded only in the depths of the 1982 recession), a clear majority of firms are seeing, and paying, higher prices for their inputs.

I still see great numbers of analysts worrying about the risk of deflation, despite the Fed's extraordinary efforts to avoid such an outcome, and despite mounting evidence that a lot of prices are rising. I would strongly recommend scratching deflation from your list of things to worry about. Doing so reveals a distribution of expected returns for all manner of risk assets that is strongly skewed to the positive.

V-shaped recovery in manufacturing



The ISM manufacturing survey released today again reinforces the fact that significant portions of the U.S. economy are experiencing a V-shaped recovery. As this chart suggests, we are likely to see real GDP growth of 4% or possibly even more in this first quarter of the new year. I'll stick with my projection of 3-4% real growth on balance for the year. This is undeniably excellent news for the economy.