In a week when US Gross Domestic Product was revised disown to a level slower than the growth in population while inflation continued strong, it must surely be clear that the collection of economic policies followed since 1995 by both parties and the Federal Reserve Board has failed. The Fed can neither cut rates nor increase them, yet it needs to do both. The George W. Bush administration is finding that its 2001-03 tax cuts are untenable in the face of the inexorable rise in public spending and the Democrats in Congress are coming to the reluctant conclusion that if they try to implement even half their wish-list of changes, the sums don’t add up. So what next?
Reality has not yet dawned on the political classes. The Fed is currently claiming that the US economy will turn up after its weakness in the first quarter, even though there is absolutely no evidence of it doing so and indeed the collapse in subprime home loans happened only in late February, so has hardly had time to affect the aggregates. The Administration is continuing to bloviate about its success in cutting the budget deficit and the magnificent economic effect of its 2003 tax cut, omitting to notice that the budget deficit is still very substantial when social security is taken into account, while its 2001 tax cut, which was five times the size of its 2003 cut, appeared to have had no economic effect at all.
Meanwhile the Democrats are continuing to claim that their increase in the minimum wage will have a magical effect on increasing low-end incomes, while omitting to notice that their immigration policies will have an equally magical and much larger effect in depressing them. Once illegal immigrants have been legalized on temporary visas, there will no longer be any disadvantage to the more cost-minded of American technocrats in employing such illegals for every job outside the executive suite.
And the stock market goes on rising, while investors go on putting money into hedge funds. They are ignoring the troubles of one of the most celebrated hedge fund operators, John Henry, who has lost 36% of his investors’ money and is likely to have to scale back operations drastically if not wind up his funds altogether. Fanatical supporters of the Boston Red Sox were charmed by Henry’s purchase of the team in 2001, believing that infinite resources would now be combined with exquisitely tuned intellect rather than the dozy obscurantism of the previous owner, timber heir Tom Yawkey. They should about now be enduring a horrible sense of déjà vu.
In 1920 the Red Sox’s financially strapped owner Harry Frazee sold Red Sox legend Babe Ruth to the hated New York Yankees – the rest was history, a history of 26 Yankee pennants and an 86-year Red Sox drought. This time, Henry can no doubt gain liquidity in any crunch by selling the contracts of sluggers David Ortiz and Manny Ramirez, pitchers Josh Beckett, Daisuke Matsuzaka and Jonathan Papelbon and rising stars Kevin Youkilis and Dustin Pedroia – though not to the Yankees again, please! Last time around, Frazee’s financial wheeler-dealing resulted in quite a good Broadway musical, “No, No Nanette.” Regrettably, none of Henry’s deals appear likely to produce anything of such lasting quality.
Outside the dreamland of Red Sox baseball, the outlook is equally grim. The U.S. economy appears to be slowing further, while inflation stubbornly refuses to disappear. At some point, either the stock market wakes up to the problem or revenue shortfalls appear at the U.S. Treasury or the bond markets exhibit an inflation panic, or all three. A major bankruptcy in the hedge fund or private equity fund area, doubtless with an accompanying scandal of embezzlement and excess might also be the trigger. Whatever the trigger, the bubble of investor confidence is now stretched very tight indeed, and will not repair itself once a shock to the system has occurred.
Once the stock market has burst, decline will feed on itself. The unconquered inflation will cause a rise in long term bond yields, which itself will cause a swathe of bankruptcies in the world of private equity and hedge funds. Indeed the fallout here may well be greater than any other seen in history, with an overall debt default rate peak higher than the 9.2% one-year bond default peak of 1932. That’s not entirely a fair comparison; issuers have been much more aggressive in recent years than they were in the 1920s, so the average rating quality of issued bonds is much lower. The ten-year default rate from 2007 to 2017 on A-rated bonds may be nothing like the 12% of the Great Depression, perhaps little higher than the 3.82% 1920-1999 average. However today there is a huge universe of bonds rated nowhere near A, and defaults rates on those may be much higher, perhaps 25%-50% over a 10 year period on bonds rated BB or below. The only factor preventing a Great Depression-like bond market collapse will be inflation, which will cause the real value of debt obligations to decline rather than increase as it did in 1929-33.
The decline in house prices, already apparent while the bond market has remained ebullient and credit quality problems have been confined to the over-extended subprime mortgage sector, will extend much further. The apparent small house price rise shown by OFHEO statistics on Thursday was misleading; it relates only to houses financed by Fannie Mae and Freddie Mac, and therefore misses both the top end of the market (their loan limit is currently $407,000) and the more exotic cowboy end of the sub-prime and Alt-A sectors. From other evidence price declines in those sectors and in new housing generally are already substantial. I forecast last August an eventual house price drop of 15% nationwide and 30% on the costs; I now think that was conservative, although possibly not drastically so.
With house prices declining sharply, any junk bonds they have bought showing a tendency to disappear into default and the stock market under pressure, consumers, particularly affluent consumers, will cut back sharply on spending. In this case, the retrenchment will be concentrated at the high end rather than the low end; low and middle income consumers who don’t have excessive mortgage or credit card debt will initially not be deeply affected provided they keep their jobs.
The overall effect of reduced consumer spending will be to reduce the U.S. payments deficit. Huzzah! This will export deflation around the world, particularly to economies such as China and Japan whose economies depend on exports to the United States. However China will have its own problems by this stage; it is most unlikely that a downturn in the US stock market will leave the Shanghai/Shenzen bubble unaffected.
The other devastating effect of a consumer spending and asset price downturn will be on the US Federal, state and particularly local budgets. These are already in poor shape. Expenditure at all levels of government has increased rapidly in recent years. However the greatest increases have been seen in local government spending, which have seen their normal budgetary constraints removed as rampant property price increases have caused revenues to soar. The worst possible solution to this would be the one Herbert Hoover chose: aimless public spending to fight recession, followed by a panic increase in taxes as deepening recession leaves a huge hole in the budget.
If this downturn had occurred in 2004-05, that pattern would almost certainly have been repeated, with the switch from Republican to Democrat control of Congress producing the tax increases. In today’s political situation, the pattern is likely to be rather different. Spending is already being increased by the Democrat-controlled Congress, but the Democrats wish to demonstrate their fiscal discipline and the irresponsibility of President Bush’s tax cuts; thus tax increases are likely to accompany the spending increases. This will limit both, and ensure that the further state encroachment on the economy which recession inevitably causes will be moderate.
Meanwhile, the trajectory on inflation will depend on Federal Reserve Chairman Ben Bernanke’s life expectancy; how long he can stay in the job before the market rebels and ousts him, as it did G. William Miller in 1979. If Bernanke can remain in office, it is likely that a downturn will cause him to lower interest rates, in an effort to reflate the economy. This in turn will cause inflation to surge, and make the process of recovery longer. On the other hand, inflation will reduce the real value of debt and make the debt default crisis less. Conversely, if Bernanke is forced out quickly, the recession may be over more quickly, because inflation will remain under control, but debt defaults in a Volcker-like period of tight money could be very severe.
Thus the choice is between a short sharp depression, albeit presumably less severe than 1929-33 (unless the forces of protectionism take a hand as well) or a lengthy period of stagflation like the 1970s, probably with a deeper dip than 1973-75. The third possible pattern, a prolonged period of stagflation like Japan in the 1990s, now seems rather unlikely.
Nobody’s saying this yet. But then, everybody has been forecasting a “soft landing” for the U.S. economy. That would be the only possible outcome that might save the Red Sox from being broken up; it thus looks like they’d better make the most of any success in 2007.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)