The Economy: Recovering, Or Ready To Plunge Again?

Alan Blinder's recent editorial in the Wall Street Journal extolled the imminent blast-off for the US economy of Samuelson's accelerator-multiplier effect.

Blinder didn't credit the retired MIT Nobel Economist in his editorial, but he provided the math to explain how housing and autos, having plunged so low, will kick-start the US economy in the next quarter just by being non-negative.

Dick Hoey, whom I knew briefly at EF Hutton many years ago, was saying the same things on CNBC yesterday afternoon.

Then we have a very detailed, persuasive editorial in last Tuesday's Journal, written by Mort Zuckerman. In his piece, the chairman of US News & World Report, and head of Boston Properties, dwells almost exclusively on the under-representative current unemployment rate of 9.5%.

Zuckerman lists 10 separate, but related points, all of which provide evidence that the demand side of the economy, via consumer spending, will almost certainly be much lower in the next few years than most pundits, analysts and economists realize.

Among his points, Zuckerman cites: underemployed, those no longer even looking for work, workers 'employed' but on unpaid leave, part-time workers who were once full-time, shorter work weeks among the employed, a 65% capacity utilization at US factories, and, finally, the longest average length of official unemployment- 24.5 weeks- since this data item has been tracked back in 1948.

For good measure, Zuckerman adds that low consumer confidence and high debt levels have increased the savings rate which will, of course, dampen any subsequent recovery, as the consumer's 'marginal propensity to consume' will be much lower than in recent years. He laments that now, when a truly job-creating, infrastructure-building federal spending bill would help, it's too late. That's because $787B was allocated for what has been, to date, largely increases in Medicare and other state-based transfer payment programs.

In effect, Zuckerman would conclude that people like Bank of New York's Hoey mistakenly believe that there will be sufficient consumer demand to justify rebuilding inventories, building new cars and houses.

Who's right?

Personally, I'd put my money on Zuckerman. Leaving aside that Dick Hoey was a fixed income manager back in the day, and his BONY/Mellon/Dreyfus bio doesn't exactly laud him as an economic Nobel Laureate, I don't think Hoey is sufficiently observant of the real differences in the effects of the recent recession on the US labor force from those of recessions prior to 1992.

That so-called 'jobless recovery' may well have marked a turning point for the US economy which has not yet been captured in various models and adequately observed by pundits-cum-economists like Hoey. Or even Alan Blinder.

Prior to the 1991-92 recession and recovery, you are looking back to 1982-83, the early Reagan years, now very nearly thirty years ago. For perspective, was the 1960 economy different from that of 1930? Very much so. And the 1980 economy was so radically different from that of 1950, thanks to electronics and technological advances in communications as to make forecasting the former with models of the latter seem laughable.

I suspect that's what is happening now. Those analysts and economists harking back to the early 1980s and using conventional models with estimates of consumer spending and labor growth have missed some important transformations in the US economy of 2009.

I don't think Zuckerman is one of them.

Paul Samuelson's Brilliant Idea

As the US finds itself firmly in a recession, with the potential for this phase of the natural economic cycle to worsen before the economy recovers, I am reminded of one standout economic insight, about which I have written before, here and here.

I am referring, of course, to MIT emeritus/retired Professor of Economics and Nobel Laureate, Paul Samuelson's 'accelerator-multiplier' theory.

Regarding the current recession, I wrote in the second linked post,

"Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses."

As this phenomenon from the housing sector spread through banking and into the general economy, I have ruminated recently, at length, as to what factors can turn a deepening recession into an eventual recovery.

What is it that turns a gloomy consumer outlook, vanishing banking assets, shrinking spending levels and spreading joblessness into subsequent economic growth?

The answer, quite simply, was discovered by Samuelson in the 1950s. Inducing cyclicality into a system is often simply the result of including a 'first difference' term. Samuelson's genius was understanding that businessmen and consumers view the 'first difference' between today and some past period- say, a year ago- to judge whether things have gotten better, worse, or are unchanged.

Right now, a look backward shows that volumes are shrinking, so near-term economic behavior echoes this with more belt-tightening.

But in six-twelve more months, business volumes will probably appear flat. This realization will cause businesses and consumers to conclude that the bottom has been reached in this economic cycle. Sales aren't falling anymore, joblessness isn't growing, and economic activity generally has leveled out.

Since this will be a positive change in the rate of change, planning becomes focused on maintenance or growth, rather than more cutting.

Samuelson quantified natural human behavior for economic purposes in a manner never before articulated.

Of course, there is a huge implication due to Samuelson's work on the accelerator-multiplier theory.

It demonstrates a natural cyclicality to economic conditions that cannot be 'fixed' by any sort or amount of governmental intervention. As I noted in the more recent linked post, this is why one-time fiscal 'stimuli' never work. Only permanent tax cuts can deliver a lasting change in incomes that effectively shock the perceptions of businesses and consumers into seeing the present as better than the recent past, so to trigger expansionary activity.

Further, any promises of governmental program activity, e.g., infrastructure spending, won't do much for widespread business and consumer behavior, either. It is simply impossible to arbitrarily, or determinedly lop off the 'recessionary' phase of economic cycles. The latter exist for a reason, and give society the opportunity to clean out unsustainable, unprofitable businesses, recycling their resources for use in better business opportunities.

Not only does Samuelson's work give us confidence that every recession, in effect, automatically brings about its own consequent expansion, but it confirms that this is a necessary phase in national economic cycles.

Where'd It All Go?

Last week on CNBC's morning program, co-anchors Joe Kernen and Becky Quick were asking, regarding the mortgage/housing market troubles,

"Where'd all the money go that went into these houses that are now empty?"

Kernen was musing about where all that money went which was borrowed to build now-useless housing.

Who ended up with the money? Or did it just 'disappear?'

Pardon me for saying so, but, isn't that a stupid question? And Kernen and Quick are both smart enough to already know the answer.

The money was part of the assessed, imputed present-value of those homes, lent by financial service providers.

Essentially, based upon local demographics, overall economic outlook and the borrowers' financial outlook and current condition, someone lent them the money to build a house of some assumed value in that market at that time. No matter how long the chain of borrowers and lenders, eventually, at the end of it, some person or entity bought a financial instrument promising repayment, over time, at some interest rate, in exchange for the cash that trickled back to the home's purchaser, with which to pay the various people engaged in building the home.

So the money in those homes- the value lent against them- went to the contractors, tradesmen, and, yes, a little went to the financial intermediaries, as well.

As with the excessive lending and capitalization of web-based companies during the 'dot.com' boom, capital flowed from people and entities to projects- homes or businesses- judged to have future value and an ability to repay the borrowed money.

Of course, to the extent that financial intermediaries used excessive leverage, the dollars lent by investors became, in some cases, 30 or more times that amount. Banks are allowed certain capital ratios by the Basel Accords, while the banks allow certain ratios for brokers to which they lend. With firms such as Merrill Lynch and Bear Stearns purchasing and operating mortgage banks, I'm sure the leverage for dollars flowing into the housing sector were greatly amplified versus prior housing bubbles.

As I reflected on this post earlier this morning, it occurred to me that one of the by-products of the excessive investment in the housing sector was an overall economic leverage which was much greater than if those investor dollars had flowed to a non-financial sector, such as energy, consumer goods, or almost any other sector.

The investments in housing and related sectors diverted funding from other sectors. But, since so much of the real estate boom was predicated on values which, especially in 'hotter' markets like Las Vegas, Florida and California, could not long be sustained, those investments were at risk nearly from the outset.

When the leveraged 'values' declined, the thinner-than-normal equity slices evaporated quickly, and investors took their hits next- almost immediately. For example, a low-down-payment mortgage requiring only 5% of the purchase price of the home from the buyer could only withstand a 5% drop in real estate values before investors began to lose their capital.

With so much borrowed money flowing into an overheating sector, the damage to our economy was magnified because so much forecasted future value was brought forward, monetized as housing prices, lent, and spent.

So the answer to Kernen's and Quick's question is that an abnormally large amount of economic 'value' was created on paper, in the financial markets, to lend to buyers of over-valued houses which quickly lost value and destroyed the imputed values which had been assessed, borrowed, lent, and spent on housing and related items.

The cash went to pay builders, furnishers, appliance makers, etc. The offsetting 'credits' for these 'assets' are, of course, assets on the lenders/investors balance sheets. But they have now had to be written down to current values.

The laborers, contractors, and publicly-held house-furnishing-related companies enjoyed a brief, accelerated boom in revenues. Perhaps some even expanded capacity and created downstream revenue growth themselves.

Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses.

Since valuation is a function of perceptions, those values are now gone. And so is much of the transitory wealth which existed at the time of peak values in the housing markets.

Samuelson's Economic Insight

Are we in a recession? Are we truly experiencing two consecutive quarters of decline in real GDP?

Is fiscal action by the Federal government useful or even necessary?

What may have caused the softening growth that many now swear is a recession?

The more I reflect on what I learned about economics in college and graduate school, and since, the more I come back to one simple insight.

Paul Samuelson's 'accelerator-multiplier' theory.

Stunningly simple, it seems to square, for me, at least, with human behavior. As many great economic insights do. Such as fellow Nobel Laureate Milton Friedman's concept of income as a steady, long-term expected value.

Samuelson noted that when growth slows from a higher rate, to a lower one, the mere slackening of growth is transmitted back through what we now would call the supply chain, as a series of demand reductions.

Instead of 10% more materials each year to make my products, this year, I need only 5% more.

My supplier will see a decrease in expected sales. Growth will be half of what it was, and, thus, sales fall below expectations.

While real output is still higher, the gradual cutback in production from expectations results in a contraction, as workers work to produce less. The cycle continues, and the multiplier effect, which, in forward gear, causes economic expansion, is responsible for its contraction when run in reverse.

Seen in this light, recessions which are attributable to simple changes in economic outlook can't really be affected very effectively by one-time fiscal monetary transfers.

Plus, as noted by Alan Reynolds in his recent Wall Street Journal editorial, writing checks to one group of US citizens by the Federal Government simply means borrowing from someone else, in some way, and paying interest in the bargain. But nothing is really created. Either other spending is curtailed, or debt is assumed, crowding out someone else's potential spending, and making the stimulus really a function of differential marginal propensities to consume, to be technical.

Samuelson's genius seems to lie in his identification of a fundamental tendency of humans to view the lack of attainment of growth objectives to feel like a cutback in business. If this is what is happening, even as a result of the wealth effect of the many tens of billions of dollars of recent equity losses in US markets, it remains a phenomenon which is unlikely to be fully and successfully addressed by one-off fiscal spending by the Federal Treasury.

If any fiscal actions were to have longer-term consequences, they would seem to be the act of making soon-to-expire tax rate cuts permanent. And perhaps going further and lowering rates, permanently, once more.

Anything less would seem unlikely to provide a sufficient, long term change in demand to alleviate any potential recession. Instead, simple spending programs like that now contemplated by Congress might just feed inflation and aggravate the dollar's price.