Why This Economic Recovery is Destined for Disaster

A most revealing comment was made today by The Maestro, Alan Greenspan, speaking at a conference in Alberta on energy and the global economy:

We have been very fortunate that the stock markets moved back and are re-liquifying the whole process.

He pointed to the “wealth effect” created by a rising stock market, especially when investors cash in their capital gains.

In olden times, before Alan Greenspan spent over a decade as Federal Reserve Chairman, Fed officials worried about the growth in money supply, the level of prices in the economy, unemployment, and the strength of the dollar overseas. In fact, if you read the enabling legislation for the Fed, these are the things the Board of Governors should be concentrating on.

Greenspan of course is no longer the Chairman of the Federal Reserve – his protégé Ben Bernanke is. For the most part, when he was Chairman he never spoke about the stock market for fear of influencing its direction. Now that he is a private citizen, he can blurt out whatever he wants to say, and how illuminating it is to hear him talk about the stock market “re-liquifying” the economy.

Not for nothing was he given the sobriquet “Bubbles Greenspan” when he was in office. Economists, Fed watchers, traders, investors – all sorts of people suspected Greenspan never met a financial bubble he didn’t like. He cheered on the 1990s tech bubble as an example of a paradigm shift in the economy. He sat back idly while the housing bubble in this decade blew out of all proportions. The best he could say was that central bankers were helpless in the face of growing financial market distortions, and all they could do was clean up the mess afterwards.

The reality was that he encouraged these bubbles through deliberate inaction. After the end of the tech bubble he was terrified of deflation, pushed interest rates to 1%, and kept them there long enough for a housing bubble to ignite. He gave speeches encouraging home buyers to take out adjustable rate mortgages – the type that have blown up disastrously in the face of thousands of homeowners. He wanted the explosion in consumer spending that resulted from the housing bubble. He didn’t care if he caused asset inflation, as long as it didn’t seep into the general price levels of the economy.

Were he still at the Fed, he’d obviously be very pleased with the stock market recovery this year, because it makes people more confident, it gives them the illusion of being wealthier, and in some cases if they cash in their gains, it gives them real money to spend. Maybe he’d be happy with the weak dollar, and the fact that the infamous “carry trade” has moved from Japan to the U.S. Now the speculators of the world borrow dollars at 0%, driving the exchange rate down for the dollar, and they invest in the hottest commodities, like gold, Chinese real estate, oil, equity markets everywhere, high yield bonds, and even mortgage backed securities.

Does Ben Bernanke believe in the re-liquifying dreams of The Maestro? In the infamous words of Sarah Palin, “You Betcha!” Just look at his actions. He has pushed interest rates to zero and said they will stay there for a long, long time. He is knowingly encouraging the carry trade and devaluing the dollar. Neither the Fed nor the Treasury has lifted a finger to support the dollar on the exchange markets. He has thrown trillions of dollars at the banks and encouraged them to revive their speculative practices from a few years ago before the crash. He is trying desperately to get the securitization business up and running again, and he would love the hedge fund and leveraged buyout boys to get back into the equity extraction game.

Of course, he would also love to see more controls on leverage this time, smaller bonuses being paid to bankers, and less swagger emanating from Wall Street, but he’s not pressing too hard on these points. The important thing is to get the economy back to where it was before 2007. Nor is he alone in this desire; the G-20 countries this weekend said the same thing – it is way too early to remove the excessive liquidity that has been pumped into the global economy.

This stock market rally is therefore both welcome and engineered by our financial masters. So is the bubble in gold, the collapse of the dollar, and in Asia, the construction of even more high rises and industrial parks that are destined to remain empty.

Not a single lesson has been learned from the market collapse last year. Every effort is being made to avoid letting anyone suffer any pain for their mistakes. The great global reflation that is underway is nothing but a repeat of the bubble-inducing liquidity push that occurred at the start of this decade. The whole effort is a tremendous gamble – a hope that real and substantive economic activity will be ignited by all this speculative activity.

But remember what Greenspan said is the end result of the stock market rally – a “wealth effect” – spending on vacations, McMansions, luxury automobiles, and other goodies for the wealthy who happen to own an equity portfolio. You yourself won’t be getting a decent raise in your salary; it certainly didn’t happen during the last two bubbles. The cost of education or medical care isn’t going down. In short, the real economy is not going to rebound based on the most recent bubbles.

Inevitably these bubbles too must burst. Where will we be then? For one thing, there will be a lot of embarrassed economists, almost all of whom now are predicting a slow but steady recovery, because that’s what the Leading Economic Indicators say, along with the stock market, credit spreads, and all the usual auguries. Few people are willing to say “this time is different”, but it really is different. The old tools of the past don’t work anymore. We are not suffering through a typical recession caused by overinvestment, excess inventories, and so on. This is much rarer – a recession caused by the collapse of credit, by too much outstanding debt that must now be paid or defaulted on, by deflation, and by a government that won’t be there this time to lift us up.

Perhaps then our central bankers will learn that asset bubbles are just another form of inflation, one that benefits a few of the wealthiest in the world, and hardly anyone else. Unfortunately, when an asset bubble bursts, we all share the pain.

Numerian November 9, 2009 - 8:48pm

Numerian's diary | printer friendly version |

( categories: Agonist Exclusives | Economics | Global Financial Crisis | Opinion | The Markets )

I got lucky and learned about this when gold ...

... was still at $400. Sometimes this almost makes me have a bad conscience although I really tried to warn people.

quax November 10, 2009 - 12:45am

He gave a speech

"He gave speeches encouraging home buyers to take out adjustable rate mortgages ..."

He did indeed. Excellent post. Let me quote from that speech:

"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home." Understanding household debt obligations, Federal Reserve Board, Feb. 23, 2004 (2nd paragraph from end)

No wonder we're in the current mess. This wasn't Greenspans normal obtuse rhetoric. It's an injunction.

Michael Collins November 10, 2009 - 1:58am

I never understood why he gave this speech

There was supposedly some research the Fed did at the time that showed a fixed rate mortgage was more expensive in the long run than ARMs, but the only historical data they could use for such a comparison was the 1980s to 1990s when ARMs became popular, and when interest rates were falling due to the peace dividend.

On top of this, Greenspan was saying that investors were savvy enough to "manage their own interest rate risks", but they were certainly not savvy enough to understand the complex option components built into their ARMs. Pick a payment, teaser rates, and balloon mortgages (which at one time were outlawed due to the damage they did to S&Ls) were very expensive options under a variety of potential market conditions, but what consumer could model these possibilities and weigh the consequences?

The only thing consumers could do was refinance time and again as rates went lower, but then the banks were able to extract $5,000 in points each time from the equity that had been built up in the home. Some borrowers gave away $50,000 in fees to the bank, and didn't care because they themselves used multiple refinancings to take out $300,000 in "cash" from their home, some of which came from appreciation "earned" in the past year or so from the last refinance.

Now we discover that 25% of all homes in the US are underwater. People think that's because housing prices have declined, but it is also as much because trillions of dollars of equity has been extracted and spent from our housing stock in the past twenty years.

It is really hard to imagine that the Fed couldn't understand this process as it unfolded. It was all there in the quarterly Flow of Funds statement they published.

Numerian November 10, 2009 - 6:57am

You worry about money

Supply when 35 percent of it wasn't destroyed. I received the opposite from the missive. Immense reassurance. There were two things learned from this crisis. One average americans cannot on their own identify their own best financial interest. In that they will sign their life away on a mortgage they cannot pay and the believe god will provide. Two context matters. Your own model may work but there needs to be a mechnism for aggregating models and there is a tremendous Mount of work being done in this area.

Those lessons are moving fast through finance and coupled with reliquidation we are in for many quarters in a row with surprise to the upside. The efficiencies wrung out of the system have also been a surprise so this will be a jobless recovery. Thoug household income has stabilized and retail will not fall any more. The efficiency 'problem' is another matter.

Scotjen61 November 10, 2009 - 8:07am

Obviously

you're not one of the many jobless.

Nor am I, for the record, but I do look around once in a while.

If you haven't noticed, over 20% of Agonistas responding to the employment poll are unemployed, another group of over 20% describe themselves as underemployed.

What does recovery look like when you have no job and reach the end of unemployment benefits as better than a half a million Americans did last month?

I did inhale.

Don November 10, 2009 - 8:25am

I believe

we are talking macro economic issues in this discussion since it is about money supply. It is a little bit like here in the Midwest. We had a disastrous drought one year devastating the agricultural sector. When the economist was asked what the impact on the state would be, he said negligible because the ag sector is smaller than 2% of the states economy.

If you want me to say it is difficult to be unemployed. That is true. Better? But from an economists standpoint the important figure that is followed is not unemployment (a lagging indicator) but manufacturing numbers (way up in 13 of 14 measures currently) and median household income (stabilized and rising again). GDP was up better than expected, no inflation, productivity is going through the roof (very positive), inventories need to be rebuilt, export growth is off the charts, the transport sector is over 20% above the general market, merger activity is emerging again, and there is even the beginnings of IPO activity. House prices are rising again, inventory of housing is way down from its peak.

Think about it: The economy grew at 3.5% in the third quarter after being down 6.5% in the first - that is a 9 point swing in only two quarters. Amazing. Does anybody even begin to say good job? That is the best turn around recovery in Post WWII history.

Scotjen61 November 10, 2009 - 9:40am

Funny you should mention WWII

That was the last time the US economy was so dependent on Federal government spending. All those "off the charts" numbers you mention are ultimately dependent on off the chart government spending and deficit growth.

Productivity may be off the charts, but that is coming on the backs of the unemployed and those still left with jobs, who are forced to do the work of one or two of their departed colleagues. And they are not allowed any overtime to do it.

To keep this V shaped recovery going, we are going to need continued, if not increased, federal government spending. We will need renewed buying of our Treasuries by the Japanese and Chinese, because at the moment the federal deficit is being financed by US banks. That is where all their bailout money is going - right back to the government, not to small business or big business, and certainly not to the consumer. Fannie and Freddie and the FHA are the source of 90% of all mortgage financing this year. So who is buying their paper? Not the Chinese or Japanese or even the US banks - it's the Federal Reserve!

What sort of housing recovery is this when the only loans available are from the US government, whose debt is being financed by the US government because no one else will buy it? This is the type of distorted economy we are enjoying. It's phony, and it will only last as long as investors want to be delusional about what is happening.

Admittedly, given the powerful way the government and Wall Street and corporations can spin their numbers into green shoots and V shaped rebounds and earnings that beat estimates, there is an over-abundance of positive information out in the market that is reflected in the exuberance of the investors themselves. The information game is stacked against them, which is why they always react with panic when some reality creeps in.

Numerian November 10, 2009 - 10:54am

What value do banks add?

What sort of housing recovery is this when the only loans available are from the US government, whose debt is being financed by the US government because no one else will buy it?

So why mess with the banks? This seems a strong argument for banking being a government service, like a utility. If the banks are doing for the whole economy what they did for student loans, we're getting a very bad deal.

nihil obstet November 10, 2009 - 11:59am

Funny you should say that

The utility of home lending has been in Government hands a very long time. That's what Freddie and Fannie are. I am baffled by the notion that when the economy is in a dive that the Government coming in to smooth the decline is somehow a bad thing. Everyone complains about unemployment until Government action keeps it lower and then everyone is up in arms about that. All this stuff adds up to is no matter what its bad bad bad. Give me a break.

One year ago a house on my block went on market and sat for 150 days, a house on my block for sale this month and was sold in 10. I guess that's a bad thing somehow. Granted I live in an area that actually educates its people and provides healthcare to 96% of its population already, which I guess is bad because much of it comes out of the public sector.

All good news is bad news. I'll remember that when GDP is continuing to defy everyone's expectations.

The biggest change is manufacture. The low dollar, high cost of energy and rising wages in the 'low wage' nations is bringing manufacture back to the U.S. in a huge way. The most recent AMR survey of manufacturing executives had 21% planning to increase manufacturing activities in the United States over the next year, while another 21% expect to increase near-shore production. Only 7% were planning to go the other direction. It accounts for the 21% rise in export activity. This is a sea change shift and one that will be fed by the present administration.

A low dollar and high energy is the exact formula to bring manufacture home. This is a manufacture led recovery, and one that is encouraging innovation in new tech, new energy, and new transport systems. The energy I see in manufacture right now I have not seen since the mid 1990's.

Scotjen61 November 10, 2009 - 4:26pm

I hear what you say

And then I read this:

Greenscam.

I did inhale.

Don November 10, 2009 - 11:44am

Do you want to know if we have a stock market bubble?

Denninger provides some P/E data. Bear in mind that the traditional range for the S&P 500 has been a low P/E ratio of 6 at market bottoms, and around 25 at market tops. The average is about 15 over the past 80 or so years.

As of this third quarter's earnings, the S&P 500 P/E average over the 500 stocks is 138. Repeat: a P/E of 138 as calculated by Standard & Poor's itself, using reported third quarter earnings. At the peak of the NASDAQ bubble in 2000, their P/E was 44. And remember, throughout this earning period around 75% of all companies beat the analyst estimates for the quarter, and this was always the headline behind the earnings, not the actual P/E. Company X beat the earnings estimate! Buy! Buy! Buy!

The Wall Street Journal quibbles with the S&P methodology and therefore presents their own calculation, provided by Birinyi and Associates. This is a P/E of 70. Aren't you comforted now?

But wait, there's more! You may wonder why the market isn't selling off stocks like crazy, rather than buying up every little dip. The answer is the market doesn't hear about these P/E numbers. Corporations calculate their P/Es based on operating earnings, leaving out all the nasty stuff like charges for layoffs, plant closings, accounting errors, fraud, etc.

Also, the Wall Street analysts who work at investor friendly firms like Goldman Sachs, Chuck Schwab, etc. don't look at any of these numbers. They make up numbers for earnings one year from now. Based on these very optimistic projections of earnings, the analyst average P/E for the S&P 500 is 17. A year from now, given the fantastic growth in earnings we are sure to see from our recovering economy, the market's P/E will be just about near the long term average.

Maybe these analysts are right. That's the bet you are taking if you buy stocks at today's levels. You are betting on an amazing economic recovery, corporate earnings getting back to 2007 levels, and no surprises along the way. You have absolutely no room for error in this bet, because history is dead set against you if the current P/Es do not improve dramatically and quickly. Even if the P/E is 70, that is setting up the market for a crash, not a nice, orderly correction.

Numerian November 10, 2009 - 4:36pm

Not so sure about retail; wait and see

I work there, its going to be a disastrous holiday season if the last two weeks are an indication. The trend since mid-October is very much down. There was a burst of consumer activity during the first two weeks of October that gave stores hope. Everyone should be done with fall sales right now and should have holiday inventory on the floor. My observation is that inventories for many stores are low for this time of the year so I'm not sure where your confidence is coming from; retailer are just hoping to survive into the new year. Sales are normally ramping up now and are but not enough. No one is panicking yet. It is possible that weather is playing a role and we will see the activity in a week or two; wait and see. Watch what happens in the next two weeks; you will see big sales if this trend continues. BTW we sell across the country.

We need a NATION WIDE STRIKE for Real healthcare reform

Joaquin November 10, 2009 - 8:27am

ICSC is down this morning

Remember any YOY comparisons to last year is comparing now to a disaster. Sales 2-3% above last year's disaster is still a disaster. Redbook is up next this morning.

We need a NATION WIDE STRIKE for Real healthcare reform

Joaquin November 10, 2009 - 8:35am

Redbook YOY change of +1.7%

EOM

We need a NATION WIDE STRIKE for Real healthcare reform

Joaquin November 10, 2009 - 10:03am

I think

you're sorely mistaken about the retail climate. I, too, work in the retail sector, and the local chain I work for has been setting all-time records for gross sales...all time LOWS, that is. CE manufacturers are scrambling to try to spark new orders. Manufacturers reps are logging fewer sales than most can remember. Some of the deals that are coming across my desk are attractive, but without sales at the storefront, it would be madness to invest in inventory that will just gather dust in the warehouse. I, as most of my peers, are purchasing in a "just in time' fashion. In the past, this has not been a problem, but I foresee shortages in key demand items over the next few months. Manufacturers are not willing to hold inventory that has the potential to become stagnant.

_____________________________________________________
Distrust anyone who wants to teach you something.

OldLakeRat November 10, 2009 - 10:36am

Denninger

Does disaster loom from Dollar carry trade?

The U.S. currency dropped against 12 of its 16 major counterparts as the International Monetary Fund said traders are probably using the dollar to fund so-called carry trades around the world and it may still be overvalued.

I hope everyone here in The United States takes a moment to understand what this means. Let me lay it out for you:

When the global economy truly recovers oil will skyrocket up to or beyond the $150 where it was in late 2008. If the dollar is indeed still "overvalued" and going to 40 as many technicians predict, oil will likely reach $300 a barrel. This will in turn drive gasoline prices north of $6, heating oil will reach $7-8/gallon, and diesel will be commensurate with heating oil.

This will in turn decimate the trucking industry. Now you know why Buffett bought BNI. Many things he may be, but dumb isn't one of them. Trucks will of course remain for terminal-to-door deliveries but for long-haul they will simply be uneconomic. Those who currently are employed in this business will lose their jobs. All of them.

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Why This Economic Recovery is Destined for Disaster

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