Thoughts On The Current Economic & Financial Markets Situations- Part One

Beginning with an article by Bill Wilby in last Wednesday's Wall Street Journal, entitled "The Dollar and the Market Mess," I've been reflecting broadly and seriously on the current combination of US economic and financial market situations.

More than any other time in my memory or study, the current situation is far from simple. And I believe, after a lot of thought, that part of this is attributable to a few recent technological factors.

Wilby began his article by quoting Keynes, who cited Lenin, that

"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

That's food for thought right now, isn't it?

The core of Wilby's piece, for me, are these passages,

"Doesn't a failure to respond aggressively to the credit crisis by cutting rates too slowly risk a recession, or a Japan-like breakdown of the world's financial system? Unfortunately the recession risk is high, but not because of high interest rates (which are currently negative in real, after-tax terms). The recession risk is high because of a breakdown in the absurd system that developed for the packaging and underwriting of debt, and the excess liquidity that developed from the combination of that system and a highly stimulative monetary policy.

The Fed took a gamble on inflation to ward off what was perceived as a deflationary threat in 2001-02. The inflationary consequences of that gamble are now here, with the petrodollar monetary merry-go-round fueled by the weaker dollar. Those consequences will be much easier to deal with now, rather than later. Unlike Japan, where the capital-markets risk was concentrated in a handful of thinly capitalized large banks, the very growth of the credit-derivatives market that is the source of the current crisis in the U.S. has also resulted in a wide dispersion of risk in the financial system, and any recession will likely be mild and short.

While we might see a number of hedge funds and some isolated banks fail, the pool of distressed asset buyers waiting in the wings would result in a needed consolidation of the financial-services industry, without systemic failure. In the meantime, the systemic risk posed by the failure of one or more of these institutions is minimal compared to the moral hazard and longer-term inflation risks we incur from their bailout.

Sadly, the dimensions of the Fed's great dilemma would be much less acute had the Fed and Treasury officials not taken such a cavalier approach to the U.S. dollar over the past eight years. Our "strong dollar" (wink, wink) policy has never been articulated by either institution with any real conviction, and markets have rightly sensed that maintaining employment, growth and stock-market happiness has begun to take precedence over maintaining the value of money. In a world of fiat currencies, where trust is your most powerful policy tool, dollar strength is a far better indicator as to the appropriate stance of monetary policy than "core" inflation."

Wilby touches on one of the most important aspects of the current debacle. Does the loss of asset value among privately-monetized, housing-based financial instruments qualify as sufficiently deflationary for the US economy to merit the Fed's recent easing? And concomitant damage to the US dollar's global market value?

As a nice sort of bookend economics editorial, Brian Wesbury wrote "The Economy Is Fine (Really) in yesterday's Wall Street Journal. Among the more important statistics Wesbury cites are,

"It is most likely that this recent weakness is a payback for previous strength. Real GDP surged at a 4.9% annual rate in the third quarter, while retail sales jumped 1.1% in November. A one-month drop in retail sales is not unusual. In each of the past five years, retail sales have reported at least three negative months. These declines are part of the normal volatility of the data, caused by wild swings in oil prices, seasonal adjustments, or weather. Over-reacting is a mistake.

A year ago, most economic data looked much worse than they do today. Industrial production fell 1.1% during the six months ending February 2007, while new orders for durable goods fell 3.9% at an annual rate during the six months ending in November 2006. Real GDP grew just 0.6% in the first quarter of 2007 and retail sales fell in January and again in April. But the economy came back and roared in the middle of the year -- real GDP expanded 4.4% at an annual rate between April and September.

With housing so weak, the recent softness in production and durable goods orders is understandable. But housing is now a small share of GDP (4.5%). And it has fallen so much already that it is highly unlikely to drive the economy into recession all by itself. Exports are 12% of the economy, and are growing at a 13.6% rate. The boom in exports is overwhelming the loss from housing.

Personal income is up 6.1% during the year ending in November, while small-business income accelerated in October and November, during the height of the credit crisis. In fact, after subtracting income taxes, rent, mortgages, car leases and loans, debt service on credit cards and property taxes, incomes rose 3.9% faster than inflation in the year through September. Commercial paper issuance is rising again, as are mortgage applications."

So, in Wesbury's view, the current economic data do not scream "RECESSION!" Rather, what we seem to have is a ceaseless drumbeat of media focus on gloomsayers who keep assuring us that a recession is already here.

In this role, CNBC has taken, in my opinion, a leading role. Frequent guests and on-air staff parrot whatever negative views they can find. Steve Liesman and Mark Haines regularly wring their hands over the state of the economy. Jim Cramer is showcased confirming that we are surely in a recession.

In fact, just this morning, in an example of incredible irony, co-anchors and reporters on CNBC held a little on-air debate among themselves as to whether the media, specifically CNBC, could, by itself, lead the US public into a stronger belief that a recession is occurring, than data might otherwise indicate. Of course, most of the CNBC personalities dismissed this. But the mere fact that they were covering themselves covering the story speaks volumes.

One of the frequent visuals on the network since its publication is the recent BusinessWeek cover depicting a road and asking if we are on it to a recession. They love that on CNBC this week. Just love it.

I think that today's ubiquitous cable news media have, in fact, accelerated the spread of public opinion that the US may be in a recession.

Consider last night's comment by the woman on CNBC's "Fast Money" program. In just 10 seconds, during which I surfed by and heard this comment, she said, to paraphrase,

'I think we're in a recession right now. Well, not a recession like the definition. But you know what I mean- it's a lack of growth.'

When a major business entertainment (news, too, occasionally?) network has people using technical terms so casually, and deliberately incorrectly, what do you think is going to happen? Most people don't know that there is a very technical definition of a recession. Determined by the National Bureau of Economic Research to be "two consecutive quarters of negative real GDP growth."

Confusing the general populace by calling a slowing of positive economic growth a recession is bound to create havoc and panic. Congratulations to the media- it is.

Wesbury continues in his editorial,

"Yet many believe that a recession has already begun because credit markets have seized up. This pessimistic view argues that losses from the subprime arena are the tip of the iceberg. An economic downturn, combined with a weakened financial system, will result in a perfect storm for the multi-trillion dollar derivatives market. It is feared that cascading problems with inter-connected counterparty risk, swaps and excessive leverage will cause the entire "house of cards," otherwise known as the U.S. financial system, to collapse. At a minimum, they fear credit will contract, causing a major economic slowdown.

For many, this catastrophic outlook brings back memories of the Great Depression, when bank failures begot more bank failures, money was scarce, credit was impossible to obtain, and economic problems spread like wildfire.

This outlook is both perplexing and worrisome. Perplexing, because it is hard to see how a campfire of a problem can spread to burn down the entire forest. What Federal Reserve Chairman Ben Bernanke recently estimated as a $100 billion loss on subprime loans would represent only 0.1% of the $100 trillion in combined assets of all U.S. households and U.S. non-farm, non-financial corporations. Even if losses ballooned to $300 billion, it would represent less than 0.3% of total U.S. assets."

I think this is a very important few paragraphs. Who really believes that a loss of less than 1% of asset values in the US constitutes concern that we have severe monetary contraction?

Wesbury continues,

"Beneath every dollar of counterparty risk, and every swap, derivative, or leveraged loan, is a real economic asset. The only way credit troubles could spread to take down the entire system is if the economy completely fell apart. And that only happens when government policy goes wildly off track."

In the Great Depression, the Federal Reserve allowed the money supply to collapse by 25%, which caused a dangerous deflation. In turn, this deflation caused massive bank failures. The Smoot-Hawley Tariff Act of 1930, Herbert Hoover's tax hike passed in 1932, and then FDR's alphabet soup of new agencies, regulations and anticapitalist government activity provided the coup de grace. No wonder thousands of banks failed and unemployment ballooned to 20%.

But in the U.S. today, the Federal Reserve is extremely accommodative. Not only is the federal funds rate well below the trend in nominal GDP growth, but real interest rates are low and getting lower. In addition, gold prices have almost quadrupled during the past six years, while the consumer price index rose more than 4% last year."

Again, the comparison of current conditions to the Great Depression, as, for example Gary Shilling once again hinted at on CNBC this afternoon, is unwarranted.

These monetary conditions are not conducive to a collapse of credit markets and financial institutions. Any financial institution that goes under does so because of its own mistakes, not because money was too tight. Trade protectionism has not become a reality, and while tax hikes have been proposed, Congress has been unable to push one through.

The irony is almost too much to take. Yesterday everyone was worried about excessive consumer spending, a lack of saving, exploding debt levels, and federal budget deficits. Today, our government is doing just about everything in its power to help consumers borrow more at low rates, while it is running up the budget deficit to get people to spend more. This is the tyranny of the urgent in an election year and it's the development that investors should really worry about. It reads just like the 1970s.

Here, Wesbury makes a very good point. First, what Democrats decried only last year, they are now pushing through at light speed- deficit spending and a falling dollar. It truly does begin to make you worry that we may be on the brink of losing all the economic sanity of the Reagan and after years, in which inflation fell and real economic growth skyrocketed.

It was Democratic Congressional spend-and-tax policies that helped mire us in nearly a decade of what became stagflation.

The good news is that the U.S. financial system is not as fragile as many pundits suggest. Nor is the economy showing anything other than normal signs of stress. Assuming a 1.5% annualized growth rate in the fourth quarter, real GDP will have grown by 2.8% in the year ending in December 2007 and 3.2% in the second half during the height of the so-called credit crunch. Initial unemployment claims, a very consistent canary in the coal mine for recessions, are nowhere near a level of concern.

Because all debt rests on a foundation of real economic activity, and the real economy is still resilient, the current red alert about a crashing house of cards looks like another false alarm. Warren Buffett, Wilbur Ross and Bank of America are buying, and there is still $1.1 trillion in corporate cash on the books. The bench of potential buyers on the sidelines is deep and strong. Dow 15,000 looks much more likely than Dow 10,000. Keep the faith and stay invested. It's a wonderful buying opportunity."

Which brings me to my own conclusions about the current twin situations- our economy, and our recent financial markets turmoil.

On the economy, I am with Wesbury and Alan Reynolds. I don't believe we are in a recession now, nor are we likely to be technically in one anytime soon. However, I believe that many US citizens have been led to believe, and be scared that we are in a recession.

The current Federal government stimulus package is a huge mistake. Unfortunately, all of our political leaders have chosen to cover their collective asses, rather than simply sit tight and tell voters to get ready for the result of their collective economic misbehavior. To wit, people buying homes they couldn't afford, and, with their subsequent delinquencies and defaults, causing a ripple back up the supply chain to various other purveyors of goods and services. Yes, growth will slow. But it's not causing huge unemployment and a drop in GDP.

By caving into populist expectations, and a desire by a do-nothing Democratic Congress to be seen as doing something, the Federal government is probably doing exactly the wrong thing at the wrong time. Making the Bush tax cuts permanent would be much better for the economy's health, now and in the future, than sprinkling a few hundred dollars into millions of pockets, to be briefly spent and vanish into the much larger GDP.

Again, echoing Fox News' Neil Cavuto from last week, 'if this is what we do in a mild economic period, what will we do when we really have problems?'

Given the length of this post, I'll conclude with my thoughts on the financial markets turmoil tomorrow or the next day.