The Oser View

Unemployment Continues to Increase

The Bureau of Labor Statistics reported this morning that the unemployment rate rose to 10.2% and the “true” unemployment rate, which includes discouraged workers and those who want full-time work but can only find part-time jobs, rose to 17.5%.  The number of unemployed persons now stands at 15.7 million, more than double the recent low of 7.67 million in April 2008.  Total non-farm payrolls fell by 195,000 in October.  

The details of the employment reports offer little comfort.  Manufacturing employment fell by 61,000.  The sector has lost jobs for 23 months in a row and in 38 out of the last 39 months.   Fully one-third of the 17.3 million manufacturing jobs that existed in the US at the beginning of this decade are now gone.  The situation in construction is as bad, if not worse.  In October, there were less than six million construction jobs, down from a peak of 7.7 million in January 2007.  There are almost 800,000 fewer today than at the turn of the century

Yesterday, the Labor Department announced that US labor productivity rose an astonishing 9.5% percent in the third quarter.  It was the biggest productivity jump since 2003, but it came on the back on workers, whose hours of work fell by 5% from the second quarter.  In fact, the year-over-year decline in hours worked of 7.5% was the largest since record-keeping began in 1948.  As in all recent recessions,  business has been forced to find ways to do more at less cost.  

There are, however, two bits of good news in the data.  First, job losses in September and August were revised downward by 91,000.  Second, the pace of losses is clearly slowing.  The three-month average of monthly job losses is down to 188,000 from 428,000 in the second quarter and 691,000 in the first quarter.  It’s likely that most businesses are now working with as limited staffing as they can.  But, the question of when we will finally see employment increase remains to be answered.

The Fed Does the Right Thing

The Federal Open Market Committee, the Fed’s policy arm, today voted without dissent to keep the fed funds target rate at 0.00% to 0.25%.  While “economic activity has continued to pick up” and “activity in the housing sector has increased,” the overall economy remains weak.  “Low rates of resource utilization (Fedspeak for “not enough people have jobs”), subdued inflation trends and stable inflation conditions” permit the Fed to encourage business and personal borrowing by keeping the rate target at “exceptionally low levels…for an extended period.” 

This is extremely good news, particularly as the vote was unanimous.  The worst thing the Fed could do in this environment is raise the cost of borrowing too soon.  That the economy is no longer in the ICU does not mean it has returned to health.

Sales of existing homes increased to an annualized rate of 5.57 million units in September, the highest level since July 2007.  The bottom was an annualized rate of 4.94 million units in January.  Much of the recent increase is attributed to a rush to take advantage of the $8,000 first-time-homebuyer tax credit.  Low 30-year mortgage rates, which have averaged 5.0% the last couple of months, also spurred sales.  

The median value of the homes sold in September was $175,000, which is about the average for the year. The table below shows the average median value for the last few years:

 

Year	Price
2002	$163,900
2003	$177,100
2004	$193,200
2005	$218,200
2006	$222,000
2007	$216,600
2008	$197,200

The supply of homes for sale—that is, the inventory of unsold product—also improved.  From highs in the range of 4.5 million units, the number of unsold homes dropped to 3.6 million.   A normal level is about 2.5 million units.  

The bottom line is that home sales and values have reached a level of stability, roughly equivalent to 2002.  We believe that it will be some time before they can move substantially higher given the November 30 expiration of the homebuyer credit, the  recent rise in the 10-year UST Treasury yield (against which mortgage rates are set), and the continuing high level of unemployment.   

The Fed's Dilemma

 

On November 21, 2002, Ben S. Bernanke, then a newly-appointed Governor of the Federal Reserve Board, gave a speech to the National Economists Club that made him famous.  “Deflation: Making Sure ‘It’ Doesn’t Happen Here” was a speculation on how the Fed would attack the “purely hypothetical” danger of a prolonged and widespread decline in prices.  It may seem counterintuitive that lower prices for most goods and services are a bad thing, but as Bernanke pointed out, “Deflation is in almost all cases a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”  In other words, deflation and economic recession—or worse—almost invariably go hand in hand. 

 

In those happy, innocent days, Bernanke could reassure his audience that deflation was improbable for two reasons.  The first was the strength of the US economy, and particularly, “the strength of our financial system…Our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.”  That, of course, was then. 

 

The second reason was the primary focus of Bernanke’s remarks.  He asserted that the Federal Reserve System was “the second bulwark against deflation in the United States.”  The Fed’s main tools for implementing monetary policy are setting a target interest rate for overnight borrowings between banks, called the fed funds rate, and then “enforcing that target by buying and selling securities in open capital markets.”  Lowering the rate effectively reduces the cost of borrowings of all sorts and thereby stimulates consumer spending, the primary driver of our economy.  But, there is an obvious, inescapable, and non-trivial difficulty: No matter what, interest rates cannot fall below 0%.  Economists call this fact the “zero bound.”  It’s kind of like the speed of light, an absolute limit.  Once a central bank reduces the overnight borrowing rate to zero, it has exhausted what Bernanke called “its traditional means of stimulating aggregate demand.”

 

Bernanke then enumerated a number of potential weapons the Fed could use against deflation when and if the zero bound was reached.  What made the speech so remarkable was that most of them had never been tried.  Even more remarkable is that most of them, in one form or another, were tried in 2007 and 2008.  As Bernanke suggested it might, the Fed has greatly expanded both the amount and variety of securities it buys in order to pump cash into the financial system.  Between June 27, 2007, and September 30, 2009, securities on the Fed’s balance sheet increased from $791 billion to $1.59 trillion. None of the growth was Treasury securities, which, until the crisis was all the Fed bought. Instead, the Fed bought debt obligations of Fannie Mae, Freddie Mac and other Government-Sponsored Enterprises (GSEs).  This spring the Fed announced that it would buy up to $1.25 trillion of mortgage-backed securities issued by the GSEs plus another $200 billion of direct GSE debt. Last month, it reiterated its intention to purchase the full amount by March 31, 2010.  

 

Another option Bernanke posited in 2002 would be to offer fixed-term loans to banks, secured by a wide range of financial assets.  During the financial crisis of 2007-08, the Fed did this, and more, offering loans not only to banks, but to money market funds, investment banks, and commercial paper issuers.  Federal Reserve loans outstanding ballooned from zero on June 27, 2007, to almost $1.5 trillion at the end of 2008, though it has since fallen back to $348 billion.  Cooperation with “fiscal authorities”—that is, the executive and legislative branches of government—was a third option.  Bernanke suggested broad-based tax cuts and greatly increased government spending, which the team of Bernanke, Henry Paulson, and Tim Geithner were foremost in promoting at the end of the Bush presidency. 

 

The one proposal Bernanke made that was not at all new was, ironically, the one that was not implemented.  “As suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.”  The phrase “as suggested by a number of studies” is essential in understanding Bernanke’s thinking.  As David Wessel notes in his outstanding recent book, In Fed We Trust, Ben Bernanke was still, in 2002, a life-long academic.  His specialty was the Great Depression.  Bernanke believed that a series of misguided monetary policy decisions by the Fed was a primary cause of the Depression in the first place and of its persistence through the 1930s. According to Wessel this belief, “dominated Bernanke’s thinking throughout the Great Panic.  He was determined that no future scholar would convict him of similar timidity or complacency in the face of a financial crisis.”[1] 

 

Bernanke’s determination to avoid blame was tempered by an equal determination, at least early in his chairmanship, to make his Fed more transparent and collegial than Alan Greenspan’s had been.  While laudable, the results were unfortunate.  Instead of acting “more preemptively and more aggressively” in the latter half of 2007, the Fed moved cautiously and, by early 2008, found itself seriously behind the needs of the financial markets and the economy for easier monetary policy.  Part of the reason is that it’s much easier to recognize a crisis retrospectively than prospectively.  But, the process was slowed by several Federal Reserve Bank Presidents, notably Richard Fisher of Dallas, Jeffrey Lacker of Richmond, and Charles Plosser of Philadelphia, who in speeches and Federal Open Market Committee (FOMC) meetings strongly opposed the initial easing of credit. Fisher, in particular, seemed slow on the uptake.  Wessel describes him as man of “little prescience” perpetually “fretting” about inflation.[2]  As a result, the Fed had to play catch up, finally bringing the target overnight lending rate to 0-0.25% in December 2008.  There it remains and is likely to do so “for an extended period” according to the latest FOMC statement.

 

But Fisher was not chastened; if anything, he has become a more hawkish inflation-fighter (now that no inflation exists to be fought).  On September 29, he told an audience at Texas Christian University:

 

As to the long-term dangers of inflation…I remain ever vigilant.  I have not hesitated in the past to vote against the majority of the FOMC when I felt they were being too accommodative, and I have been outspoken on the dangers of prolonged monetary stimulus in the future…I am not alone on this front.  I have faith my colleagues on the Federal Open Market Committee will stand and deliver in a timely way.  And I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that which we pursued monetary accommodation.

 

Them’s fightin’ words, and here’s why they’re scary.  The basic economy is not improving.  At best, we have flattened out to a lower level of economic activity.  As Fisher himself admitted in the same speech quoted above, “While housing is showing some signs of having reached a bottom, we need to recognize that the sector is still on life support.”  The employment picture is even gloomier.  The official 9.8% unemployment rate is at a 26-year peak, and the rate for adult men, at 10.3%, is the highest since records began in 1948.  The employment-to-population ratio fell to 58.8%, the lowest since women began to enter the workforce in large numbers.  In December 2007, the ratio was 62.7%.  The average time of unemployment is now a full six months and the median is 17 weeks.  The “real” unemployment rate, which includes people forced to work part time instead of full time and those too discouraged to even look for work, rose to 17%.  More than 26 million Americans are effectively out of work.  A senior Goldman Sachs economist recently predicted that all 8.3 million jobs created between 2003 and 2007 will probably be lost before the economy recovers.

 

So here’s the Fed’s dilemma.  If the economy remains weak for a prolonged period, as I expect it will, the Fed will have no choice but to maintain short-term interest rates at the zero bound.  And, since it has already tried all the novel remedies Ben Bernanke proposed in 2002, the Fed probably is out of ammunition.  But doing nothing for a long time is always an uncomfortable option.  It’s just not the American way.  The Fed will be pressured to do something, and that something most likely will be to raise interest rates to ward of future inflation.  Bernanke will be reminded relentlessly of what is now considered Alan Greenspan’s catastrophic mistake for keeping the fed funds rate too low for too long in 2003 and 2004.  Bernanke’s own recent statement that the recession is “probably” over could well come back to haunt him.

 

The first criticisms of accommodative monetary policy may come as early as October 28.  That’s when the initial estimate of third quarter Gross Domestic Product—the total output of goods and services produced by labor and property located in the United States—will be released.  After falling for four consecutive quarters and five out of the last six, an increase is virtually certain.  But the first stage of any recovery is fragile and no matter how much the economy grows in the next few quarters, it will take years to make up what has been lost.  No one can understand this better than Ben Bernanke, the student of the Great Depression.

 

The Federal Reserve, though differently constituted at the time, actually tightened credit by raising its discount rate—that is, the rate at which it lent directly to banks—twice in October 1931.  It didn’t begin easing credit conditions until early 1932, but tightened again in March 1933.  That tightening move was followed a month later by the start of an easing cycle that finally, in February 1934, brought the discount rate back to 1.50%, just where it had been in May 1931.  The whole schizophrenic process was pointless and destructive.  And here’s what nobody knew while the Fed was dithering.  In 1933, after three years of double-digit declines, US GDP fell just 3.9%.  It rose 17% in 1934, 11.1% in 1935, 14.3% in 1936, and 9.7% in 1937.  Nobody knew it because GDP metrics were not compiled until after World War II.  If the Fed had had GDP statistics in the 1930s, it wouldn’t have tightened credit in 1931, but it might well have in 1933.  After another year or two of growth it almost certainly would have.  This is the risk we face, that the Fed will be under increasingly intense pressure to restrict credit too soon.  Premature tightening is a classic recipe for plunging a recovering economy back into recession.  Sure, the economy had started growing again in the mid-1930s…but it was still the Great Depression.   

---

[1] David Wessel, In Fed We Trust (New York: Crown Business, 2009), 41.

[2] See pages 134, 146, and especially 258.

He’s in the Jailhouse Now

“Mr. Madoff’s crimes were extraordinarily evil…   The breach of trust here was massive.” --US District Judge Denny Chin on sentencing Bernard Madoff to 150 years in prison. 
How did Bernie Madoff do it?  How did he perpetuate a God-only-knows how many billion dollar Ponzi scheme for two decades?  Most of the media focus has been on how he deluded investors, but he also slipped past three examinations and two investigations conducted by the Securities and Exchange Commission (SEC).  This month the SEC’s Inspector General (IG) issued its report on the botched handling of the Madoff affair. 

The SEC is a federal agency created in the aftermath of the 1929 stock market crash to enforce America’s first comprehensive regulations of securities.  Up through the Roaring Twenties, the financial markets were self-regulated.  Companies issued financial statements when and if they felt like it; smart operators were continually plotting to corner one market or another; and insider trading was taken for granted.  The SEC’s mandate was to stop all that.  To make sure that it did, President Franklin Roosevelt appointed Joseph P. Kennedy as the SEC’s first chairman.  Kennedy, the father of John, Bobby, and Ted, had been a none-too-scrupulous Wall Street operator himself.  Roosevelt was widely criticized for the appointment, but his reasoning was solid. “It takes a thief to catch a thief.”  It’s too bad there were no Joe Kennedy’s at the SEC when it looked at Madoff’s companies.  Instead, as the IG report concludes, “The SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December of 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.”

The IG’s report exonerates SEC personnel from “any financial or other inappropriate connection” with Madoff or his interests.  It also clears senior SEC officials from interference or direct attempts to influence the staff’s investigations.  The IG report details the many errors of commission and omission that allowed Madoff to escape discovery for so long, but it draws no conclusions as to how or why such a systematic pattern of error originated and persisted. The reader is left with the impression that the SEC is simply incompetent; a collection of Inspector Clouseaus whose buffoonery would be a good joke if it hadn’t cost so many people so much money.  This is a highly unsatisfying conclusion, calling in to question as it does the entire regulatory apparatus of the US securities markets.  The performance of the Madoff investigators and examiners certainly was incompetent, but, I would argue, their failure can be traced to two reasons that are deeply embedded in human nature.

The first reason has to do with Madoff’s purported investment strategy.  I am going to explain the strategy in the next few paragraphs.  I have simplified it somewhat by using a single stock and options on that stock, while Madoff claimed to use a basket of 30-35 stocks and options on stock indices.  The principles are the same, and besides, Madoff never actually executed the trades, so a little license in describing them won’t matter much.

On a given day, Bernie buys 100 shares of Coca Cola stock at $50 a share.  Simultaneously Bernie sells a “call” option to another investor, whom we will call Bob.  Bob’s option gives him the right but not the obligation to buy (or call away) Bernie’s 100 shares of Coke stock at specified price on some specified future date.  Bob pays Bernie a fee, called a “premium” up-front, and Bernie gets to keep it, no matter whether Bob exercises his option to buy the stock or not.  Let’s suppose that Bob’s option gives him the right to buy Bernie’s stock in three months at $60 a share, which is called the “strike price.”  Bob hopes that Coca Cola stock will be trading above $60 in three months.  If it is, Bob will exercise his option.  He will buy Coke at $60, sell it at the market price, and pocket the difference.  If Coke is trading below $60, Bob will let his option expire and simply be out the premium. 

Bernie now has three ways to make money.  He has received Bob’s premium; he will get any dividends declared by Coca Cola while he owns the stock; and the price of the stock can rise.  But, stock prices can fall as well as rise.  Bernie protects himself by buying a “put” option from a different investor, whom we will call Alice.  The put option gives Bernie the right but not the obligation to sell (or put to) Alice 100 shares of Coca Cola at $50 a share three months from now.  If, at that time, Coke’s stock price is under $50, Bernie will exercise his option and recoup his investment, minus the up-front premium he paid Alice.  If Coke is trading above $50, Bernie will let his option expire and simply be out the premium. 

The difference between the current price of Coca Cola, $50, and the strike price of Bob’s call option, $60, is large.  Such a big price movement in only three months is unlikely, and therefore, the option is “out of the money.”  As a result, the premium Bob pays is low, in the same way a life insurance premium for a healthy 21-year old is low. But, the put option Bernie buys from Alice is “at the money.”  The probability that Coca Cola stock will be trading near its current price of $50 in three months is high.  In consequence, the premium Bernie pays Alice is higher than the premium Bob pays Bernie for the call option.  Bernie is underwater the day he initiates his trades.  He has to significantly and consistently outperform the market to succeed. 

Bernie Madoff did claim that success. Over a period of more than 15 years, he reported an average annual return of 12%, with only seven losing months and no monthly loss greater than 0.55%.  The years Madoff claimed to be earning 12% included 2000, 2001, and 2002, when the S&P 500 stock index lost 9.13%, 11.8%, and 22.1% respectively. 

I hope the explanation of Madoff’s trading strategy is clear and easy to follow because—and here is the heart of the first reason for Madoff’s successful deception—it can be made extremely complicated and confusing.  My version of the price relationship between at-the-money and out-of-the-money options is accurate, but the mathematics behind the specific pricing and, especially, the forecasting of option values is frighteningly difficult.  A financial professional named Harry Markopolos made three separate complaints to the SEC, in May 2000, March 2001, and October 2005. In the last one, titled “The World’s Largest Hedge Fund is a Fraud” (and footnoted in the preceding paragraph), he writes, “Very few people in the world have the mathematical background needed to manage these types of products but I am one of them.” 

I am making a conjecture, but I believe something very like it must have happened repeatedly.  The IG report stresses that most of the people who investigated Madoff were young, inexperienced lawyers.  But, they worked for the SEC and so they were supposed to understand how the various securities markets work.  When Madoff “explained” his methods, quickly dropping into the jargon of “split-strike conversions” and “Black Scholes models,” I can imagine the SEC lawyers nodding their heads, each one too embarrassed to admit bewilderment, and each one assuming that all the others understood Madoff perfectly.  How human, and how comprehensible a weakness, especially when connected to the second reason: Who Madoff was perceived to be.

Bernie Madoff, in his glory days, was a really big deal.  He was one of the key developers of the NASDAQ stock market and had been chairman of its board and a Governor of the National Association of Securities Dealers.  He was a founding member of the International Securities Clearing Corporation in London.  His legitimate broker-dealer, ECN, was highly respected and, in fact, has not been implicated in the scandal.  And Madoff knew how to throw his weight around.  Here is an excerpt from the IG’s report:

“The other [SEC] examiner noted that ‘all throughout the examination, Bernard Madoff would drop the names of high-up people in the SEC.’  Madoff told them that Christopher Cox was going to be the next Chairman of the SEC a few weeks prior to Cox being officially named.  He also told them that Madoff himself ‘was on the shortlist’ to be the next Chairman of the SEC.  When the examiners would seek documents Madoff did not wish to provide, Madoff would become very angry, with an examiner recalling that Madoff’s ‘veins were popping out of his neck’ and he was repeatedly saying, ‘What are you looking for?...and his voice level got increasingly loud.’”

Junior examiners were told by higher-ups that Madoff “was a very well-connected, powerful, person.”  And, “when the examiners reported they had caught Madoff in lies, the Assistant Director minimized their concerns, stating ‘it could just be a matter of semantics.’” 

Bernie Madoff intimidated the SEC through bluster and rants, but most of all by the strength of his reputation as, in the words of an SEC branch chief, “the sort of people who are seen as reputable members of society.”  The intimidation factor went beyond posing.  Anyone managing tens of billions of dollars has true power.  In his 2005 report, Markopolos begged the SEC to keep his identity secret.  “I am worried about the personal safety of myself and my family.”  Certainly an SEC employee who got on Madoff’s bad side would have reason to fear for his or her career at least. 

Embarrassment at perceived ignorance and intimidation by power are strong dampers on human action and initiative.  I suspect that they were strong enough to stymie three SEC examinations and two investigations. 

The really astonishing part, though, is how easy it would have been to trip Madoff up.  If Madoff were really making the trades he claimed, there would have been independent third-party records confirming them.  The records would have been readily available to the SEC.  Time and again, the examiners failed to ask for them “‘because it can be tremendously voluminous and difficult to deal with’ and ‘takes a ton of time’ to review.”   But SEC examiners didn’t need “voluminous” records; they only needed the records of a day or two.  That’s all the IG asked for, and the records “immediately revealed” Madoff’s fraud.  The records would have “immediately revealed” the fraud to you or me too.  Imagine that you were being audited. The auditor asks to see the register where you keep a record of the checks you write, but never request your bank statement.  That’s all the SEC had to do, ask for the equivalent of Madoff’s bank statements. They never did.    

 

Call me Goofy

Call me goofy, but I am not ready to join the “recession is over” parade just yet.  While the economy has hit bottom, it is likely to stay bouncing along that bottom for many months at least.  A rapid and sustained recovery beginning this fall is an improbable scenario.

 

In a spirit of fairness, we will begin by looking at the four main arguments supporting a near-term end to the recession.  The first, and strongest, is the healing of the financial markets.  The Standard & Poor’s stock index is up 12% for the year and 40% from its March lows.  The flow of credit between banks has returned to normal as evidenced by the cost of borrowing.  The yield spread between three-month LIBOR, which represents the costs of funds for large banks, and three-month Treasury bill yields has fallen from an astronomical 4.6% in October 2008 to 0.29% last week.  Yield spreads between Treasury bonds and bonds issued by corporations and smaller governmental units have narrowed, making it cheaper for these entities to borrow.  While there are still exceptions—it’s still next to impossible to securitize mortgages without a government guarantee—the financial markets are back to business as usual.

 

The second argument is that the $787 billion of stimulus to be provided by the economic recovery act has barely begun to flow.  As more projects come on stream, the stimulus package will provide a substantial boost to growth.  The stimulus, though, is just that, “something that incites to action or exertion or quickens action.”  The question, that only time will answer, is whether stimulus-induced growth will be sustainable, or simply limited to projects whose jobs evaporate when they are completed.

 

The third argument, put forth cogently by FTN Financial Chief Economist, Chris Low, is that the traditional leader of economic growth—inventory rebuilding—will come to the rescue again.  Inventory fluctuations were once a primary lever of economic decline and recovery.  In the past, suppliers, caught by surprise, often needed many months to work off excess inventory when bad times hit.  Then, equally surprised, they had to rebuild inventories quickly when good times started to return.  The process tended to lengthen recessions with longer layoffs, but quicken recoveries with faster re-hiring.  “Just-in-time” inventory management, imported from

Japan

in the 1980s, changed all that, and inventory levels played a minimal role in the mild recessions of 1991 and 2001.  But, as Low points out, the current recession hit so hard and so fast that businesses had no time to manage inventories; they simply stopped making things.  The corollary is that when the economy begins to rebound, inventory rebuilding will also have to be faster and more robust, and, in Low’s words, “slingshot growth.”

 

The fourth argument is in the interpretation of the data.  Several recent government and private sector reports have been widely cited as evidence of an economic rebound. 

 

·        Housing starts in June rose by the largest percentage since 2004. 

 

·        New home sales increased 11%, the most since 2000. 

 

·        Pending sales of existing homes have risen nearly 20% from their January low. 

 

The story on the employment front is similar. 

 

·        Initial weekly applications for unemployment insurance have been below 600,000 for the last five weeks, after having been above that level since the last week of January. 

 

·        Most importantly, job losses in July were the smallest since August 2008. 

 

Government agencies and private groups pour out an endless stream of economic reports every working day. In each report, one number or percentage, the so-called “headline” number, stands out and seems to tell the whole story.  But underneath it are mounds of detailed information that tell a more nuanced tale. Often, their interpretation is not merely a result of honest differences of opinion but of political, ideological, and financial motives.  Also, the numbers themselves are far from reliable.  They are seasonally adjusted, based on incomplete samples, and subject to frequent revisions.  Finally, there’s the question of which data provide insights into the future and which merely offer a look in the rearview mirror. 

 

With all these caveats in mind, let’s take another look at the data noted above. 

 

·        Housing starts rose 3.6% in July, but, at an annualized rate of 583,000 units, they are barely a third of the average for the last 10 years and a quarter of the boom period, 2004-2005. 

 

·        Pending sales of existing homes have also risen, but they remain down more than 13% from the pre-recession average. 

 

·        The four-week average of initial unemployment claims has fallen to 555,000, from a recent high of 659,000, but that’s still terrible by any but the most recent standards.  From the end of the last major recession in the early 1980s to the beginning of the current recession, the four-week average of initial claims averaged 354,000 and never hit 500,000, except for one week at the peak of the 1991 recession.  

 

·        Job losses in July showed major improvement at “only” 247,000 compared to 741,000 in January.  But the worst month for job losses in the 2001 recession was October with 325,000, and there were only two other months when losses exceeded 200,000.  The worst month in the 1991 recession was February with 306,000 jobs lost, but again job losses exceeded 200,000 in only two other months. 

 

To the extent this data is reassuring, other data is less so.  As is well known, our economy runs on consumer spending, which accounts for 70% of Gross Domestic Product.  And the consumer is still not spending.  The Commerce Department reported recently that retail sales were down 9% between June 2008 and June 2009.  On an annualized basis, that’s a difference of about $405 billion.  Spending was down in almost all categories:

 

·        Furniture & home furnishings:          -12.6%

·        Electronics & appliances:                -11.5%

·        Building materials:               -13.0%

·        Clothing:                                         - 6.2%

·        Department stores:              - 9.4%

·        Non-store retailers:             - 6.7%

 

Consumer spending is off because consumer income is off.  Wages and salaries paid to US workers in June were $6.24 trillion on an annualized basis.  They have dropped every month since peaking at $6.58 trillion in August 2008.  Had wages and salaries continued to increase at their pre-recession pace, they would have been about $6.69 trillion in June.  That difference of $450 billion pretty much accounts for the drop in spending.

 

There is another dynamic at work too.  Americans are paying down debt and saving at record rates.  According to Goldman Sachs (and who could question them?) consumer and non-financial company debt fell 0.7% in the first quarter this year, marking the first contraction since 1952.  The Federal Reserve reported that total consumer debt excluding debt secured by real estate, after rising steadily for decades, has fallen $80 billion since peaking in July 2008.  We still owe more than $2.5 trillion, about where we were in October 2007.  As the chart below indicates, we would have to cut another $550 billion more to turn the clock back just five years.

 

 

 

Personal savings has spiked recently as well.  The Commerce Department reported that Americans socked more than $500 billion away in June and $680 billion in May.  Since May 2008, we have been saving about 4% of our disposable income a month, double what we saved in the boom years.

 

The increase in savings leads to a key question: Will we go back to our old free-spending ways when the recession finally does end or is our newfound frugality permanent?   Retail sales increased every quarter for seventeen years before the recession struck.  “Never bet against the American consumer” was economic dogma.  But things are different now.  Americans have been scared into saving and two powerful forces—one demographic and the other economic—could keep that trend in place for a long time.

 

The demographic trend is the aging of the Baby Boomer generation.  The older people get and begin to contemplate imminent retirement, the more prone they are to save, regardless of economic conditions.  A recession can only reinforce this tendency.  The economic trend is deflation, or at least the lack of inflation.  The most serious previous recession since the 1930s occurred at the beginning of the 1980s.  That recession, unlike today’s, was accompanied by double-digit inflation.  Inflation discourages saving because it erodes the value of money.  Who wants to put $1,000 in a CD if two years later its buying power has been reduced 30%?  When the value of money is rising or stable as it is now, savers have a powerful incentive even if interest rates are low.  Having been burned by the precipitous fall in stock prices and the even more catastrophic destruction of home equity, simply maintaining the cash you have is appealing. 

 

I hope I am wrong.  I hope the recession really is ending and recovery is beginning.  If so, dear readers, you will have every right and my cordial permission to call me Mr Goofy from now on. 

 

Economic bulletin

The Census Bureau reported this morning that monthly sales for retail and food services increased 0.6% in June following a 0.5% increase in May.  Hooray!  Well, not so much.  The increases were entirely due to rising gas prices (up 5% in both May and June) and to a bump in automobile sales (up 2.6%) as buyers snapped up bargains. 

In dollar terms, retail sales in June were $342.1 billion, sort of.  The number is adjusted for “seasonal variations and holiday and trading-day differences” to make month-to-month comparisons more meaningful.  (We actually spent $350.7 million in June.)  But, the number is not adjusted for price changes.  This means that stable or outright falling sales are weaker than they appear, since a modest amount of inflation is the normal condition of our economy. 

The chart below shows monthly retail sales in billions of dollars going back four years.

As you can see, spending is back to the level of summer 2005.  We are now spending $35-40 billion less each month than two years ago.  The economy is improving, but it’s a slow process with many a mile to go.

My Crisis Gone By, I Miss It So

 

Yes, the financial crisis is over.  The big banks have been saved, and Treasury Department staffers no longer keep cots in their offices.  How I miss those days when the action was in boardrooms 60 stories up instead of homes and workplaces all over America!You have perhaps read or heard that the recession is abating or that recovery can be looked for later this year.  In a technical sense this may be true.  The following table shows actual and projected annualized percentage changes in Gross Domestic Product:

Period	Percentage Change
3rd Quarter 2008 – actual	-0.5%
4th Quarter 2008 – actual	-6.3%
1st Quarter 2009 – actual 2nd Quarter 2009 – projected	-5.5% -1.8%
3rd Quarter 2009 – projected	+1.0%
4th Quarter 2009 – projected	+1.9%
1st Quarter 2010 – projected	+2.2%

What does this actually mean?  GDP is the total income of every entity in an economy or the total expenditure on goods and services of every entity in an economy, depending on how you want to look at it.  Either way it’s a measure of total dollars earned or spent.  Here is the same table as above, but this time including the total dollar amounts, actual and projected:

Period	Percentage Change	GDP in billions
3rd Quarter 2008 – actual	-0.5%	$11,712.4
4th Quarter 2008 – actual	-6.3%	$11,522.1
1st Quarter 2009 – actual 2nd Quarter 2009 – projected	-5.5% -1.8%	$11,360.5 $11,309.4
3rd Quarter 2009 – projected	+1.0%	$11,337.7
4th Quarter 2009 – projected	+1.9%	$11,391.5
1st Quarter 2010 – projected	+2.2%	$11,454.2

As you can easily see, the bottom number in the third column is lower than the top number despite nine months of growth. In fact, if GDP actually reaches $11.45 trillion in next year’s first quarter, it will be almost exactly where it was in the first half of 2007.  And, assuming a fairly conservative “normal” growth rate of 2.5% a year, GDP would be running at an annualized rate of $12.2 trillion by the first quarter of 2010 had there been no recession. 

If the lost GDP were divided equally among the entire labor force of the United States, this loss of roughly $750 billion means that each working adult will earn or spend $4,800 less a year than he or she otherwise might have.  Of course, the lost GDP is not divided equally, and here is where the long-term consequences of our current economic problems are most ominous.  The growing income disparity among Americans was a hot topic earlier this decade.  The recession has certainly taken a slice off many previously high earners, but the impact has been greater on those at the bottom of pile.

About a third of the civilian labor force has, at most, a high school diploma.  Over the last 12 months, however, 46% of increased unemployment was in this category.  And the jobs low-skilled workers can qualify for are evaporating quickly.  The chart below shows the change in the percentage of jobs classified as production work at durable goods manufacturers over the last 60 years:

These are the “guys on the line,” the people who make, or used to make, the heavy equipment, machinery, and appliances built to last.  In 1953, they represented more than 12% of the work force; today, they are barely 3% and falling fast.  When Senator McCain told unemployed plant workers in Ohio their jobs weren’t coming back, that was straight talk for sure.  What was once the high road to the middle class has become a dead end.  In June, just 623,000 people—a mere half a percent of all those employed outside of government—were motor vehicle and parts production workers.  And that number was down from 909,000 a year earlier.

It’s a bit difficult sifting through the mounds of highly detailed Bureau of Labor Statistics data to reach meaningful generalizations, but the average hourly wage last year for production workers doing jobs like drilling, grinding, boring, extruding and punching was somewhere in the high teens.  This is a bit less than double what people make in occupations like food preparers and servers, building and grounds cleaning, and personal care and service occupations.  Workers without training or sufficient skills, which includes a large percentage of those with no more than a high school education, who lose production jobs have little alternative but to compete for personal service jobs that pay half of what they previously earned.  They, their families, and communities will bear the full brunt of the recession, and many will never approach their former earnings for the rest of their working lives. 

That a large number of such workers are African-American is clearly documented by Bureau of Labor Statistics data on median weekly incomes for the first quarter of 2009.

	Median Income	Pct of Median	Pct of White Men
All Workers	$738	-----	-----
Whites – All	$758	102.9%	-----
Whites – Men	$855	115.9%	-----
Whites – Women	$666	90.2%	77.9%
Blacks – All	$577	78.2%	67.5%
Blacks – Men	$595	80.6%	69.6%
Blacks – Women	$559	75.7%	65.4%

It’s a measure of how far we still have to go as a society that such data must still be reported along racial lines.  Urban African-American communities in the North today are no longer growing.  The old pipeline of migrants from the rural south in search of manufacturing jobs dried up long ago.  Affluent African-Americans can and do live wherever they choose.  But, non-African-Americans have shown no inclination to move to predominantly African-American neighborhoods.  Thus, fewer internal resources can be brought to bear when earnings decline.  Another concern is the lack of outside resources.  In the recent past, big banks brought financial services into low-income urban neighborhoods largely to meet their Community Reinvestment Act obligations.  They needed a good CRA rating to get regulatory approval to expand their branch networks and acquire other banks.  In the next few years at least, they will have far less incentive to lend in poorer communities.  Their focus will remain on building capital levels and what are called “fortress” balance sheets. 

We at ShoreBank are seeing a significant portion of the economic progress of the last 30 years being eroded in the neighborhoods we serve, now being disfigured by a growing number of boarded-up homes and businesses.  At some point, when the economy finally begins to improve, we and our neighborhoods will start rebuilding.  I am troubled that there may be fewer resources both from inside and from outside the neighborhoods with which to address this task.  A second revitalization may be even more difficult than the first.      

The Middle Way

The markets were jittery all morning, waiting for the announcement following the close of a two-day meeting of the Federal Open Market Committee (FOMC), the Fed’s policy arm.  Usually such anxiety is stirred by the prospect of a change in the fed funds rate, but this time everyone knew the target would stay at 0.00% to 0.25%.  Instead, the focus was on how the Fed would react to an economy no longer in free fall. 

The first paragraph of the FOMC statement, when it finally came, was a balanced capsule summary of present conditions.  The “pace of economic contraction is slowing,” consumer spending is “stabilizing,” and businesses are aligning inventories with sales.  Weighing against these gains are “ongoing job losses,” “tight credit,” and cutbacks in business spending on fixed assets.  In short, the economy remains very fragile and downside risks abound, but a bottom has been reached.  The FOMC’s conclusion is that under these conditions “inflation will remain subdued for some time.”  Fed officials are no longer worried about deflation, even though the Consumer Price Index has fallen 1.3% in the last year.  But they remain convinced that further monetary stimulus is necessary and that their policies “will contribute to a gradual resumption of sustained economic growth.” That’s why the fed funds target will stay near zero, and the Fed will continue its program of buying $1.25 trillion of Treasury and Agency securities.

The markets have not reacted well to the FOMC announcement because no one got quite what they wanted.  Inflation hawks wanted some indication of when fed funds rates would rise.  Those worried about the recession continuing were hoping the Fed would commit even more than $1.25 trillion of liquidity.  In the end, the Fed went down the middle and both stocks and bonds fell.

Of Spirits, both Animal and Human

  Many long-time readers have met my wife Patsy.  She is woman of strong character, great generosity, and an impeccable moral sense, but Economics is not her forte. Patsy recently accompanied me to a conference hosted by the Federal Reserve Bank of Atlanta and held on one of the Georgia Sea Islands.  One morning over breakfast, I outlined the classical theory that economic decision-making is entirely rational.  Patsy burst out laughing.

Patsy’s spontaneous reaction was spot on.  There is very little that’s rational about economic decision-making, or any other kind of decision-making for that matter.  In his new book, Human: The Science Behind What Makes Us Unique, cognitive neuroscientist Michael S. Gazzaniga describes patients with injuries to a part of the brain that rendered them unemotional.  One patient, for instance, “tested normally in intellectual ability, social sensitivity, and moral sense, and could devise appropriate solutions and foresee consequences to hypothetical problems, but he could never make a decision.”  Gazzaniga’s conclusion from this study and much additional research is that “pure reason was not enough to make a decision.  Reason made the list of options, but emotion made the choice….Even though we humans like to think of ourselves as being able to make non-emotional decisions, emotions play a part in all decisions.” (pp. 72-73)

Like Patsy and Dr Gazzaniga, we all know this.  We know that even our most basic economic decisions about food, shelter and clothing—the things we need to stay alive—are heavily influenced by non-rational forces. Otherwise, who would ever wear high heels?  Decisions about finance and business are no different.  “Jack Welch’s phrase ‘straight from the gut’ sums it up: decisions that matter for investment are intuitive rather than analytical.” (p.144)

The authors of this assertion are George A. Akerlof and Robert J. Shiller.  Akerlof is a Professor of Economics at the University of California, Berkeley.  He won the Nobel Prize for Economics in 2001 and is married to Janet Yellen, the former President of the Federal Reserve Bank of San Francisco. Shiller is Professor of Economics at Yale and co-creator of the influential Case-Shiller Home Price Index.  Earlier this year they published Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.  The book’s premise is that the current economic crisis “was caused precisely by our changing confidence, temptations, envy, resentment, and illusions—and especially by changing stories about the economy.” (p. 4)  The authors call these emotional forces “animal spirits” following John Maynard Keynes, the famous British economist who coined the term in the 1930s.  Keynes believed that animal spirits, or “the spontaneous urge to action,” are the essential motivation behind business decisions.  But while Keynes’s economic prescriptions form the heart of the global financial rescue plan, and his description of how capitalist economies function is more or less gospel, his conclusions about how decisions are made have been largely discarded.

Although purportedly written for a general audience, Shiller and Akerlof are not really focused on lay readers.  Their true target is academic economists.  The book is filled with what can only be called blatant rebukes to the profession.  Here is just a sampling:

“Natural rate theory (the idea that there is a sustainable level of unemployment that keeps inflation in check) is now economists’ conventional wisdom.  It is accepted by the vast majority of economists—but we do not believe it to be true.  And it has also been the justification for economic policy of great foolishness.”  (p 107)

“Over the years economists have tried to give a convincing explanation for aggregate stock price movements in terms of economic fundamentals.  But no one has ever succeeded.” (p.131)

“The theories economists typically put forth about how the economy works are too simplistic.”  (p.146)

“The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory.” (p.167)

I could go on, but you get the point. 

So why do academic economists refuse to take animal sprits into account?  Why do “they fail to consider the most important dynamics underlying economic crises”? (p. 167) Shiller and Akerlof get part of the answer to these questions, but they too are part of the academy and they cannot or will not follow their conclusions to the source. 

The part they get is that economists have insisted on a theory based on rational behavior because it can be quantified and modeled.  “In their (that is, economists’) attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structures and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational.” (p. 168)   Dear reader, I will make you a deal.  I know there are a lot of quotations in this commentary, but I promise not to include any more if you re-read this one slowly and carefully.

Good. Now, what Shiller and Akerlof don’t get is why economists wanted to “clean up macroeconomics and make it “more scientific.”  For the answer we have to go back to 1957.  In that year, the Soviet Union successfully launched Sputnik, the first artificial satellite.  It was the height of the Cold War, and America was stunned.  The Federal Government responded in the best American tradition: It threw massive amounts of money at universities for mathematical and scientific research so that we would not lose the Space Race.  Suddenly, brand new physics and chemistry buildings sprang up on campuses across the country.  Professors got grants for all the equipment and graduate students they wanted. The liberal arts had to make do with the dowdy old buildings the scientists abandoned.   The message was obvious.  Science equals money, power, and prestige.  Economists realized that if their field became a science, a Social Science, they could cash in too. 

There were two problems with this change of direction.  Since the discovery of relativity and quantum mechanics in the first quarter of the 20th century, the advances in the hard sciences have required increasingly more difficult and abstruse mathematics.  The math has made it all but impossible for non-scientists to follow new developments, which is why so many books and articles on physics and biology for laymen are published every year.  Scientists want their discoveries understood by the widest possible audience.  Altruism and a desire for recognition undoubtedly play a role in this spate of publications, but scientists know that without public support, their funding could be threatened.  An informed public is clearly in their interest.  Economists faced exactly the opposite situation.  The father of economics, Adam Smith, did not include any calculations or statistics in his 1776 masterpiece, The Wealth of Nations.  Things didn’t change much in the next two hundred years.  Economics was a qualitative discipline that required no special mathematical knowledge.  It was more or less accessible to any reasonably well educated person.  To become a “real” science, Economics (with a capital E) had to become less accessible and more quantitative.

That led to the second problem.  At some level, economists knew just as well as everyone else that economic decisions aren’t rational.  But you can’t be a scientist unless you can make mathematical models, and irrationality is extremely hard to model.  So economists made models using assumptions of rational behavior in hopes that they would be close enough to reality to be useful. 

But they aren’t.  Economists have been no better at predicting the economic future than anyone else.  Oh sure, a few predicted the 1987 stock market crash, and a few predicted the long boom of the 1990s, and a few predicted the dot-com bubble, and a few predicted the spectacular rise in home values, and a few predicted the housing debacle that followed.  But nobody predicted all or even most of it.  And economists aren’t even very good about predicting the past; the causes of the Great Depression remain a subject of debate. 

It may seem that I am specifically attacking the economics profession for short-sightedness, greed, or vanity.  Not really.  I have singled out economists only as an example.  The heart of the matter is categorization.  The 20th Century was all about putting things into categories, creating specialties, and making experts.  Economics, considered as specific academic discipline is as artificial as Sputnik, and so are chemistry, Russian literature, and playing the clarinet.  Perhaps no one person can be proficient enough to earn PhDs in all these fields, but that simply speaks to our limitations as human beings.  The fields themselves are all parts of the human and universal condition.  They are not inherently discrete, and many people have a good understanding of and keen interest in them all and more besides.  Twenty-first Century communications, globalization, and the interactive Internet community are rapidly breaking down the barriers between disciplines that were so painstakingly erected in the previous century.  In this century “doing the math” will only be a part, and small part of understanding economics.  A full understanding will require “doing” and blending the cognitive science, the psychology, the sociology, the history, the linguistics and maybe even clarinet playing.  Welcome to the Fun House.