The Third Depression

Krugman's thoughts via Pragmatic Capitalist on whether or not we could be facing a third depression...

'That’s what Paul Krugman says is on the horizon. In a sobering article in Sunday’s NY Times Mr. Krugman says policy errors are leading us right off the cliff:' http://www.pragcap.com

“We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.”

Regular readers know my position. I never thought the secular bear ended or that the credit crisis was over. This has become abundantly clear as unemployment has remained stubbornly high and the credit crisis evolves into a full blown sovereign debt crisis. The recent evolution of the Greek crisis and scare mongering of certain market participants is almost certainly walking us off the edge of the cliff. Policymakers have misdiagnosed this crisis from the very beginning so it’s not surprising to see them continue down this same path.

It’s unfortunate that this is all unraveling with Greece at the epicenter. Policymakers have utterly failed in understanding that the Euro currency system is fundamentally different from the others around the globe – specifically in Japan, UK and USA. We’ve all become convinced that we are the next Greece (which is utterly insane). The Euro crisis is staggering and beyond frightening in my opinion. As I have maintained for years there is no true fix in Europe that doesn’t include full unity (a United States of Europe – which is impossible) or partial or full restructuring (full restructuring is inevitable in the long-run in my opinion). There is no bailout that can fix the inherent flaws in the single currency system. It is destined to fail in my opinion. That’s a terribly frightening thought and the Euro’s death might very well be on our doorstep. A swift death would be preferable in my opinion. Unfortunately, I see this crisis playing out for a very long time as politicians hang on to their Euro baby for as long as possible. The first step in rehab is always admission. We’re not even there yet.

Sometimes this feels like a terrible dream to me. It’s as if we are reliving the gold standard days all over again when countries realized the inherent restraints imposed on their nations via this foolish currency system. Many are arguing that austerity is the only way out of the Euro crisis, but austerity is already proving futile in countries that have undergone austerity measures. Exhibit A is Ireland where their budget deficit continues to expand. The same will occur in Portugal, Italy, Spain and Greece where austerity measures are in the works. Unfortunately for the Europeans this is a currency problem and not just abudget problem. Europe appears doomed in my opinion unless a true currency fix is implemented. That alone could bring us all to our knees. Unfortunately, the problems don’t stop at the borders of Europe.

Here in the USA the economic woes continue long after the supposed end of the recession. I have long argued that we are Japan, yet we have implemented almost all of their failed policies. In 2008 I wrote a letter to the Fed asking that they very seriously consider what I referred to as the “Swedish Model” (I figured that even a married man like Ben couldn’t resist a Swedish model – I was wrong). In the late 80’s and 90’s the Swedes were suffering from a banking crisis that arose from a private sector debt bubble. It was strikingly similar to the problems in Japan, however, their responses were drastically different. The Riksbank detailed their options at the time:

“The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank?s current income for a gradual writedown of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point.

With the other method, an open account of all expected losses and write-downs is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended. The Swedish authorities opted for the second option.”

Option A: Take your pain. Avoid the inevitable. Make the losers lose. Avoid moral hazard. Be transparent with the public’s money. Option B: bailout the losers. Let them live to fight another day. Hope they survive. Let moral hazard run wild. Use the public’s money foolishly and secretively. We obviously chose the same plan B that Japan chose – don’t make the losers lose. Now we are wrangling with a giant sized case of moral hazard and a banking sector that is still sitting on a potential time bomb.

The worst part is that public faith is slowly being shattered. This is, in my opinion, the death grip in deflation – which is very much a psychological battle. Allowing the losers to win was essentially admitting that the system is rigged. That’s no way to instill trust & confidence (which, at the end of the day, are the foundations of any economy).

I have long advocated an approach that was focused on Main Street and not Wall Street. After all, the crux of the issue has always been Main Street. And after years of bailing out Wall Street (only to discover that it achieved nothing – thank you Ben and the other Monetarists!) we are going to implement policy that further kicks Main Street when its down (thank you Austrians!). Last week’s watered down financial regulatory bill was just one more sign of how corrupt and inept our politicians are. It’s as if we keep bailing these losers out no matter what. This sort of backwards policy that ignores history is destined to fail. We continue to ignore Main Street at the benefit of Wall Street. History has shown this to be a very poor approach to a credit crisis.

We have truly wasted a crisis. Effective reform has been debauched. The banks remain as powerful as ever. Main Street remains weak. Monetary and fiscal policy has been primarily focused on helping the losers win (homebuyers tax credits to boost home prices, TARP & QE to bailout the banks, cash for clunkers to give more debt to the financially incompetent, etc). We could have crushed the banks and given the power back to consumers. We could have bailed out Main Street and not Wall Street. We could have forced the losers to lose and ensure trust and confidence in a capitalist system that has served this country pretty damn well since its inception. We have failed on all fronts.

I hate to sound so negative, but if policy continues to devolve with the flat earth economists at the helm we might very well end up being something worse than Japan – the United States (circa 1937). It’s looking more and more likely to me.

Many continued thanks to Prag Cap for providing us with pertinent information about the state of economy...

CBC

CHINA SIGNALS END TO DOLLAR CURRENCY PEG

20 JUNE 2010 BY BONDSQUAWK

By Bondsquawk:

The Chinese Central Bank announced Saturday evening that it will proceed with exchange rate reform and allow a more flexible currency, signaling an end to the renminbi’s peg to the U.S. dollar according to an article from The New York Times.

The People’s Bank of China said that the Chinese economy was strengthening after the global financial crisis and that it was “desirable to proceed further with reform” of the currency, known as the renminbi or yuan. The announcement comes a week before world leaders gather in Canada for the Group of 20 and Group of 8 summit meetings. A growing number of countries have been calling for China to let the renminbi appreciate, including not just the United States and European nations, but India, Brazil and Singapore in recent weeks.

Details are vauge in the PBOC’s press release but more information may come this Monday as to the degree of appreciation. The New York Times added the following.

China’s announcement strongly echoed the central bank’s decision in July 2005, to begin allowing the renminbi to rise against the dollar. The renminbi then rose 21 percent over the next three years, until the central bank informally repegged the renminbi at 6.83 to the dollar in July 2008, as the international financial system and the global economy began deteriorating rapidly.

The central bank’s statement on Saturday, like the statement nearly five years earlier, said that the People’s Bank of China would set the value of the renminbi in relation to various currencies, and not just the dollar.

But in contrast with the 2005 announcement, the People’s Bank did not include any immediate appreciation of the renminbi. In 2005, the new currency policy was accompanied by a one-time, 2 percent rise in the currency against the dollar, followed by further, gradual appreciation against the dollar.

President Obama has sought a stronger renminbi as one of his central foreign policy goals. It would tend to make Chinese exports more expensive and less competitive in the American market, encouraging American consumers to buy more American goods instead.

For China, a stronger renminbi will increase the buying power of its consumers and could make gasoline and other imported commodities seem less expensive. Faced with spreading labor unrest, particularly in the auto industry, the Chinese government has started to make an energetic effort to improve the standard of living of industrial workers.

According to a Bloomberg article, U.S. Treasury Secretary, Tim Geithner supported the decision.

“This is an important step, but the test will be how far and how fast they let the currency appreciate,” Geithner said in a statement today in Washington. “Vigorous implementation would make a positive contribution to strong and balanced global growth.”

Despite the praise, U.S. Senator and vice chairman of the Joine Economic Committee of Congress, Charles Schumer who suports legislation for increased tarifs on Chinese imports as a result of the two-year peg, expressed his displeasure.

“We hope the Chinese will get more specific in the next few days,” Schumer said. “If not, then for the sake of American jobs and wealth, which are hurt every day by China’s practices, we will have no choice but to move forward with our legislation.”

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Why It's Still a Secular Bear Market

An argument has been made about the metrics defining our 'economic' recovery, whether they are invalid measures, and the accuracy of the numbers therein. One major point I would make is to glance at the derivatives of those anaylses in order to note that they show progression and uptrends in some of our leading indicators. If you follow closely, you will note that those same indicators have either been slowing, peaking, or reversing as opposed to showing any valid signs of improvement.

Below is an article - agree or disagree - containing REAL numbers signifying that our time in a secular bear market is far from over and that recovery is going to be a painfully slow process.

Enjoy the article, and many thanks to Comstock Partners for the informative literature.
CBC



WHY IT'S STILL A SECULAR BEAR MARKET

By Comstock Partners

In our view the stock market is in a secular (long-term) downtrend that began in early 2000 and still has some time to go. The collapse in the dot-com bubble (2000-2003) gave way to the historical housing bubble that itself collapsed in 2007, leaving the U.S and the world awash in enormous debt, huge overcapacity and overvalued markets. The deleveraging of this debt and its negative consequences for the economy will create serious headwinds for the stock market for a long time to come.

The current debt crisis cannot be solved by mere declarations from official authorities. The debt crisis began with the decline of the housing market in 2006 and is continuing to this day. Phase I involved the transfer of private debt to sovereign debt by means of massive monetary and fiscal stimulus that has led to statistical economic recovery that remains anemic by historical standards. The problems that emerged with the Dubai crisis heralded the beginning of a sovereign debt crisis and phase ll—the transfer of weak sovereign debt to relatively stronger sovereign debt. The problem is that total debt is not reduced, but keeps getting shifted from weaker to stronger entities. Overall debt is too huge to ever be paid off and the relatively stronger nations will run out of ammunition long before the crisis is resolved.

The only long-term solution is a deleveraging of global debt, a process that cannot be solved with a magic wand waved by central bankers and prime ministers. It is a process that will take many years and will be accompanied by slow growth, numerous recessions and financial turmoil. The weaker European nations are already going on austerity, and there is more to come. Greece will have to undergo severe budget cuts without the benefit of an independent monetary policy or the ability to devalue its currency. Spain is cutting its budget by $18 billion and Italy by $15 billion. The UK, too, had announced major reductions in healthcare, IT and civil service.

Germany’s plan to aid the southern EU nations and to slash its own fiscal deficit has threatened to bring down its governing coalition. France has proposed increasing its retirement age, leading to protests in the streets. The new austerity throughout Europe will lead to a sharp slowdown or recession in with negative implications for the rest of the world at a time when the U.S. economy is still fragile and China is trying to restrain a major housing boom. The entire globe is in danger of becoming like Japan, which is still struggling after two decades of monetary and fiscal stimulus—and Japan was operating within a global economy that was still robust during most of its time of trouble.

As for the economy, the general impression that the U.S. is undergoing a normal recovery is highly misleading. The following outlines a number of key economic series that supports our case that the rebound has actually been quite weak.

1) While May retail sales were up 8% from the early 2009 low they are still 4.4% below the peak reached 2 1/2 years ago in November 2007. By way of comparison, over the last 43 years retail sales have seldom declined at all, even in recessions.

2) May industrial production (IP) was 8.1%% over its June 2009 trough, but still 7.9% below the late 2007 peak. At its current level, IP is still where it was over 10 years ago in early 2000.. Never since the 1930’s depression has IP failed to exceed a level attained 10 years earlier.

3) New orders for durable goods in April were up 21% from the low of March 2009, but still 22% below the top in December 2007. In fact new orders are at the same level as in late 1999, over ten years ago.

4) Initial weekly unemployment claims steadily declined from 651,000 in March 2009 to 477,000 by Mid-November, but have been range-bound with no improvement in the last 6 ½ months. Furthermore the current number of claims is still in recession territory.

5) April new home sales were up 14.8% from a month earlier and are up a seemingly robust 48% since the low. However, the current number is still a whopping 64% below the 2005 monthly peak. Prior to the current recession the last time new home sales were this low was in February 1991.

6) Existing home sales in April were up 27% from the low in late 2008, but still 20% below the peak in late 2005. We also note that both new and existing home sales were boosted by the homebuyers tax credit that has already expired, and that the housing market has weakened considerably since that time.

7) May vehicle sales of 11.6 million annualized were up 14% over the prior month and 26% from the trough. However, this remains far below the annual average of about 16 million vehicles in the decade starting 1997.

8) Personal income for April was up 3.2% from the May 2008 trough with major help from government transfer payments, but is still 0.8% below the peak about two years earlier. We note that prior to the current cycle, personal income was never down year-over-year in any month going back to 1960, and the current figure of plus 2.5% is still at recessionary levels.

9) Payroll employment in May increased 431,000, but the vast majority of these were government census jobs. Private employment was up only 41,000, leaving the total number of employed still 7.4 million jobs below the pre-recessionary peak. In fact, on a point-to-point basis no new jobs have been added since January 2000.

10) March consumer credit outstanding was 3.4% below a year earlier, the 13th consecutive monthly decline. Prior to the current recession, consumer credit had never been down from a year earlier in any month since the waning days of World War II.


The data cited here cover the major indicators of economic activity, and they paint a picture of an economy that has moved up, but only from extremely depressed numbers to a point where they are less depressed. And keep in mind that this is the result of the most massive monetary and fiscal stimulus ever applied to a major economy. In our view the ability of the economy to undergo a sustained recovery without continued massive help is still questionable.

Although the majority assumes that the housing market has already bottomed, a second wave of decline is already underway. Recent housing numbers have mostly been bolstered by the home buyers’ tax credit that expired on April 30th, the date when contracts had to be signed to qualify. Sales, however, are not recorded until closing, which has to take place by June 30th. Sales of new and existing houses may therefore show some further strength until then, but fade after that time.

The point we’re getting to is that sales already appear to have declined significantly after the tax credit expiration. New home sales, existing home sales and housing starts are all soft. In addition the Mortgage Bankers Association (MBA) purchase application index, probably the best leading indicator of future home sales is down about 40% since the April 30th tax credit expiration, and is now at a level not seen since 1996.

All of the evidence we see indicates that the tax credit merely pushed home sales ahead, and that without it, sales and prices will resume their decline. In addition to the lack of tax credits, adjustable rate mortgage resets will soar from about now until November and then reach an even higher peak in 2011. This will put more and more mortgage holders into a position where they can longer meet their monthly payments, leading to another round of defaults and foreclosures.

Furthermore, delinquencies were climbing even before the rise in resets. According to the MBA, 1st quarter delinquencies surged to a record in every single category—fixed prime, adjustable prime, fixed subprime and adjustable subprime. At the end of the quarter fully 10% of all prime and 27% of all subprime mortgages were in delinquency.

Another big problem for the industry is the so-called “shadow” inventory, consisting of homes that banks are holding, but haven’t foreclosed; homes that have been foreclosed, but not put on the market; and delinquent homeowners who have not yet foreclosed. We should also mention that 14.9 million homeowners owe more on their homes than the homes are worth, fully one-third of all U.S. mortgage holders. Of these, 9% are more than 20% underwater. Many of these homeowners may walk away from their homes even if they are capable of making their payments, and many already have done so. Some reputable studies have estimated that one-quarter of all defaults is caused solely by negative equity.

The prospect of declining home sales and prices has dire consequences for the economy. The further drop in prices will put even more mortgage holders underwater and exacerbate the number of subsequent defaults and foreclosures. The resulting decline in consumer net worth feeds back into lower consumer spending and sets up a negative feedback loop that works its way through the economy. Furthermore the drop in home values sharply reduces the value of the mortgages held by the banking system. Although the suspension of mark-to-market regulations means that banks won’t be forced to write down the loans, bank managements will certainly be fully aware of the potential threat to their capital, and be even more reluctant to make loans than they are today.

In that kind of financial and economic climate it is hard to conclude that the stock market is cheap or oversold. Most major stock market bottoms have occurred with the S&P 500 selling at 20% or more under its 200-day moving average. The index sold at 28% under its 200-day average at the 2002 bottom and 38% under at the 2009 bottom. Even at the recent lows the market was only 6% under its 200-day average. In addition sentiment is nowhere near as gloomy as it usually gets at major lows.

Valuation metrics, too, do not indicate that investors are really fearful at current levels with the S&P 500 selling at slightly over 17 times trailing smoothed reported earnings. At major past market bottoms the P/E was below 10. In fact the P/E was below 10 on trendline earnings at some point in 17 of the last 60 years going back to 1950. If anything, the current P/E is more indicative of complacency rather than fear. As we have stated many times “it’s all about debt” and the deleveraging process has a long way to go. We are therefore maintaining out bearish position on the market.