Commentators, including the egregious Ben Bernanke are increasingly claiming that the US is in the process of a V-shaped recovery from the Great Recession. Certainly first quarter GDP, to be announced next week, is likely to show a substantial bounce, albeit not quite the inventory-driven 5.6% annualized growth of the fourth quarter. Yet commentators should be careful what they wish for: a V shaped recovery is likely to lead, not to a prolonged period of healthy growth, but to an economic explosion and collapse.
This may seem counter-intuitive. You would normally expect a period of above-normal growth after such a deep recession, whatever the political environment. After all, even in 1934, a year in which the Federal government was taking a hatchet to the banking system and capital markets through the Glass-Steagall Act and was micro-managing wages, prices and product specifications through the National Recovery Administration, US Gross Domestic Product, it is now estimated, rose by an extremely healthy 10.9%. Indeed, 1933-34 form the principal supporting evidence for the efficacy of Keynesian “stimulus” – real Federal expenditure rose by 23.7% in 1933 and no less than 34.2% in 1934, a public sector bloat rate of which even President Obama might be proud.
In the very short run, intuition may be right. Manufacturing numbers for the last couple of months have been good, while surging retail sales and the plunging savings rate suggested that the US consumer has discovered yet another credit card in an old jacket pocket that he had forgotten about. Automobile sales too have rebounded nicely, and Ford in particular is looking solider than it has for several years. Tech sector profits seem to be “surprising on the upside” as they say with Google reporting sharply rebounding ad sales. With such growth, even the projected Federal deficit may decline by $50 billion or so, still not quite a rounding error.
The recovery may be V-shaped in the next quarter or two, but it is very doubtful indeed whether it can continue to be so for long enough to define itself as a true recovery rather than merely an intermediate bump in a “double-dip” recession. On unemployment, for example, since 8.4 million jobs have been lost in the recession, a US recovery that lasted two years from now would have to create 350,000 jobs per month to restore the jobs lost – and that would still leave unemployment much higher than in December 2007, at 6.5-7%, because over 5 million more people would have been added to the labor force between December 2007 and April 2012.
With an employed US labor force of 139 million currently, job creation at 350,000 per month implies an increase in the work available of 0.252% per month or 3.02% per annum. Add the 2% trend growth in productivity, and you’re talking more than 5% GDP growth for two full years. A lovely V shaped recovery if you could get it, but in terms of duration and extent the bare minimum necessary for the recovery to qualify as a true economic expansion and not simply a bump in a prolonged recession.
So what are the chances of 5% US annual GDP growth for the next two years and commensurate growth in international markets? To see the problems involved, consider the question of commodity and energy prices. In the last twelve months, while the global economy has been operating far below capacity, the OPEC benchmark crude oil price has risen from $50.20 to $81.52 per barrel, a 62.4% increase. Yet US GDP, which bottomed out last April/May, has risen no more than 5% in the last twelve months, probably less. Thus two years of 5% GDP growth would imply energy prices rising at least as quickly as in the last twelve months, as Chinese and Indian growth continued rapid and US oil consumption rebounded towards historic trends.
Two more years of 62.4% price rises would take oil prices to $215 per barrel. Given that $147 per barrel oil was a major contributor to the 2008 crisis, do we really think the US economy capable of bearing $215 oil in 2012 without caving in on itself? I don’t think so. At least, not unless the dollar has collapsed and inflation has taken off to a level of perhaps 20-25% per annum, which is certainly a possibility.
Then there’s iron ore. The annual contract system appears to have broken down, with contracts settled at 100% above last year’s prices and the spot price running 50% higher still. Given the assumption of robust global growth and thus maintenance of this rate of increase, iron ore prices by April 2012 could thus be quadruple their current level, or $600 per metric tonne. Automobile production would have to shift entirely to plastic – except that being derived from petroleum, plastics prices would also have grown exponentially.
Then there’s copper. That’s also up more than 60% over the past year, and on the London Metal Exchange is closing in on its all-time record price, set in April 2008, around $9,000 per tonne. Existing copper mines deplete rapidly unless capital is invested in them, and with new investment having ceased for a year in 2008-09 there is now a serious supply shortage, not expected to be alleviated until major new capacity comes on stream in 2014-15. Again, if economic recovery is robust for the next two years, copper prices will continue rising at the same rate as in the last year, reaching $21,000 per tonne by 2012. Any bets on what that will do to the economy, or to inflation?
In short, rapid expansion at 5% per annum for the next two years, the minimum necessary for this to be termed a true V-shaped recovery and not just a blip, will run into one of two constraints. Either inflation will take off, reaching an annual rate of at least 20% by 2012 as commodity and energy prices continue their inexorable climb, so forming a larger and larger part of the consumer’s purchase basket. Or, alternatively, a collapse in the government bond market, panicking at the rapid acceleration in inflation, will choke off economic recovery, plunging asset prices including housing back into the depths of gloom and sparking off another banking crisis caused by yet another wave of home mortgage defaults.
In other words, a true V-shaped recovery is impossible, at least without some very unpleasant consequences indeed. Presumably in the latter stages of a rise in inflation towards 20-25%, even Ben Bernanke would be forced to recognize its existence and raise short-term interest rates from
their present derisory levels – which would itself cause a crisis in the financial and housing sectors.
When considering the recovery’s future trajectory, there is another fairly benign possibility, that of a gamma-shaped recovery (the English language has no appropriate letters!) in which growth starts off at the V-shaped rate of 5% or so, but within a quarter or two from now slows down to a “soft landing” pace of 1-1.5%, at which the commodity price explosion levels out, inflation remains a potential problem but not an immediate danger and the global economic imbalances are allowed to work themselves out over time.. However that would not allow US unemployment to decline much – once the slow recovery had set in, productivity growth would prevent net job creation and so with the workforce expanding steadily, unemployment would remain stubbornly high, probably around 9%.
To achieve the optimal gamma shaped recovery, however one policy change is absolutely necessary: the Fed must increase forthwith its Federal Funds target and other short-term interest rates from zero to a level slightly above the rate of inflation, perhaps in the 3-4% range, increasing them further if as is likely inflation trended upwards. That would remove the incentive for banks and hedge funds to borrow at negative real interest rates and invest in anything, such as commodities and energy, which seemed likely to maintain its value.
It would also remove two anomalies in the present market, which make healthy and sustained recovery impossible. First, it would remove the subsidy for banks to “borrow short and lend long” investing their balance sheets in Treasuries and housing bonds, thus starving small business of funding. With commercial and industrial loans now down 25% from their October 2008 peak, small business is starving for working capital at the same time as the banks make record profits.
Second, it would remove the disincentive to saving that is driving the US savings rate back down to the near-zero levels of 2005-07, making the US financial system in the long run unsustainable. Japan can sustain public debt of 200% of GDP because of its enormous savings pool; blowout is likely in the US at much lower levels because no such savings pool is available.
Higher interest rates would also reduce stock market speculation, returning the market to its sustainable level of around 8,000 or below on the Dow. It would also, by reducing bank enthusiasm for housing bonds, begin to remove the excessive subsidization of housing, diverting capital back into more productive channels.
A gamma shaped recovery may look fairly unattractive, but it’s a lot better than the alternative of rapid recovery followed by blowout. It could also be engineered so that the gammaization of 5% growth into 1.5% growth did not become apparent until after November’s midterm elections, thus allowing the Obama administration to present simple folk in the electorate with the impression of a vigorous and sustainable recovery.
However with Ben Bernanke at the Fed the necessary rise in interest rates is unlikely to happen. So the wise investor will remain long commodities and energy – and brace himself for eventual inflationary collapse into a “double-dip” Greater Recession.
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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.)