Winehole23
10-29-2009, 02:08 PM
The Death of the Muddle-Through Economy (http://www.minyanville.com/articles/muddle-economy-recovery-japan-jobless-jobs-economy-gdp-buy-debt-tax-real-estate/index/a/24992/p/4)?
I first wrote about the Muddle-Through Economy in 2002, and the term has more or less become a theme I've returned to from time to time.
In 2007 I wrote that we would indeed get back to a Muddle-Through Economy after the end of the coming recession. If you Google the term, at least in the case of the first four pages, more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle-through middle is comfortable to me.
Last week I expressed my concern that we as a country are taking actions that could indeed “kill the goose” of our free-market economy (see: The Killing of America's Free-Market Economy (http://www.minyanville.com/articles/recovery-recession-crisis-market-deficit-inflation-hyperinflation-deflation-GDP-congress-banks-spending-lending-health-Fed/index/a/24891)). I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I’ve given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.
Muddle Through, R.I.P.?
I defined a Muddle-Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we’d return at some point to such an environment at the end of the recession I was predicting.
I’m not surprised about the response of the Fed to the current recession and credit crisis -- whether it’s the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there’s nothing that would make me think we don’t eventually recover, albeit at a very slow Muddle-Through pace, with a jobless recovery that lasts for several years. It won’t be pleasant, but we’ll survive.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud1.jpg
However, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there’s real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.
And that assumes nominal growth that’s north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We’ll look at what might be the answer, but first we need to look at a basic concept in economics.
Savings Equal Investments
GDP (Gross Domestic Product) is defined as Consumption (C (http://finance.minyanville.com/minyanville?Page=QUOTE&Ticker=C)) plus Investment (I) plus Government Spending (G (http://finance.minyanville.com/minyanville?Page=QUOTE&Ticker=G)) plus [Exports (E (http://finance.minyanville.com/minyanville?Page=QUOTE&Ticker=E)) minus Imports (I)] or:
GDP = C + I + G + (E-I)
(For the wonks out there, GDP is usually termed “Y.”)
You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.
This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it’s not a guess or an approximation. It’s simple reality.
Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.
In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings, a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you don’t get job growth or economic growth.
Japanese Disease
Some readers wrote this week telling me I’m far too worried about a rising government deficit. Right now we’re at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it’s at 178%, and the world hasn’t come to an end for them. In fact, they’re running massive government deficits today and plan to do so for a long time. Why, I am asked, can’t we be like Japan? And my answer is that it’s possible, but the cost that Japan has paid has been high.
In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it’s at 110%. And the totals of both government and private debt is roughly the same (within 5%) of where they were 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management’s latest letter (last week’s Outside the Box):
The federal government’s promise to extricate the US economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro’s book, Macroeconomics -- A Modern Approach, p. 370).
This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is three, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.
For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at levels the same as 20 years ago. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President’s Council of Economic Advisors, and further explored by European economists. There’s general agreement on these facts.)
In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it’s 373%. We’ve added over $15 trillion in debt, yet total employment today is roughly where it was nine years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I’m sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease -- a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).
Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.
The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have won’t go into the investments we need, but into government debt.
Who Will Buy the Debt?
Now, let’s go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they don’t disappear. They can only go back into a dollar-denominated investment. Up to now, that’s typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud2.jpg
The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or, at the most, goes flat. But now we’re experiencing something new: Bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks’ lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud3.jpg
Banks put their cash and reserves they’re not lending at the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt), and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.
And that’s what we’re seeing. Banks are taking the money the Fed is printing and the government’s giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they’re likely to continue to do so since bank balance sheets are still deteriorating -- especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans compared to only 21% of single-family loans. Banks (in general) need to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we’ll see over 400 banks fail in this cycle.
One quick chart to further highlight the problem that banks are facing. I’ve been writing for several years that commercial real estate loans will be the next shoe to drop. Moody’s calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they’ll have to make. And my bet is they put those reserves they’re not lending into government debt.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud4.jpg
Given that the current Congress is hell-bent on massively raising taxes in 2011, we’re likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It’s a vicious spiral.
The New Muddle-Through Economy
This isn’t a prescription for a return to normal growth. We’re headed for a New Normal that’s less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so, but it won’t be fun. It won’t be long-term 2% growth and employment going back to 6% any time soon. With a different attitude and leadership in Congress, maybe we can reverse the course. But it won’t happen next year, and it’s unlikely in 2011.
I’m afraid we’ll have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait: If my friend at PIMCO, Mohammed El-Erian, can tell us we’re going to a “New Normal,” then I can decide that we’re going to a “New Muddle-Through Economy” -- just not one as benign as I used to think.
In the end, that’s what we’ll do. We’ll figure out how to deal with the environment in which we find ourselves. That’s what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.
As an aside, I’m not expecting to see the crisis I’m thinking of any time soon. We can move along with positive GDP for some time. Instead, I’m thinking of the longer term – one to three years out. We’ll become complacent. I’ll get letters telling me I’m too pessimistic, just as I did in late 2006 when I said we’d be in a recession by late 2007. But I firmly believe we’ll see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.
I first wrote about the Muddle-Through Economy in 2002, and the term has more or less become a theme I've returned to from time to time.
In 2007 I wrote that we would indeed get back to a Muddle-Through Economy after the end of the coming recession. If you Google the term, at least in the case of the first four pages, more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle-through middle is comfortable to me.
Last week I expressed my concern that we as a country are taking actions that could indeed “kill the goose” of our free-market economy (see: The Killing of America's Free-Market Economy (http://www.minyanville.com/articles/recovery-recession-crisis-market-deficit-inflation-hyperinflation-deflation-GDP-congress-banks-spending-lending-health-Fed/index/a/24891)). I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I’ve given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.
Muddle Through, R.I.P.?
I defined a Muddle-Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we’d return at some point to such an environment at the end of the recession I was predicting.
I’m not surprised about the response of the Fed to the current recession and credit crisis -- whether it’s the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there’s nothing that would make me think we don’t eventually recover, albeit at a very slow Muddle-Through pace, with a jobless recovery that lasts for several years. It won’t be pleasant, but we’ll survive.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud1.jpg
However, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there’s real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.
And that assumes nominal growth that’s north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We’ll look at what might be the answer, but first we need to look at a basic concept in economics.
Savings Equal Investments
GDP (Gross Domestic Product) is defined as Consumption (C (http://finance.minyanville.com/minyanville?Page=QUOTE&Ticker=C)) plus Investment (I) plus Government Spending (G (http://finance.minyanville.com/minyanville?Page=QUOTE&Ticker=G)) plus [Exports (E (http://finance.minyanville.com/minyanville?Page=QUOTE&Ticker=E)) minus Imports (I)] or:
GDP = C + I + G + (E-I)
(For the wonks out there, GDP is usually termed “Y.”)
You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.
This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it’s not a guess or an approximation. It’s simple reality.
Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.
In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings, a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you don’t get job growth or economic growth.
Japanese Disease
Some readers wrote this week telling me I’m far too worried about a rising government deficit. Right now we’re at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it’s at 178%, and the world hasn’t come to an end for them. In fact, they’re running massive government deficits today and plan to do so for a long time. Why, I am asked, can’t we be like Japan? And my answer is that it’s possible, but the cost that Japan has paid has been high.
In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it’s at 110%. And the totals of both government and private debt is roughly the same (within 5%) of where they were 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management’s latest letter (last week’s Outside the Box):
The federal government’s promise to extricate the US economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro’s book, Macroeconomics -- A Modern Approach, p. 370).
This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is three, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.
For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at levels the same as 20 years ago. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President’s Council of Economic Advisors, and further explored by European economists. There’s general agreement on these facts.)
In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it’s 373%. We’ve added over $15 trillion in debt, yet total employment today is roughly where it was nine years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I’m sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease -- a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).
Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.
The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have won’t go into the investments we need, but into government debt.
Who Will Buy the Debt?
Now, let’s go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they don’t disappear. They can only go back into a dollar-denominated investment. Up to now, that’s typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud2.jpg
The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or, at the most, goes flat. But now we’re experiencing something new: Bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks’ lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud3.jpg
Banks put their cash and reserves they’re not lending at the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt), and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.
And that’s what we’re seeing. Banks are taking the money the Fed is printing and the government’s giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they’re likely to continue to do so since bank balance sheets are still deteriorating -- especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans compared to only 21% of single-family loans. Banks (in general) need to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we’ll see over 400 banks fail in this cycle.
One quick chart to further highlight the problem that banks are facing. I’ve been writing for several years that commercial real estate loans will be the next shoe to drop. Moody’s calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they’ll have to make. And my bet is they put those reserves they’re not lending into government debt.
http://image.minyanville.com/assets/FCK_May2009/Image/LisaCatch/mud4.jpg
Given that the current Congress is hell-bent on massively raising taxes in 2011, we’re likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It’s a vicious spiral.
The New Muddle-Through Economy
This isn’t a prescription for a return to normal growth. We’re headed for a New Normal that’s less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so, but it won’t be fun. It won’t be long-term 2% growth and employment going back to 6% any time soon. With a different attitude and leadership in Congress, maybe we can reverse the course. But it won’t happen next year, and it’s unlikely in 2011.
I’m afraid we’ll have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait: If my friend at PIMCO, Mohammed El-Erian, can tell us we’re going to a “New Normal,” then I can decide that we’re going to a “New Muddle-Through Economy” -- just not one as benign as I used to think.
In the end, that’s what we’ll do. We’ll figure out how to deal with the environment in which we find ourselves. That’s what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.
As an aside, I’m not expecting to see the crisis I’m thinking of any time soon. We can move along with positive GDP for some time. Instead, I’m thinking of the longer term – one to three years out. We’ll become complacent. I’ll get letters telling me I’m too pessimistic, just as I did in late 2006 when I said we’d be in a recession by late 2007. But I firmly believe we’ll see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.