Sunday, December 16, 2007

James Grant Explains the Business Cycle

ECONOMISTS cannot reliably forecast recessions. Nor can they detect for certain when a recession is in progress. Only after the fact do the official cyclical timekeepers identify the beginning and ending dates of a slump.

Though deficient in the powers of foresight and observation, economists do believe they know how to treat an economy on the brink of recession, as this one seems to be. They administer what non-economists know as the “hair of the dog that bit you.”

And thus, James Grant begins his lesson in Austrian Economics by explaining the business cycle. In a recent essay, I talked about the buildup of debt in our economy over the last 50 years. It has caused increased indebtedness and reduced savings which does not augur well for the US economy over the long term. Grant argues that the Fed shouldn't be trying to lessen the blow of the economic slowdown:

Now what to do? Why, slash interest rates to coax forth still more lending and borrowing. It’s the customary curative, seemingly as humane as it is politic.

And if recessions served no useful purpose, it might be. But recessions do. On Wall Street, they speak of “corrections.” What corrections correct are errors in judgment. So do recessions.

They allow the sorting out of boomtime error. They permit — indeed, force — the repricing of inflated assets. In a downturn, previously overpriced businesses, houses and buildings are made affordable again.

Naturally, people hate these painful, salutary interludes. Nobody likes insecurity, bankruptcy and joblessness. So the Fed keeps slashing interest rates. And this balm does mitigate the suffering. Homeowners and businesses refinance their debts. Fewer houses are thrown on an overstocked market.

Grant is right of course, but that doesn't mean the the Fed will accomodate. That would be an admission that Fed policy to date has been a large part of the cause of our economic troubles. And I doubt that will happen.

Grant concludes with an observation that I've made previously:

Presently, a new upcycle does begin, but it’s slow off the mark. The world’s top economy seems curiously sluggish. And the economists and politicians ask, “What happened to America’s dynamic economy?” The answer: It’s wrapped in the coils of debt.

The interest rate cycle since the early 80s has been one of lower highs and lower lows. Every interest rate raising cycle ends at a lower level and every subsequent interest rate lowering cycle ends at a lower level. That makes sense; the increased debt load after each up cycle means that there is a greater headwind each time the Fed embarks on a rate cutting cycle.

The question we face today as investors is this: "Has the economy finally been larded up with so much debt that it will not recover during this rate cutting cycle?" As long time readers know, I don't think so. I believe that the US economy can overcome the ill effects of high debt at least one more time. The real danger will come in 2009 or 2010 when tax rates rise. I suspect that will be a very ugly recession whether economists are able to predict it or not.

No comments: