The Great Inflation

Thorsten Polleit has a very readable article that explains the current credit crisis in Austrian Economics terms. The root of our current crisis can be found in Federal Reserve policy:

Initially, the artificial lowering of the interest rate creates an illusion of richness and affluence. The increase in the money stock via bank credit expansion erroneously suggests that the supply of savings increases. Investment picks up, and the economy expands. The illusion of plentiful resources leads to malinvestment, and sooner or later the boom turns into a bust. While the money-fueled expansion is a manifestation of the crisis, it is actually the slump — the correction of malinvestment — that people complain about.

He uses a wonderful quote from Mises that perfectly encapsulates the argument of those like Desmond Lachman who believe the Fed can cure a problem created by the Fed:

"In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils inflation and credit expansion have brought about."

As I stated in my debate with Lachman, my fear is the response of a government that can no longer create more inflation to cure the last credit inflation:

Inflation is a societal evil. It redistributes real wealth from creditors to debtors. It impairs the role of money as a means of exchange. The efficiency of the market's price mechanism is greatly reduced, encouraging bad decisions, which in turn harm peoples' economic well-being. At the end of the day, inflation is a serious threat to freedom. The majority of the people, suffering badly from inflation, would most likely blame the free market for their plight, rather than blame the central bank for the debasing of the currency.

From the Austrian viewpoint, the current credit crisis appears to be a precursor of great inflation. If a deliberate policy of great inflation is chosen in the United States, a monetary policy of debasing the currency would most likely also take hold in other currency areas of the world. The credit crisis has become a threat to the free societal order: as people become dispirited with the free market order, the door would be pushed open for anti–free market policies.

Read the entire article.

Poetic Justice

I don't agree with Warren Buffet about some things - the estate tax comes to mind - but he's got it right in this speech in Toronto:

TORONTO (Reuters) - The woes in the U.S. financial sector are "poetic justice" for bankers who designed and sold complex investments that have since gone sour, billionaire investor Warren Buffett said on Wednesday.

The head of the Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research) (BRKb.N: Quote, Profile, Research) group of companies also played down worries about a credit crunch by saying that recent interest rate cuts mean low-cost funds are readily available.

But he warned that the U.S. dollar will continue to slide unless the country can rein in its yawning trade deficit -- the "biggest factor" behind the decline. Still, he said, the U.S. economy will "do very well over time."

It never ceases to amaze me that Citigroup finds a way to get in the middle of every banking crisis that comes down the pike. From Latin American debt in the 80s to sub prime today, Citigroup and other banks, always find a way to lend money to folks who can't or won't pay it back. As Buffet put it later in the speech:

"I wouldn't quite call it a credit crunch. Funds are available," Buffett said during a question and answer session at a business event. "Money is available, and it's really quite cheap because of the lowering of rates that has taken place."

He added: "What has happened is a repricing of risk and an unavailability of what I might call 'dumb money,' of which there was plenty around a year ago."

Yep, the dumb money. Why do people keep bailing out these idiots?

Insider Buying that Homebuilders

What do homebuilding executives know that we don't? Apparently, they know when to buy and sell their own stock. The WSJ Marketbeat blog has an entry about recent insider activity at the major homebuilders:

Three major home builders, KB Home, Lennar, Standard Pacific and Hovnanian all have insider score rankings above 75 for the last month, suggesting positive sentiment among insiders at those companies in the last few months.

Two of the three (LEN and HOV) currently rank in InsiderScore’s top 100 companies in terms of positive buying interest, which means insider buying has spiked in the last month. Hovnanian is ranked highest, with notable purchases in January from Kevork Hovnanian, chairman, and Joseph Marengi, a director at the company. Notably, insider sentiment went negative in the first quarter of 2007, when CEO Ara Hovnanian sold off shares.

Apparently they know when to buy; the insiders at HOV are up about 80% on their investment in less than a month. There was a lot of insider selling in the homebuilders near the top as well so these guys are pretty good at timing their purchases and sales. Maybe we are near a bottom in the homebuilding industry.

Weak Demand for 30 Year Bonds

The government auctioned new 30 year bonds today and found weak demand. Most of the bonds were apparently bought by Wall Street dealers as bids from foreign buyers was very weak. That could be due to Asians celebrating the Lunar New Year. Or it could be because no one wants to lend the government money at less than 4.5% when the Fed is busily creating bunches of new dollars. One or the other.

Schizophrenic Market

We've had another volatile day in the stock market. Cisco's earnings outlook and some more weak economic data got us off to a slow start, but Cisco recovered and the market posted a 100 point gain this afternoon. Now we've sold off again into the close, down about 8 points right now at around 3:30. Volatility like this is wearying but pretty typical of a market at a turning point. There is a tug of war right now between those who are finding bargains and those who are afraid. Fear and greed. It's what always drives the market.

Cisco is a great example. They reported earnings last night in line with expectations and up 15% from the same quarter last year. Their revenue forecast for this quarter however was less than expected and they complained about orders during January. On the other hand the stock trades for just 14 times earnings and has $22 billion in cash. That's value investor territory for one of the great growth stocks of our time. And bargain hunters bought the stock from the traders who were betting on a good quarter and hoped to make a quick buck.

The economic data this morning was not very good. Jobless claims came in at 356,000, down from last week but still too high. Last week's numbers were a little suspect but this week confirms that jobless claims are trending higher. That is not good news for future employment reports. Pending home sales were down again dropping 1.5% from November. That of course shouldn't surprise to anyone.

It appears though that, at least for today, the market had already discounted most of the bad news. If things get worse of course the market could make another down leg, but at least for now we are holding above the lows set on 1/22. The pullback this week is fairly normal even if we are making a bottom. Markets rarely go straight back up after a break like this. It takes time to rebuild investor confidence.

Jobless Claims-Feb. 2 Week

The Labor Department reported a drop in initial jobless claims for the latest week. First-time claims fell by 22,000, to 356,000, from an upwardly revised 378,000 the prior week.

The 4-week moving average also rose, increasing 8,500 to 335,000. It's the highest since January 5th. The 4-week moving average is a less volatile and more accurate measure of the direction of jobless claims.

Continuing jobless claims, however, hit a high not seen since October 2005. The Labor Department reported an increase of 75,000 to 2.78 million.

Another Chapman Article

John Chapman had an article critical of Bernanke in October last year at The American. Chapman takes a decidedly Austrian view of the economic world that coincides with my general view of how things work.

Given the current panoply of worries—the housing crunch, rising oil prices, decreased consumer spending, depressed corporate profits, and slowing growth in Japan and Europe—most economists appear to welcome such a move. Harvard’s Martin Feldstein summed up the conventional wisdom last month when he said the federal funds rate should drop to 4.25 percent or less in order to prevent a significant economic downturn.

Not so fast. While it is true that substantial housing crises have often presaged a recession, the U.S. economy still has considerable strengths and solid growth prospects. What matters now is that monetary policy be oriented toward sustainable economic growth—which is to say, we need a policy that acknowledges the long-term linkage between sound money and solid, sustainable growth. Financial markets—and economic agents—are highly efficient at discounting the future into the present, and they will react positively if the Fed moves to defend the dollar’s value and stability.

Chapman analyzes the how we got in this current Fed induced mess:

Consider the present environment. From late 2001 to 2004—in the wake of a global recession, terrorist attacks, and war—U.S. monetary policy pursued a dramatic reduction in short-term interest rates. Indeed, for much of that period the real federal funds rate was negative. When interest rates are artificially held below their natural level, investors get false signals, particularly in interest-sensitive capital goods sectors, such as housing and construction, which experience a boom. The falsified interest rates induce a flurry of lending and investment in capital goods, and hiring and spending increase in these sectors. Conversely, financial institutions, which now have an excess of reserves to lend due to the Fed’s expansionary policy, seek out borrowers of dubious credit. For several quarters, or even years, a general economic boom occurs.

But the housing and capital goods booms—along with the loans to marginal borrowers—are not based on real savings. Rather, they are based on a spike in fiduciary credit triggered by Fed policies that inject reserves into the banking system to cut interest rates and fuel the boom. As such, some increases in spending and employment are unsustainable, and marginal projects undertaken without the backing of real demand may face insolvency.

Eventually the central monetary authority faces a dilemma, which is roughly where we are now. It can compound its errant intervention by accelerating the expansionary policy, keeping interest rates below where they would be otherwise. Or it can allow interest rates to return to their natural levels and thereby cause an economic slowdown, as marginal projects are liquidated, assets are repriced, and labor markets readjust.

As dislocations deepen, postponement usually makes the eventual correction more painful. But a bigger problem with continued monetary ease is the loss of confidence in the Fed’s commitment to protecting a strong American dollar. Given that the dollar serves as a global reserve currency, a flight from dollar-denominated assets abroad could mean a return to 1970s-style inflation and global recession.

As I have said a number of times, our problems are a result of bad monetary policy. They won't be solved by more bad monetary policy.

It would be interesting to see what Mr. Chapman's view of the economy is now. I'll see if I can contact him at AEI and invite him to participate on the blog.

Different Analysis from Chapman at AEI

John Chapman, a fellow at the American Enterprise Institute, has a letter to the editor of the Wall Street Journal Europe about a recent editorial from John Snow. The contrast with Desmond Lachman, also of the AEI, is stark.

Instead, what happened is the Greenspan Fed held U.S. interest rates too low for way too long earlier this decade. Inflationary increases in credit, channeled through the banking system into credit markets, fed the housing boom. But as this boom was not backed by an increase in real savings, it was by definition unsustainable.

Further, because the U.S. dollar is the world's de facto reserve currency, the Fed can "export" inflation for a time. But this too is unsustainable, as over time the dollar must fall, and U.S. inflation and real interest rates rise, to adjust to too-expansionary a monetary policy. More monetary easing is exactly what should not happen now. What we do need is less federal intervention, which breeds moral hazard in the U.S. financial system, and in turn the asset repricing, recapitalization and restructuring Mr. Snow applauds will quickly stabilize financial markets. Additionally, broader tax cuts and lower federal spending will help prevent a recession.

Fed Over Reaction?

This wonderful chart is courtesy of Greg Ip at the WSJ. It shows inflation expectations based on a five year forward basis. Inflation expectations have been rising since the Fed threw in the towel on the economy and decided to slash interest rates. The actions of the Fed may limit the slowdown in the economy but as this chart shows, there is no free lunch.

Mankiw's Wish

It's Greg Mankiw's birthday and he has an editorial in the NYT to celebrate the occasion titled, "My Birthday Wish: Not Burdening Our Children". Unlike the politicians on the campaign trail who invoke "the children" at every turn, Mankiw wants to make his wish come true through increased personal responsibility. He starts the column by talking a little about the current economy:

As I reach this particular milestone, it is hard not be worried about the economy. No, I am not talking about the subprime meltdown and the possible recession that looms on the horizon. I am confident that the team at the Federal Reserve can contain that problem.

Moreover, from the broad vantage point of history, the next recession, whenever it occurs, will likely be a minor blip. My guess is that it will be similar to the recession that was enveloping the economy the day I was born.

Don’t remember the recession of 1957-58? Most people don’t. It was a garden-variety slump — painful to those who lived through it, but short-lived and leaving few lasting scars. Today it is remembered only by the few experts who crunch the numbers in the study of macroeconomic history. My parents’ recession is not my problem, and our next recession will not concern our children when they reach adulthood.

Economic slowdowns, whether they morph into a recession or not, always seem like they will never end. Like Mankiw, I am not much worried about the present state of the economy - this too shall end. What Mankiw is worried about is the long run cost of Social Security and Medicare:

Long before I was born, Franklin D. Roosevelt established a compact among the generations. Families had long cared for their elderly members, but Roosevelt federalized that responsibility in the form of the Social Security system. Social Security is sometimes viewed as a pension plan, but it is mostly pay-as-you-go. The working-age population taxes itself to support its parents, in the hope and expectation that its children will do the same. On the day of my birth in 1958, the payroll tax to pay for this program, including both the employer and employee shares, was 4.5 percent.

Around the time I started grade school, Lyndon B. Johnson expanded the generational compact to include health care for the elderly. The Medicare system increased the payroll tax, but only modestly at first. Health care technology was far more primitive back then and, as a result, less expensive. By 1968, when, like my younger son today, I was in third grade, the payroll tax for both programs had risen to 8.8 percent.

Today, the payroll tax for these programs is 15.3 percent, far higher than the programs’ creators ever imagined. More worrisome is that this 15.3 percent is nowhere near enough to maintain solvency in the future. When my generation of baby boomers retires in large numbers and starts claiming benefits, spending on these programs will far outstrip revenue at the current tax rate.

Mankiw is right. If we don't do something about these programs, taxes will just keep rising and the cost to the economy will be enourmous. Mankiw makes some great points in this editorial. Read the entire thing.

My Final Response to Desmond

Dear Desmond,



I have said that I don’t expect a recession but I am the first to admit that is a position that is increasingly hard to defend. The economic statistics have deteriorated dramatically over the last two months and the credit crunch continues. Bank balance sheets have taken a big hit and I wouldn’t be surprised if there are more writeoffs to come. Housing prices are falling and it appears they will fall further with inventories at record highs. The stock market, even if the Dow and S&P 500 haven’t met the accepted definition of a bear market, have dropped dramatically. We are about to get a real world test of the wealth effect.



The long term problems we face will not be solved by monetary policy:



1. The housing market is in trouble because the Fed reduced interest rates to generational lows and held them there too long. Given a huge incentive to borrow, Americans did exactly that. Given a huge incentive to lend, banks did exactly that. Now as the credit spigot is tightened the process is working in reverse. Home prices are indeed falling and absent Fed action to reduce rates, they would no doubt go down faster. Now that the Fed has lowered rates again, ARM resets will not affect as many people as they would have absent Fed action. That will just prolong the price adjustment that is needed to bring home prices down to the long term trend (which is roughly the rate of inflation). This is not a pleasant prospect, but it is a necessary one. The US government needs to get out of the business of subsidizing the housing industry. Fannie Mae and Freddie Mac helped to create this problem by making the “originate to distribute” model so profitable that it would have been dumb for banks not to participate. More cheap money does not address the root cause of the housing problem and will only prolong the pain of the adjustment.

2. The banking system is in dire straights because of exactly the medicine being peddled once again by the Federal Reserve. The problem with the banking system is not a lack of liquidity. Funds are available; banks aren’t willing to lend them on the easy terms that got them into trouble in the first place. Nothing the Fed does will change that in the short term, but over the longer term, a yield curve artificially steepened by the Fed will get banks back to borrowing short and lending long. The last thing our economy needs is more debt. As you point out the US household debt to income ratio is at an all time high. Lower interest rates will only further exacerbate the problem by discouraging saving and encouraging further debt accumulation.

3. Oil prices and other commodity prices are high because Fed policy has fed a boom in every country with a currency pegged to the dollar (and that boom has led to a boom even in countries without a peg, such as Brazil). China is the prime example but the Middle East countries are another often overlooked example. If we have to live with the Fed it would be nice if they spent at least a little of their time defending the purchasing power of our national currency. Cutting interest rates and expanding the supply of dollars will not solve this problem. The economic slowdown (or recession if you prefer) will only bring commodity prices down temporarily unless we cure our addiction to cheap money.

4. You have written about the current account deficit as a major problem facing our economy and I agree. In 2003 you wrote in the Washington Post:

In normal times, an orderly decline in the dollar would be a welcome development. By cheapening American exports and increasing the cost of imports here, the fall of the dollar would facilitate the needed long run adjustment in the current account deficit. Moreover, by raising import prices it would play a useful role in countering the rapid pace of disinflation that is bothering Federal Reserve Chairman Alan Greenspan.

Well, the dollar is cheaper now and with oil and gold at or near all time highs, disinflation no longer seems to be an issue. Unfortunately, the current account deficit is still with us. I’m sure your response would be that the dollar has fallen against the wrong currencies and if the Chinese would only revalue the Yuan, that current account deficit would disappear. You might be right, but what would be the consequences of that revaluation? My bet would be much higher interest rates. If the Chinese know they are going to revalue the Yuan, why would they continue to fund our current account deficit when that revaluing would result in a huge loss in their sovereign wealth fund? So if the path to solving the current account deficit is higher interest rates, why should we wait for the market (or the Chinese in a sense) to force the issue. The only way to solve the current account deficit is through higher domestic savings and that will only happen with higher interest rates. I am not saying that there is no pain involved in that adjustment; just the opposite in fact. Solving our debt problems will be very painful, but it will only be more painful the longer we put off the day of reckoning.





You are right that we part company when it comes to the correct policy response. I don’t know if we will have a recession, but I do know that monetary policy has worked every time in my adult lifetime to minimize the impact of economic slowdown. It is powerful medicine. And I suspect that it will again. As I said in my last response though, just because we can minimize the pain doesn’t mean that we should. I could be wrong and in that case we will finally get the unwinding that some are looking for. If that happens, monetary policy will not be able to respond to the crisis. What worries me is the potential for bad fiscal policies in response. If the stimulus package currently being considered is an indication of the type of economic thinking we can expect from our politicians, I mourn for our future.



I believe the only way to solve our long term problems is to suffer some pain now in lieu of suffering much greater pain down the road. Policies that I think can move us in the right direction include:



1. A dramatic reduction in corporate tax rates.

2. A dramatic change in our individual tax system. I would prefer a consumption based tax, but I have problems with the Fair Tax proposal. A flat tax seems the most likely change. The change should include an elimination of capital gains taxes and the mortgage deduction.

3. A unilateral removal of all import tariffs. If we fund our government through income taxes, import tariffs are by definition punitive. And the way I see it the one being punished is us.

4. A new international currency regime based on gold or possibly a basket of commodities. A pure gold standard is probably impossible but the only way we will get any kind of currency stability is in a system that doesn’t allow governments in the system to run excessive deficits. I suspect the Chinese are planning to switch to a gold standard at some point in the future and it would be to our advantage to beat them to the punch.





Unfortunately, I don’t think any of these things (or the myriad other proposals I can think of) will be enacted. I expect us to muddle through this time and face a bigger crisis down the road. Politicians cannot think past the next election cycle and have no incentive to think long term. My fear is that when the crisis finally arrives (if it hasn’t already), the policy responses will be toward ever greater government intervention. The results of such a course are easy to predict. One need only look to Europe with double digit unemployment and a stubbornly high inflation rate.





Best regards,



Joe

Further Response from Mr. Lachman

Dear Joe,



I am in complete agreement with you that the Federal Reserve’s repeated past egregious mistakes have got us into our present predicament. However, I part company with you in diagnosing where we are now headed and what the appropriate policy response might be.



It would seem to me that most indicators are now clearly suggesting that a recession has already begun. Employment growth has stalled abruptly, consumption has been weak, housing remains in a deep downturn, the ISM indicators are now in recession territory, and GDP growth in the fourth quarter of 2007 was weak.



Worse still, looking forward the US economy is being hit by the following major shocks, which show little sign of abating:



(a) The housing market is in its worst slump in 60 years with housing starts down precipitously and with housing prices now falling by 8 percent. Housing prices are almost certain to fall in 2008 by at least 10 percent against the backdrop of record inventories, tightening lending conditions and the scheduled resetting of ARMs. Such a decline in home prices would wipe out another US$2 ½ trillion in household wealth and would complicate balance sheet problems in the banks.



(b) Equity prices have already declined by close to 20 percent, which has wiped out another US$2 trillion in household wealth. It is doing so at a time that the US household debt to income ratio is at a record 140 percent.



(c) The banking system is in the grip of its worst credit crunch in over 25 years as it grapples with losses on past bad lending, now widely estimated to be in the ballpark of at least US$500 billion. This week’s Quarterly Federal Reserve’s Senior Loan Officer’s Lending Survey could not have painted a bleaker picture of the banking system’s lending intentions going forward, which points to an abrupt decline ahead in bank lending.



(d) International oil prices remain stubbornly in the region of US$90 a barrel.







In my judgment, this unusual constellation of major negative forces will swamp any support that the US economy might be getting from a weaker US dollar or from the stimulatory measures to date that in any event will only come into play in the second half of the year. The question to me is not whether we are now in recession. Rather it is how severe will this recession be. It is also my view that simply letting this recession run its course without a policy response would be highly dangerous and irresponsible. For it would risk having the economy move into a vicious circle of a weakening economy worsening both the housing bust and the banks’ problems which in turn would deal a further body blow to the economy.



I guess only time will tell who of us is making the right diagnosis and I would be happy to revisit this question in 6 months time.



Best regards,



Desmond

I will post a final comment on this later today.

Lennar

According to a story in the WSJ today, Lennar will receive an $800 million tax refund from the loss on land sales:

Late last year, the Miami-based home builder sold a big swath of land -- about 11,000 home sites -- for $525 million to a partnership that it formed with Morgan Stanley. At first glance, the deal seemed terrible for Lennar, which had the land valued on its books at about $1.3 billion.

But the deal's structure allowed Lennar to recognize a big loss that it applied against taxes paid the previous two years. The result: Lennar is expecting a tax refund of more than $800 million, according to the company's annual results filed in late January.

As an added bonus, because of the way Lennar and Morgan Stanley structured their partnership, Lennar still effectively owns 20% of the land, according to the company. It also has a 50% voting interest in the partnership, meaning it will have a say in how the land is developed.

Okay so they get to take the loss and still maintain some control over the land. In addition, because of the tax refund, they really don't have a loss. They sold the land for $525 million and get an $800 million tax refund which is basically what they were carrying the land for on the balance sheet. That is a smart deal and one that other homebuilders will likely emulate. The current stimulus bill would allow companies to apply the loss against taxes paid over the last five years rather than the two years in the Lennar deal.

Pre Market

The market looks a little higher at the open as Disney reported better than expected earnings last night and improved the mood a bit. We get Cisco after the close today. The only economic data today was productivity (higher than expected at 1.8%) and unit labor costs (lower than expected at 2.1%). Both figures are for the 4th quarter and tell us little about the future but good numbers are welcome. Biogen had good earnings and that should help the biotech sector today. Toll Brothers had another lousy quarter but no one should be surprised that a homebuilder is struggling.

It is interesting though how the homebuilding stocks have performed lately. They were up most of the day yesterday but sold off late with the market. Housing starts are probably near their eventual lows (see yesterday's post) and I guess it makes sense to see the homebuilders start to perform better, but it does seem premature with the large inventory of homes on the market. I suspect most of the move in the homebuilders recently was short covering and it will take some time before real long term buyers come back to the group.

4th Quarter Productivity, Unit Costs

Productivity in the US non-farm business sector slowed to a 1.8% annual rate over the last three months of 2007. This number is a positive, since economists had forecast a much smaller 0.8% increase, but it is down from a revised 6.0% increase in the 3rd quarter.

Productivity, or output divided by hours worked, increases profit margins and real wages, since more is being produced with less. This, in turn, becomes a key deterrent of inflation and promotes a higher standard of living.

For the year, productivity increased 1.6%, compared with a 1.0% increase in 2006.

Unit labor costs, a key measure of inflation, came in at 2.1% annualized rate for the quarter. Economists forecasted a number closer to 3.5%. For all of 2007, unit labor costs were up 3.1%, compared to 2.9% in 2006.

Full Report.

Well That was Ugly

The Dow closed down 370 today after the ISM Non Manufacturing report fell into recession territory. Apparently some hadn't gotten the memo about the economic slowdown. The ISM report showed a similar drop after 9/11 and another similar dip in early 2003. Obviously, this is not good news. I've been through the report and to be honest, I can't find anything positive to say about it.

That does not mean that the stock market did not over react to the report. It is still just one month and does not make a trend. The move in stocks today demonstrates more than anything the nervousness in the market. Anyone lucky or smart enough to buy near the recent lows was itching to take profits. Combine traders with tenuous profits and investors afraid of recession and what you get is a day like today.

This move in the market is a healthy sign. Bottoms are not made in a day or a week. Long term bottoms take time to build; a V bottom would be a sign that the final bottom has not yet been made. I expect to see a lot of volatility over the next couple of months; there will be big up days and big down days. I don't know yet (no one does) whether the recent lows will hold, but I suspect they will. I do not believe this will be a bear market like 2001-2002. The S&P 500 traded over 30 times earnings back then and was nowhere near that high when this started. I suppose anything is possible but a 50% drop from the highs would put us at single digit P/Es, something we haven't seen since the 70s.

Which brings up an interesting point. I've heard a lot of talk about stagflation recently and with gold hitting new highs some are looking to the 70s for clues about the market. So let's do that. I think the period most people are thinking about is the period from 1973 to 1982. The S&P peaked in 1973 and had a nasty bear market similar to the one we had at the beginning of this decade. August 1982 is widely considered the beginning of the great bull market of the 80s and 90s. So here's the chart from January 1973 through August 1982:




And here's a chart of the S&P 500 so far this decade:



The charts are remarkably similar. The bear market at the beginning of each period lasted for approximately 2 years. The recovery to previous highs took about five years. The recovery was followed by another bear market, but not nearly as bad as the one that started the period. Does that mean this market will act exactly like that one? Of course not; no two markets are alike. But if we relate these charts to economic data it may give us some clues about what to expect.

Obviously, the housing market is the part of the economy that has people worried the most so let's look at housing starts:



Maybe this is why the homebuilding stocks are acting pretty good recently. If history is any guide at all we are a lot closer to the bottom than anyone expects.

And since everyone seems worried about the ISM, let's look at the Manufacturing series for which we have a longer history:



This doesn't tell us a lot except that things are a lot less volatile today than they were in the 70s. If recent history is a guide then even if we are headed for recession, the bottom is not far away.

What about employment?



If this is a mid cycle slowdown, like we had in the mid 90s, then this is about as bad as it gets. If this is a recession, we've got a ways to go yet. I'm still betting on a slowdown rather than a full blown recession, but we don't have enough information yet to make a determination.

What about the unemployment rate?



Well, so much for that comparison to the 70s. We aren't even close to the unemployment seen in the late 70s or early 80s. In fact, if the trend of lower highs holds, the unemployment rate is likely to rise only a little further.

One thing that does look a lot like the 70s is the dollar:



One thing that should be obvious from this though is that there is little corellation between the value of the dollar and recessions. We've had recessions when the dollar was rising and recessions when the dollar is falling.

What about inflation? A lot of people, me included, are worried about inflation. Here's the Personal Consumption Price Index:



Seems rather tame when compared to the bad old days, huh? Any inflation is too much for me, but things aren't so bad right now compared to what we've seen in the past.

I could continue in this vein with other statistics, but the evidence is clear. The economy is not great right now, but it is not out of the norm for the last 50 years. In fact, if anything, things are considerably better than at times in the past, particularly the 70s. Are we headed for recession? I don't think so, but even if I'm wrong, we've probably already seen most of the damage. Looking back at the past will not tell us where we are going. It does provide some perspective though and that perspective tells me that all the doom and gloom out there is probably misplaced. Investors need to remember that the goal is to buy low and sell high. The market is giving investors an opportunity to do the buying part of that equation. It just takes a little perspective to gain the confidence to act on it.

Yes, We Disagree

My response to Desmond Lachman:

Yes, we disagree on at least two points. I do believe there is a role for regulation however I think it needs to be very minimal. 1907 is actually a great example for both our cases. The panic of 1907 involved a real estate crash followed by two stock market crashes so it correlates well with today’s market conditions. It was also, in my opinion, a result of the National Bank Act (of what year? 1880 something I think?) and the Gold Standard Act of 1900 both of which were a result of lobbying by banking interests (primarily JP Morgan). So 1907 demonstrates a need for regulation but also demonstrates the need for caution. Regulations are often written to favor private entrenched interests (Morgan and Rockefeller in this case) and so one must be careful that regulation doesn’t stifle competition to the detriment of the consumer. Obviously, I have grave doubts as to whether regulations can be written that will not favor those with an interest in the outcome and the means to hire lobbyists by the dozen. I would also point out that the panic of 1907, as bad as it was, lasted less than a year and was ended by the same private interests who started it (again primarily Morgan - with an assist from Jesse Livermore).



1907 is also a good parallel to today for another reason – in both cases the cause of the crisis was monetary inflation caused by the banking system. Since the likelihood of changing our banking system, abolishing the Federal Reserve and adopting a true gold standard are exactly zero we are left to argue whether the Fed is charting the proper course given the system we have. The US economy has been marked by rising debt for a very long time and that is a direct result of a Federal Reserve that has too often opted for monetary inflation rather than suffer a temporary (and natural) slowing of growth. This will continue until debt has reached proportions that no longer allow for a further expansion of the debt bubble. Has that time come? I don’t think so. If you read my market commentaries, I have said that the Fed will be able to rescue us once again with monetary policy, but that doesn’t mean that they should. As an investment advisor, I am happy to spend my days trying to figure out where the bubble goes next, but as a citizen, I am distressed that we are merely putting off the day of reckoning.



You argue that a hands off approach by the Fed could result in a nasty and prolonged recession. I don’t think we are in a recession right now and have argued for some time that we won’t have an official recession from this housing and credit crisis. That prediction is based, at least in part, on my expectations of Fed action. However, from a long term economic perspective, maybe what we need right now is a nasty and prolonged recession. At some point we as a nation will have to pay the price for all this debt. Wouldn’t it be better to start the process now rather than wait until the debt burden is even larger than it now stands? As for the possibility of a lost decade like the Japanese or another Great Depression, I don’t believe monetary policy was the primary culprit in prolonging the pain in either case. On the other hand, I have very little faith that our politicians would act any differently than the politicians of Japan or FDR. They would take actions that would prolong the recession and do little to foster the recovery. They would interfere with the market and make things worse. The Japanese politicians spent most of that lost decade propping up failed banks and raiding the public treasury for questionable public works projects. They should have let the banks fail, de-regulated the economy (especially financial services) and cut taxes and public spending. Our politicians are already talking about extending unemployment benefits - with the unemployment rate at 4.9%. God only knows what they would propose if we had a nasty and prolonged recession. And that is, by far, the best argument for aggressive Fed action that I can muster.



Again, thanks for the response and rest assured that I will keep reading. I love a good debate….

Desmond Lachman's Response

Desmond Lachman has offered a response to my critique of his TCS article. Here is is in full:

Dear Mr. Calhoun,



Thanks for your email.



While we seem to agree on many matters, it seems that we disagree on two basic points. The first is whether or not there is a role for regulation in our market economy. The second, and perhaps more important point of disagreement, is how should the Federal Reserve be responding to today’s bursting of the housing market and credit market bubbles.



I would be the first to highlight the dangers of excessive market regulation and intervention in our economy. However, I would not go so far as you in suggesting that there is no role for regulation in our economy. My view is that there is a need for some minimal regulatory framework within which markets operate in order to prevent the abuses and excesses that would otherwise occur. In this context, it is well to recall that the Federal Reserve was set up in 1913 to prevent a recurrence of severe financial market panics like that of 1907, which were commonplace during the 19th century.



There is no question in my mind that cheap money between 2001 and 2005 was a major contributor to the housing market bubble and to the associated sub-prime lending problem. However, I also think that a major source of the problem was financial innovation outpacing the regulatory framework. In particular, it seems to me that the move to an “originate-to- distribute” model of mortgage finance, coupled with the increased incidence of securitization and the creation of highly opaque and complex credit instruments, have played an important role in today’s banking crisis. In my view, the marked loosening of credit standards could very well have occurred even if monetary policy was not as loose as it was and the Federal Reserve must be held to account for allowing imprudent bank lending to occur on the scale that it did. I would not want to minimize the impact that the estimated US$400 billion losses from mortgage lending will have on the banking systems’ willingness to lend going forward.



On the issue of how the Federal Reserve should be responding to the present situation, I think that it is important to recognize that the US economy is presently being hit by four major shocks that are inter-related to an important degree and that have the potential to throw the US economy into a nasty and prolonged recession. Those shocks include (a) the worst housing market bust since the Great Depression; (b) the most severe credit crunch in the past 25 years; (c) international oil prices at $90 a barrel; and (d) an important correction in equity prices. It would seem that these shocks have already pushed the US economy into recession judging by the latest consumption and employment numbers.



A hands-off approach by the Federal Reserve now runs the real danger of having the US economy slide into a full blown recession that would only aggravate the acute problems that the banks are already experiencing as well as worsening the housing market and credit market busts. That in turn would likely deepen the economic recession. This would seem to be the clear lesson of both the Great Depression and Japan’s lost decade in the1990s following the bursting of its asset price bubble, when the central bank was far too slow in easing monetary policy. It is for this reason that I support the Fed’s belated move last week to a decidedly easier monetary policy stance as well as its commitment to take further measures should the economy weaken further in the months ahead. I would caution, of course, though that the Federal Reserve will need to remove monetary policy ease once the present real recessionary danger has passed.



Best regards,



Desmond

Non-Manufacturing ISM Report

Non-manufacturing business activity in January contracted for the first time since March 2003, according to the Institute of Supply Management's monthly report on business. The non-manufacturing index came in at 44.6%, while the business activity/production index dropped to 41.9, from 54.4. A reading below 50 indicates contraction. Economists were expecting a reading in the range of 52.4%.

New orders were hit hard, falling to 43.5, from a 53.9 reading in December. Employment, imports, and inventories, expanding just one month ago, contracted significantly as well, well into the low 40s.

To see the full report, click here.

Blizzard?

Employment drops in a pink slip blizzard

That's the headline on a story by AP Economics Writer Jeannine Aversa about last week's employment report. Is it any wonder that a majority of the public believes the US economy is already in a recession?

WASHINGTON - In a shower of pink slips, U.S. employers cut jobs last month for the first time in more than four years, the starkest signal yet that the economy is grinding to a halt if it hasn't already toppled into recession.

A shower of pink slips? Um, the economy lost 17,000 jobs last month and when you consider that government cut 18,000, the private economy actually added 1000 jobs. Not a robust number to be sure, but "a shower of pink slips"? Hardly.

It's no secret that the economy is slowing but is it too much to ask the AP to just report the facts and leave the editorializing to the editorial page?