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What a difference a year makes


More and more it becomes clear that the big collapse in 2008 was an aberration that resulted primarily from a severe shock to confidence and a huge and sudden increase in the world's demand for safety and liquidity, all triggered by fears of a collapse of the global financial system. Central banks were slow to respond to the unprecedented increase in the world's demand for money, and this resulted in a widespread selloff of all risk assets and massive deleveraging. Central banks eventually figured things out, and the return of liquidity has allowed prices of risk assets to recoup most of their losses. The collapse in monetary velocity which precipitated the recession has begun to reverse, and most economies around the world are again growing. The recovery is still in its early stages, however, and so there appears to be lots more room to the upside.

There have actually been two dramas playing out over the past year or so. One was the mechanical one that resulted from the shock to confidence and the huge increase in the demand for liquidity and safety. The other was the shock to long-term expectations that resulted from Obama's radical pursuit of a hard-left agenda that left investors struggling to comprehend the ramifications of a massive increase in government control over the economy and one new spending program after another. The expected burden of taxes began to soar; the anticipated efficiency and potential growth rate of the economy began to plunge; and the future solvency of the US government began to dissolve. The worst part of both dramas combined in a Perfect Storm to produce the equity market collapse of early March 2009.

Since then the economy has managed to heal many of its wounds, and the political scene has changed dramatically. We are now eight months into a recovery, and Obama's two signature initiatives, cap and trade and healthcare reform, are in a shambles. The Democratic Party appears to be completely out of touch with the mood of the electorate, which was never prepared for a hard turn to the left. The balance of power in Washington has shifted dramatically, and investor and consumer confidence is returning. (Whatever is bad for Washington is often good for individual liberty and free markets.)

One year ago we were asking ourselves how the economy could ever survive. Markets were braced for a future worse than the Depression, and years of global deflation were a virtual certainty. Stocks and corporate bonds were priced for Armageddon.

Today we are asking ourselves whether the economy will grow by 2% per year or by 4% per year. Whether the Republicans will regain control of Congress or not (with the best and most likely outcome being gridlock). Whether the Fed will begin raising rates before mid-year or by year-end. Whether small caps will outperform large caps or not. Whether inflation will be 2% or 5% per year going forward. Whether the Bush tax cuts will be extended or not. One year ago such questions would have been almost unthinkable—that's how far we've come in just one year.

I don't see a reason to think that the megatrends of the past year will reverse anytime soon. Things were unimaginably bad one year ago, but now there are plenty of reasons to be optimistic.

Risk aversion is receding

I mentioned earlier this month that the rise in 3-mo. T-bill rates was something to keep an eye on. Rates have now gone from essentially zero to 11 basis points. That's not huge, but on the margin it reflects a decline in the market's risk aversion and/or desire for safety. Rates jumped today across the yield curve, as signs of recovery continue to trump fears of another recession. The Fed also announced a rise in the discount rate to 0.75%. That's not actually a tightening, but it is a step in the direction of slowly returning to normal.

Once more I will note that higher interest rates are not bad news for the economy. The Fed is not tight, and no matter what, monetary policy will not be tight for a very long time. Higher interest rates on Treasuries are best viewed as excellent signs that the economy is getting better.

The untold story behind today's unemployment

Everyone understands the need for unemployment insurance. You get fired because things go badly for your company, and suddenly you're on your own. It takes awhile to get back on your feet and find a job, especially if the economy is in a recession. That's why we have government- and employer-sponsored insurance programs that pay unemployment compensation for up to six months to those who lose their jobs through no fault of their own.

Occasionally, Congress will decide that economic conditions are so adverse that an extension of these benefits is called for. The most recent extension was called the Emergency Unemployment Compensation (EUC) program, and it started in July 2008. It was also by far the most generous in its eligibility requirements, effectively covering workers who became unemployed as early as May 2006. The chart above shows the number of persons receiving EUC in red, the number receiving regular unemployment compensation in blue, and the total in green. The EUC program has been extremely successful at recruiting recipients, since it has gone from zero to over 5 million in just 18 months and continues to expand, even as the number of those losing their job each week has fallen by 30% since last March.

In mid-2007, well before the recent recession began, the unemployment rate was a mere 4.4%. Out of a workforce (those working plus those looking for work) of 154 million, some 6.8 million were out of a job, and about 2.5 million were receiving unemployment insurance. Today, the workforce has shrunk to 153 million (discouraged workers have stopped working, others have decided to call it quits and retire), 14.8 million are out of a job, and 11.5 million are receiving unemployment insurance.

To put these numbers in historical and proportional perspective, I offer the next two charts.

The number and proportion of persons receiving unemployment insurance today is far greater than anything we've seen before. Even though this recession's highest unemployment rate of 10.1% was lower than the highest unemployment rate (10.8%) of the 1981-82 recession, the portion of the workforce receiving unemployment compensation today is 63% higher than it was at the peak of the 1982 recession. Fully 78% of those looking for a job today are receiving unemployment insurance, compared to only 38% at the height of the 81-82 recession.

Never before have we seen anything even close to today's largesse and compassion for those without a job. While not wanting to argue whether this is right or wrong, I would however argue that the aggregate desire of the unemployed to find a job today is undoubtedly much less than it was during the depths of the 81-82 recession.

And so we have here one more reason why this recovery is proceeding more slowly and painfully than we all would like to see. Not only are employers reluctant to hire because of all the legislative, political, and tax uncertainty out there, but the incentive for workers to seek out the jobs on offer is weaker than ever, especially for those jobs that don't come equipped with salaries exceeding their current exceptional benefits. Congressional compassion has its costs, and they are not just measured in terms of expenditures, but also in a slower recovery.

The Fed is behind the tightening curve

These two charts focus on the yield on 2- and 10-year Treasury yields from 1977 through today. The top chart shows the yields, while the bottom chart shows the difference in the yields, which is a measure of the steepness of the yield curve. If you compare the two charts, you will see that a steep yield curve generally corresponds to periods in which short-term rates are low, and that in turn is generally a sign of easy monetary policy. Steep curves typically flatten as short-term rates rise relative to, and more than, long-term rates. When the yield curve is inverted, short-term rates are higher than long-term rates; this is generally caused by very tight monetary policy, and this is what has preceded every post-war recession.

Today the yield curve is steeper than at any other time in history. This is the bond market's way of saying that short-term rates are exceedingly low, so low that they will have to rise by a LOT in coming years. The Fed has been keeping rates artificially low for quite some time now, and they will have to correct for this by raising rates by a lot in the future. The only thing we don't know is when they will begin raising rates.

This last chart shows the market's current expectations of what the Treasury curve will look like 1, 2, and 5 years from now. The bottom line is the current Treasury yield curve. I note that the market expects all Treasury yields to be significantly higher in 5 years than they are now. Note also that the market expects the curve to be slightly inverted 5 years from now, which further suggests that there is very little risk of recession for the next 5 years.

Deflation: RIP

The January Producer Price Index data released today should put finis to any notion that deflation is a risk. The headline number is up 5% over the past 12 months, and it has risen at a 9.8% annualized rate in just the past six months. Much of this perkiness is due to rising energy prices, of course, since the Core PPI is up only 1% in the past 12 months.

But before you say, "since core inflation is still well under control, there's nothing to worry about," let me make some important points.

The second chart is the PPI index plotted on a logarithmic scale. The white trend line shows that the PPI grew at a 1.2% annual rate from the early 1990s through 2002; this was a period during which monetary policy was generally tight, and by the Fed's own admission. Not surprisingly for us monetarists, inflation by all measures was well-behaved. Monetary was so tight, in fact, that gold and commodity prices fell from 1997 through 2002, and the dollar soared. Indeed, lots of people worried about deflation in the 2000-2003 period because money had been so tight in the years prior.

Since 2003, however, which is when the Fed decided that monetary policy needed to be kept very easy for a very long time in order to avoid the risk of deflation, inflation by all measures has picked up. The red trend line shows that the PPI grew at a 3.3% annual rate from mid-2003 through mid-2009. And as I mentioned above, the PPI has grown at almost a 10% rate in the past six months. Since 2003, gold and commodity prices have soared, and the dollar has collapsed, further confirming that monetary policy has been quite easy for the past seven years.

If monetary policy were tight enough to prevent inflation from exceeding, say, 1-2%, that would not necessarily preclude a huge rise in oil prices. But it would mean that if oil prices rose a lot, then there would be a lot of downward pressure on other, non-energy prices, since on average prices could only rise 1 or 2% a year. That's not the case currently, however. Although core PPI inflation has moderated somewhat since 2008, it is still positive and it has grown at a 3.3% annual rate in the past three months. My point is that if money were tight, then a big rise in energy prices should have produced at least flat, if not falling non-energy prices. But it hasn't.

Bottom line: monetary policy is loose, and it shows. Deflation is not even remotely a threat, despite the huge "slack" in the economy (the amount by which the economy is growing below its potential). The Fed has been running monetary policy based on a flawed theory of inflation. Price pressures are significantly higher than the Fed's model would suggest. They are making a mistake, and they need to get on the tightening bandwagon sooner rather than later.

This same analysis should also tell the economic recovery skeptics that they have been too pessimistic. If deflation is no longer even remotely a threat, then the downside risks to the economy are greatly reduced. Plus, even if the Fed were to start raising rates tomorrow, they are already behind the curve. It would take a LOT of rate hikes for a long time before monetary policy could be considered a threat to economic growth. It makes more sense to worry about inflation than it does to worry about the economy these days.

Federal budget update

This chart includes the January data released today. Revenues continue to decline, falling to just under 14% of GDP, a level not seen since the early 1940s. Expenditures (both on a rolling 12-month basis) have also declined in recent months, but that mainly reflects the running off of the intense spending associated with bailouts a year ago. Despite the recent declines, spending over the 12 months ended January was about 24% of GDP, a level not seen since World War II.

The deficit over the past year was $1.46 trillion, about 10% of GDP. There have been several industrialized countries that have lived with and survived deficits this large (e.g., Italy and Japan), but that doesn't mean that a deficit of this magnitude is OK. Indeed, I can't think of any country that has enjoyed healthy growth with such a large deficit. The deficit we have now—far from being stimulative as Obama keeps insisting—acts as a big drag on the economy, mainly because it comes entirely from a surfeit of spending and an orgy of expanding government programs and mandates. When government controls so much of our national income it can only do so much less efficiently than the private sector can. Also, with our extremely progressive tax system that calls on the top 10% of income earners to shoulder over 70% of the income tax burden, the incentives to work, invest, and take risk become very distorted.

One of the often-overlooked problems (call them unintended consequences) that come with a very progressive tax system that—like ours does now—relies heavily on things like tax rebates, earned income tax credits, and direct subsidies to lower-income workers, is that it inevitably leads to extremely high marginal tax rates at levels of income that affect a good portion of the middle and lower-middle class. (See my earlier post on this subject.) This means that a person who tries to raise his standard of living may end up paying a marginal rate of 80% on every additional dollar he makes, because at higher income levels he loses his subsidies and rebates. Why work twice as hard if you can only end up with 10 or 20% more? While appearing to help the poor and disadvantaged, it ends up trapping many of them near the bottom rungs of the income ladder.

It would be far better if our tax system relied on a relatively low, flat tax with few or no deductions.

A new conservative credo

Today saw the release of The Mount Vernon Statement, a relatively small collection of ideas and beliefs that have been embraced by a wide variety of conservative leaders. I think it's something that most Tea Party followers would be comfortable with. Perhaps most importantly to me—being a libertarian who reluctantly votes Republican—the statement is essentially devoid of any references to social issues, concentrating instead on the need for smaller government and individual liberty. It's a little vague for my tastes, but it's a nice way to begin to focus a much-needed debate. Highlights:

We recommit ourselves to the ideas of the American Founding.  Through the Constitution, the Founders created an enduring framework of limited government based on the rule of law.

[The Declaration] defends life, liberty and the pursuit of happiness. It traces authority to the consent of the governed. It recognizes man’s self-interest but also his capacity for virtue.

It reminds economic conservatives that morality is essential to limited government, social conservatives that unlimited government is a threat to moral self-government, and national security conservatives that energetic but responsible government is the key to America’s safety and leadership role in the world.

It applies the principle of limited government based on the rule of law to every proposal.

It honors the central place of individual liberty in American politics and life.

It encourages free enterprise, the individual entrepreneur, and economic reforms grounded in market solutions.

It supports America’s national interest in advancing freedom and opposing tyranny in the world and prudently considers what we can and should do to that end. 

HT: Glenn Reynolds

Europe lags the rebound in U.S. and Asia-Pacific

This chart makes it easy to see how Europe has been the laggard in the global recovery from the Panic Collapse of 2008. This continues a long tradition in which the European economies prove to be less volatile but also chronically less dynamic than those of the U.S. and the Asia-Pacific region. Big Government is one big reason for this; a case in point would be that since European companies find it much harder to fire people, they are also much less likely to hire them in the first place, thus explaining why German and French unemployment rates have been generally much higher than in the U.S.

In any event, U.S. industrial production has been rising now for seven straight months, at an annualized rate of about 10%. That counts as at least a moderate V-shaped recovery, as there's a whole lot of improvement still needed just to get back to where we were in early 2008.

Housing starts continue to improve

The residential construction industry suffered its sharpest and severest decline in recorded history beginning in 2006. Housing starts fell for three straight years, by over 75%. Residential construction fell, relative to the growth of GDP, by 60%, to its lowest level ever. If we had an overhang of houses back in 2005, that overhang has surely shrunk massively.

This recovery is as much about inventories as about anything. Housing inventories were exceedingly bloated back in 2005-2006, but they have now had years to get worked off. Inventories of just about everything else began to accumulate rapidly in late 2008 as global demand went into hiding, but now they are no longer falling and will soon need to be rebuilt. Housing construction is already up over 20% from last year's lows, and a slow recovery is quite likely to continue for the foreseeable future, especially since new household formations greatly exceed the current pace of new building activity. We're not talking about rebuilding inventories of housing yet, we're just talking about starting to keep up with demand so that inventories don't decline even further. None of this is very heroic, it's just the way business cycles work. To derail this process would be quite difficult.

So even though the upturn in housing starts looks pretty timid on this chart (nowhere near the status of a V-shaped recovery), it is part of a larger process that is quite significant. It pays to stay optimistic.

Too much hoopla over foreigners' holdings of US debt

The news of "a record drop in foreign holdings of U.S. Treasury bills in December" is not necessarily as bad as people are trying to make it.

China can't necessarily harm the U.S. economy by dumping a ton of its holdings of US Treasuries. If China continues to generate a trade surplus with us, but decides to a) sell some of its Treasury holdings and b) devote more of its dollar surplus to the purchase of debt from other countries, this does not guarantee at all that the U.S. economy will suffer. The most likely outcome of such actions would be to increase China's purchases of U.S. goods and services.

This is the key thing to remember: when country A sells more stuff to us than we purchase from them, then it ends up with dollars that can only be spent, ultimately, on something here in the U.S. The dollars that we spend on foreign imports never really leave the U.S. banking system, they simply change hands. Dollars are always spent here. A country that has a trade surplus with us must spend its dollars on a) our bonds, b) our stocks, c) our real estate, or d) deposit those dollars in a US bank account. Dollars that figuratively travel overseas to buy foreign goods are always recycled back to the U.S. economy in some form or other.

If the rest of the world decides tomorrow that they are all fed up with financing our profligate spending ways, then there is really only one thing that will obviously have to happen: if all the countries that have trade surpluses with us decide to stop buying Treasuries, then they will have to spend the dollars they earn from selling things to the U.S. on something else here in the U.S., or deposit those dollars in a bank account here. A big decline in Treasury purchases on the part of the rest of the world would most likely mean, therefore, a big increase in U.S. exports of goods and services. Higher interest rates on our bonds would coincide with a big increase in our exports. Is that a bad thing? I don't know, because the answer is not obvious to me. (Though I still think that higher interest rates would be a good thing, because they would signal a stronger economy.)

There are other considerations as well. It's not obviously in China's interest to dump tens or hundreds of billions of Treasuires, because that might depress the dollar and thus destroy the value of the trillions of U.S. assets it already holds. China is really between a rock and a hard place on this issue.

The risk trade comes back

This is a Bloomberg index of real-time commodity prices. Commodities have bounced nicely in the past 10 days. The dollar is no longer rising and may be turning down. Gold prices are up. Oil is up. Equities are up. The "risk trade" is back, mainly—I think—because the signs of improving economic activity continue to trump the market's fears. A recovery like we have underway is not something that is easily derailed. Yes, policies remain awful, but that's been the case for the past year. On the margin the outlook for policy has improved, and that is what's important.

I note today the news that a Rhode Island town decided to fire all of its unionized teachers after they refused to work 25 minutes more. This probably marks the tipping point for public sector workers' compensation packages all over the country. The fact that public sector workers have great job security and make a lot more than their private sector counterparts just doesn't make sense. I won't be surprised to see many more towns and states imposing pay cuts and layoffs on their public sector workforce. This is a good thing for the economy (though of course painful for those affected). It better happen here in California.

NY manufacturing is healthy

This chart shows the NY Fed's index of manufacturing conditions in the state of New York. Sure looks like another one of those V-shaped signs of recovery, doesn't it?

The global warming crowd is in big trouble (2)

The Global Warming agenda continues to disintegrate, having passed an "extremely important inflection point" as I noted last November. The news just keeps getting worse. They don't have the data. They were making things up. The computer models were fudged and tinkered with. There has been no warming since 1995. The Medieval Warming Period, way before mankind started blowing carbon into the atmosphere, was likely much warmer than the current period. Governments are slowly coming to the conclusion that heroic attempts to alter their economies in the name of saving the planet don't make sense if there is no science to guide them.

This is good news for the economy because it greatly reduces the threat of punitive legislation that would force us to use more expensive energy sources. It is also good news because it contributes to the growing sense, felt acutely by those of Tea Party persuasion, that government has gone to far in regulating, taxing, and otherwise controlling our lives. It takes big things like this to move the public by enough to achieve transformative change in our politics. Have you noticed the growing list of long-time senators and congressman who are deciding to retire (Evan Bayh being the latest).

The political winds are shifting because the electorate is fed up with big government and all of its intrusions into our lives. The realization that this was coming helped propel the market higher beginning last March, and I believe there is still a lot more upside potential as the new reality of shrinking government begins to take shape. I can't think of anything right now that is more significant for the future of the economy than this emerging change in the mood of the electorate. The retreat of Climate Change is a small but important part of a larger movement that believes that Big Government promised way too much all along and has failed miserably to deliver.