This Is a Categorically Different Kind of Recession (Deflationary Rather Than Inflationary) Than Anything We've Seen Since the Great Depression

October 31, 2008

Contents: 


    I've suddenly realized that the "recession" (Depression?) we're currently experiencing is categorically different from the recessions with which we're familiar... a different breed of cat. Although it may look the same on the surface, it's wholly different underneath. Here's why.
How the Federal Reserve controls inflation and, in spite of its best efforts, sometimes brings on unintended recessions (the law of unintended consequences?).
    Since World War II, conventional recessions have tended to occur when the Federal Reserve has raised interest rates to slow the economy and fight inflation. More often than not, the Fed unintentionally slows the economy too much, and a recession ensues. Two reasons that this over-braking of the economy occurs so often are:
(1) there's a long lag between what the Fed does with rates and the economy's response, hiding feedback from the Fed about how well its rate cuts are doing until it's too late, and
(2) the economy is quite sensitive to the Fed's actions, making it easy to overdo the rate cuts.
One problem is that the economy is inherently unstable. Inflation feeds upon itself, and so does deflation. 
    It's as though the economy is running atop the rounded rim of a bowl. The Fed must periodically nudge the economy back to the centerline of the bowl's rounded rim before the economy slips off the centerline and gathers inward (deflationary) or outward (inflationary) momentum.
    Normally, once inflation subsides, the Fed lowers interest rates, and the stock market takes off again. But it's four to six months after the stock market rally begins before the economy finally hits bottom, and starts to improve, giving the impression in the meantime that the stock market is out of touch with reality. 
    Meanwhile, the seeds have been sown for new inflation in another couple of years.

This is in stark contrast to what's happening now.  
    Although the Federal Open Market Committee (FOMC) had begun raising interest rates in 2006 (to 5.25%) in order to head inflation off at the pass, the Fed was forced, beginning in the summer of 2007, into a rapid reduction in rates by the growing credit crisis. The Fed began "printing money" (actually, electronically creating government-approved lines of credit) at a breakneck pace, giving rise to claims (by people like me) that we were going to be facing hyperinflation within the next year or two. I was wrong! On the contrary, deflation has replaced inflation as the Federal Reserve's principal concern. Deflation isn't something that's going to happen, deflation is something that has already happened! Deflation has already significantly reduced commodity prices, with oil down more than 50% from its peak earlier this year, and gold down 30% from its high. (The CRB Commodities Index is down 23% so far this year.) With the economy sinking like a stone, deflation promises to reduce both prices and wages. One problem is: not only are banks afraid to lend money, fearing that the borrower will be laid off or go bankrupt--the borrowers themselves are less interested in borrowing money, since they're putting capital expenditure plans on hold. The graph below, taken from Kevin Depew's excellent comparison of the outlook in recent recessions to that of the present day crunch, shows the difference between credit availability during the 1990 and 2001-2002 recessions and credit availability today.
This is one of many charts in Mr. Depew's article that reveal how dramatically different the current downturn is from those to which we're accustomed.

Why the Fed's printing of more money isn't necessarily inflationary
    Normally, when the Fed lowers interest rates ("prints more money"), it is inflationary. I was taught that the economy works like an auction. At any given time there's a fixed amount of goods and services available for us to buy. The more money available to us to chase that fixed amount of goods and services, the more money we'll have to bid up the prices of goods and services. But it turns out that that's a poor analogy. Money is a medium of exchange that flows around and around through the economy. What determines how inflationary money will be is not only how much there is of it but also, how available it is, and how fast it changes hands. Trillions of dollars locked in a vault wouldn't have any effect on the economy since it wouldn't be in circulation. What's been happening is that the Fed has been loaning hundreds of billions of dollars to banks and insurance companies at rates below the rate of inflation, but these banks and insurance companies have been afraid to loan this money to each other, or to other clients, first, because they want to build up their own frighteningly small cash reserves, and second, because with big banks and brokerage houses failing, or offering highly questionable mortgages and other assets as collateral, these banks and insurance companies might lose their shirts.
    "Well," I said to myself, when I realized that so far, the money created by the Fed hasn't been inflationary, "what's going to happen when the economy heats up again? That's when inflation is really going to hit the fan! My gold will be worth beaucoup buckets of money an ounce! Ha! Then I'll get rich!"
    That's when, a few days ago, I learned about Japan. In 1989, Japan had a banking scandal like ours. The Japanese government began pumping out yen the way our Fed has been cranking out dollars. Didn't work. In 1989, the Nikkei Dow had reached a level above 38,000 (yen). Last week, 19 years later, it fell below 7,000. And this is Japan, Inc... one of the world's strongest economies. That's scary!
   To the best of my knowledge, the jury is still out on whether there will be galloping inflation in a year or two, but I don't know enough to make that call. 

    The crucial point about this is that the usual tools which the Fed uses to turn the economy back on aren't working!


The Credit Crisis moves from Wall Street to Main Street.

    The first phase of this credit crisis was confined to the financial institutions on Wall Street but it's now spreading to Main Street with a vengeance. We're now moving into the second phase of this slow-motion avalanche, in which the downturn feeds on itself. Consumer confidence falls as consumers' investments shrink and their homes fall in value. This slows the economy, leading to layoffs. The layoffs generate fear (and for those laid off, not just an unwillingness but an inability to spend). This further slows the economy, causing further layoffs, generating a downward spiral. Normally, this ends when the Federal Reserve lowers interest rates, stimulating the economy and reversing the downward trend. But the Fed has already tried this, lowering interest rates all the way down to 1% and it hasn't worked. Other techniques will be required, but in similar predicaments in the past, nothing has worked.
The credit crisis expands on Wall Street: Now the insurance companies and the automotive companies need (and get) bailouts, too.
    As a footnote to this, the insurance giant A. I. G. claimed to be solvent in September, and then announced in October that it needed $85 billion to survive. " ...A.I.G. replenished its capital by issuing $20 billion in stock and debt in May and reassured investors that it had an ample cushion. It also said that it was making its accounting more precise."Two weeks later , it advised the world that it had burned through $62 billion of the $85 billion, and would need $38 billion more. Now it's rapidly running through that, and has just been granted another $21 billion to cover its gambling debts.  In the middle of October, it was revealed that A. I. G. had treated 73 of its top performers to a $7,000-a-day spree, and was planning a similar bash for 55 others. This was followed by an $86,000 pheasant hunting trip to Dorset, England. Now it's emerging that A. I. G. won't tell how it spent the $90 billion it's already dispensed, together with an Enron-type accounting scandal. Beyond this, other major insurance companies such as The Hartford and Allstate are also slipping away because of their souring investments in financial equities. (The Hartford's stock has fallen to 10% of what it was a year ago.) (See: Hartford says it is 'well capitalized').
    One problem with these other techniques is that they require massive additional expenditures by a federal government that, on September 22, reached the highest level of national debt since 1955 (see below).

    Sam Stovall, the Chief Investment Strategist at Standard & Poor's, is forecasting four quarters of recession, ending with the second quarter of 2009. Given that the markets generally turn up 4 to 6 months before the economy bottoms, the stock market should start back up no later than late January, 2009. Given also that the current rally is expected to end anywhere from late November to late January, the October 10th intra-day low of 840 might mark the low point on the S&P 500 for this bear market. In the meantime, Minyanville's Kevin Depew states: "I believe the magnitude of this bear market is far greater than 2002 but is being vastly underestimated by policymakers and investors." I'm disposed to believe Kevin Depew and the other pundits who foresee a deeper, darker, longer period of economic malaise than Mr. Stovall is projecting. I've lost too much money this past year listening to business-as-usual pundits with batting averages of zero.
 Reconciling conflicting expert opinions
    When we read the conflicting opinions of experts, we're always left with the question, "Which expert is right?" Reading conflicting experts' opinions has the effect of negating any expert advice they might give us--like reading a weather report that says, "Today will be warm and sunny, unless there's a violent thunderstorm, followed by heavy snow." The problem is: the experts don't know. Here, for example, is yesterday's column written by Nobel-Prize-winning economist Paul Krugman: When Consumers Capitulate.Which brings me to the question: what about all these ads telling us how we can make tons of money if we'll only subscribe to their news service? And that brings us to Mark Hulbert's Hulbert Financial Digest, the "Consumers Reports" for financial newsletters. If you actually follow the advice offered by these newsletters, you'll usually lose your shirt. Only two newsletters have outperformed over the long haul: John Buckingham's (formerly Al Frank's) The Prudent Speculator, and Janet Brown's No-Load Fund X. These newsletters have averaged between 16% and 19% per year (depending upon when you compute these averages) over the 28 years that Mark Hulbert has been publishing his newsletters. Several others have beaten the markets over the long haul, although not by as much as the two front-runners. Other newsletters have performed better, and even much better, over the past five years, and they may outperform from here on out, but they haven't had time to develop the long-term track records of the two frontrunners. As for the newsletters that promise huge gains in six months, these are generally snake-oil salesmen who play upon our perceptions that others who are "in the know" are doing hugely better than we are. But I would suggest that Nobel Prize-winning economists don't know with certainty what's going to happen next, and that those who talk with great assurance and who appear to have deep understanding don't know what they're talking about. If they did, they wouldn't be talking about it, and wouldn't be selling you advice. They'd be trading their own accounts, and keeping very quiet about it. "Those who know don't talk, and those who talk don't know."
    More about this later.

To be continued.