Thursday, July 30, 2015

The $3 trillion cost of bad policies

This post is practically a repeat of my post in April 2014, "Taking the measure of our discontent," except that I've updated the charts and the numbers and adjusted the commentary somewhat. It's appropriate and timely, since the GDP revisions released today show that the recovery has been even weaker than we thought.

The Great Recession of 2008-2009 wasn't your typical recession. In every other recession in postwar history, the economy rebounded within a few years to return to its long-term growth path. But not this time, and it has nothing to do with the rich getting richer or the alleged increase in inequality. Instead, it has to do with the average person and the average family not making the kind of progress to which they've been accustomed. Understandably, people are upset.


The chart above compares the actual growth of real GDP (blue) with its long-term trend of 3.1% per year. Never before has real GDP fallen below its trend by so much for so long—and still, as we are entering the seventh year of recovery, there is no sign of a true recovery. The current "gap" between actual GDP and its long-term trend is about 15% by my calculations. That translates into a national income shortfall of almost $3 trillion.

This is the measure of the country's discontent: $3 trillion in missing income.


We see the same pattern in the chart above, which compares the actual growth of a subset of retail sales (which excludes certain volatile categories) to its long-term trend. These are the expenditures made by ordinary folk, not the mega-billionaires. This helps dramatize just how radically things changed beginning in the latter half of 2008. Retail sales by this measure would have to increase some 20% overnight to get back on their long-term trend path. This is a measure of how much middle class families are hurting.


After growing for decades at about a 1% annual pace, the labor force suddenly stopped growing in late 2008, as the chart above shows. Things have picked up a bit in the past year, but the labor force is "missing" around 10 million people—people who have given up trying to find a job or who have decided they just don't care to work.

If one thing stands out in these charts, it is the abruptness and the severity and the persistence of the divergence from long-term trends that began in 2008. Something REALLY BIG happened; what was it?

It was not demographics, since demographics change at glacial speed. The population didn't suddenly got older and start to retire en masse in late 2008.

It was arguably not monetary policy. The Fed was slow to launch its QE efforts in late 2008, but since then they have been working overtime to make sure the economy is not starved of liquidity and interest rates are as low as possible. (I could be persuaded that the persistence of extremely low interest rates has been a problem for savers, and that this has led to weak investment, but corporate profits have been setting records throughout the recovery and corporations have been very reluctant to invest those profits.)

The one thing that changed in a really big and durable way, starting in 2008, was fiscal policy. The Bush administration launched TARP in late 2008, and the Obama administration followed up with ARRA in 2009. Then came Obamacare in 2010, which purported to restructure fully one-sixth of the US economy within the space of a few years. Then came the Dodd-Frank super-regulation of the financial industry. Beginning in 2013, top marginal tax rates were increased.




As the first of the above two charts shows, massive fiscal "stimulus" (aka deficit spending) increased the federal government's debt from $5.34 trillion in June '08 to $12.45 trillion as of this week. As the second chart shows, that surge of borrowing more than doubled the federal debt burden, raising it from 36% of GDP in mid-2008 to just over 72% of GDP in the span of seven years. The only other time something of this magnitude happened with fiscal policy was WW II.

The federal government borrowed $7.8 trillion over the course of the past seven years and handed most of the proceeds out in the form of various transfer payments (which now make up over 73% of federal spending). Our leaders in Washington did this in the belief that this would stimulate spending and that would convince businesses to create more jobs. The federal government restructured the entire healthcare industry in the belief that this would lower costs and give everyone healthcare insurance coverage. The federal government rewrote the rules for the entire financial industry, in the belief that a more-highly-regulated banking system and greater consumer protections would restore confidence and optimism. And to top it off, the federal government increased taxes on the rich, in the belief that this would benefit the middle class by more fairly distributing the fruits of progress.

But it didn't work. Spending wasn't stimulated; job growth didn't surge; healthcare costs continued to rise, the vast majority of the uninsured are still uninsured, and millions have lost what coverage they used to have; banks are reluctant to lend and consumers are reluctant to borrow; consumer optimism remains weak; and the middle class has taken it on the chin.

If anything, the massive growth of government intervention in the economy since 2008 looks to be the Occam's Razor explanation for what caused the weakest recovery in history.

If there is a reason for widespread discontent, it is our federal government and its overbearing and intrusive ways. Thanks to all the government "help" that has been heaped upon us in the past six years, we have the weakest recovery in history. And the bill for all this is a staggering $3 trillion per year and counting.

Tuesday, July 28, 2015

Credit spread update

As I mentioned last week, lower oil prices (and falling commodity prices) have given the markets a case of the jitters. Default risk in the high-yield energy sector is up significantly, and this has sparked fears of a credit default contagion. It doesn't help that Chinese stock prices are extremely volatile (and currently falling) and that the Chinese economic powerhouse has slowed down measurably. But looking deeper into the numbers, so far there is no sign of any contagion; markets are still very liquid and systemic risk is low. Markets are very good at weathering storms as long as they are liquid. It's therefore likely that this storm will pass, as many others have in recent years.


This chart shows the spread on high-yield energy bonds, which has spiked of late to a new post-recession high in response to the renewed decline in oil prices.


The deterioration in the energy sector has spread somewhat to other sectors as well. Investment grade and high-yield spreads in general are up, but only moderately. The damage is more or less limited to the energy sector.


I've long touted the ability of 2-yr swap spreads to be excellent leading indicators, because of their ability to give advance warning of big problems in the economy. The chart above adds to the story, since it shows that swap spreads have indeed been leading indicators of high-yield spreads, and sometimes by a considerable amount of time. Today, swap spreads are trading well within the range of what might be considered normal: 20-30 bps. This tells us that financial markets are healthy, and that in turn is a good sign that there is no fundamental deterioration going on in the broad economy. It's an energy "crisis" of sorts that is bad for producers and associated industries, but good for just about everyone else. It's not the end of the world.


It's hard to put complete faith in the economic statistics coming out of China, but according to the government, the economy is growing at about 6-7% per year. That's way down from the heady 10% growth rates which prevailed in the mid-2000s, but it's still pretty impressive—at least twice the growth rate of the most energetic developed economies. However, one number the government can't easily fake is the central bank's holdings of foreign exchange reserves, shown in the above chart. Forex reserves have been in a $3.5 - 4 trillion range for the past several years (most of it invested in U.S. Treasuries). Over the past year China's forex reserves have fallen from $4 trillion to $3.7 trillion. Meanwhile, the yuan has been relatively stable against the dollar for the past 4-5 years. What this means is that capital is no longer flooding into the Chinese economy. The rising tide of reserves—which lasted some 20 years—has reversed, with minor capital outflows of late. That squares with China's slower growth rate. The boom times are over; now, instead of extremely fast growth, China is experiencing simply fast growth. That growth is being financed organically, and China's growing and rapidly aging population is beginning to invest overseas, at it should. None of this is troubling, but it is a big change—a great inflection point—that will take some getting used to.

UPDATE: A decline in China's forex reserves means that the central bank is selling some of its forex reserves in order to keep the yuan/dollar exchange rate stable. That in turn means China has been (and most likely will be) selling Treasuries. But what happens to the dollar proceeds of those sales? The dollars raised by the central bank's sale of Treasuries must, at the end of the day, be spent on something in the U.S., such as equities, bank savings accounts, real estate, tourism, movies, and assorted goodies. In other words, capital moving out of China means increased purchases of U.S. goods, services, and equities.

Friday, July 24, 2015

Commodity prices in perspective

Consider this post a public service announcement. The objective is to put recent commodity price trends into a long-term, historical perspective. I think that what it shows is that despite significant declines in the past few years, commodity prices are still holding up quite well relative to where they've been in the past.


We start the review with "Dr. Copper." Copper prices have been extraordinarily volatile in recent decades. Copper has declined 40% from its early 2011 all-time high, but it is still 290% above its 2001 low.


The CRB Raw Industrials index is my favorite commodity index. It doesn't include any energy or precious metals. It includes mostly just basic commodities of the sort that don't lend themselves to speculation or stockpiling. This index has fallen almost 30% from its 2011 high, but it is still almost 110% above its 2001 low.


The chart above shows the inflation-adjusted value (in today's dollars) of the CRB Raw Industrials index. Here we see that despite the huge increase in commodity prices since their all-time lows of 2001, prices today are still about 30% below their early 1980s level in inflation-adjusted terms. I don't include prices going back to 1970 because the composition of the index changed, but most commodity indices show almost no change in real terms from 1970 to 1980. Similarly, commodity prices in the 1960s were largely unchanged in real terms. In the end, what becomes apparent is that commodities tend to become cheaper over long periods. Presumably that is because of technological advances in exploration and extraction techniques. This vindicates the late Julian Simon's view that the only scarcity that exists in the world is human ingenuity. There has demonstrably been no scarcity of commodities.


The CRB Spot Commodity index consists of the Raw Industrials index featured above, plus the CRB Foodstuffs index. After adding in notoriously volatile food prices, the picture remains essentially the same.


The chart above extends the CRB Spot index back to 1970. Note that commodity prices were relatively stable from 1980 through 2000, then they surged from 2001 to 2011.


The chart above converts the index from nominal to real terms. Note that prices in the 1970s were volatile, but ended the decade relatively unchanged.


Finally, the chart above compares the price of gold to the CRB Raw Industrials index. Note how closely they move, but also note how much more volatile gold prices are than most other commodity prices. Both are in a weakening trend.

Are lower commodity prices bad? Are they symptomatic of the onset of deflationary conditions? Do they reflect a weakening of the global economy? Or do they simply reflect more abundant supplies and reversals of the very strong commodity prices that we saw in the years leading up to 2011? I tend towards the latter explanation. After, all, as the saying goes, "the best cure for higher commodity prices is higher prices." Higher prices elicit more supply. We know that for sure is the case with oil: