[THS] Draining national prosperity

[Peter Webster]

http://www.atimes.com/atimes/Global_Economy/JE07Dj02.html

May 7, 2008


THE BEAR'S LAIR
Draining national prosperity
By Martin Hutchinson

The 0.6% rise in first quarter US gross domestic product was greeted with
considerable relief by most Wall Street commentators. They had expected
the chaos in the housing market and the banking system to have pushed
the US economy into recession. This was unreasonable. The huge monetary
stimulus being hurled at the economy was always likely to prevent
immediate recession, while the fiscal stimulus of the US$110 billion rebate
package is likely to prop it up through July or so. Beyond that, the future
becomes less clear: at some stage the monetary and fiscal stimulus must
run out.

As I have frequently written, monetary conditions have been pretty
lax since 1995. It had been becoming difficult to determine how lax since
March 2006, when the Federal Reserve stopped reporting M3 money
supply, the measure used in by the European Central Bank and other
monetarist organizations. However the St Louis Fed, which for the decade
until April was run by the monetarist William Poole, has constructed its own
measure of broad money, Money of Zero Maturity, which is a reasonable
proxy for M3; it consists of M2 plus institutional money market funds minus
small time deposits. Like M3, MZM began to expand excessively in early
1995; in the 13 years to March 2008 it grew at an average annual rate of
8.88%, compared with growth in nominal GDP during that period of 5.25%.

Thus monetary policy, however measured, has been excessively
expansionary since 1995, in the sense of expanding the money supply
faster than output. As I have written previously, the inflation-creating effect
of this excessive monetary expansion has been suppressed for a decade by
the Internet, which has had a similar deflationary effect through enabling
outsourcing to cheap labor countries that the railroads and refrigeration did
in the 1880s through allowing cheap agricultural produce from the Midwest,
Canada, Australia and Argentina to be shipped worldwide.

>From the beginning of 2008, however, monetary expansion has sharply
accelerated. In the three months to April 21, the latest data available, MZM
expanded at an annual rate of no less than 28.7%. This extra-rapid
expansion is not surprising; the Fed has been terrified that the US financial
system is about to collapse and has been making funding available in large
quantities in a variety of ways. Indeed, on May 2, the Fed, concerned about
the credit-card financing market, allowed banks to use credit-card-backed
AAA bonds as security for Fed loans. Needless to say this involves yet more
monetary expansion and further risk to the taxpayer. Monetary stimulus of
this extraordinary magnitude will have an effect. It has to.

Other countries have also been expanding their money supply excessively.
The European Central bank has allowed euro M3 to expand by 11.1% in
the three months to March 2008, following an increase of 11.5% during
2007. As in the United States, this increase is much faster than that of
nominal GDP and it had been continuing for several years, with annual
growth rates of 7.4% in 2005 and 10.0% in 2006. Of the major emerging
markets, China and India have both been operating expansionary monetary
policies and now have considerable inflation problems. Vietnam too has
been surprised in spite of its rapid growth by inflation surging towards
25%. Only in Japan, where "broadly-defined liquidity" has been increasing
at rates in the 3-4% range in 2006-08, has monetary policy been
reasonably consistent with low inflation.

Monetary stimulus generally works with a lag of several months at a
minimum. Thus it is likely that the extremely lax monetary conditions of the
past few months have not yet produced their full effect. Nevertheless it is
remarkable how rapid has been the advance of energy and commodity
prices, with the Reuters CRB commodity price index up 24% since the Fed
began its misguided interest rate cutting campaign on September 18 last
year.

It is also remarkable how feeble growth in the United States has been. With
the Fed essentially printing money as fast as it could, the US economy grew
only 0.6% in each of the fourth and first quarters. Since the US population
increases by around 1% per capita, the economy has thus been in a per
capita recession since September. In the first quarter indeed, even ignoring
population growth, the economy was only pushed above the flatline by
increases in inventory and government spending, both detrimental to
economic output in the long term.

Over the next several months, it is likely that current trends of feebly
advancing GDP and soaring commodity prices will continue. Certainly the
stock market seems to think so; it has recovered nicely from its mid-March
low and is now above the levels when the crisis hit last August, even though
earnings in the financial sector, representing more than 40% of total US
earnings before crisis hit, have essentially disappeared in the last two
quarters. The Fed may not at present intend to push interest rates down
further, but it has already forced them more than 2% below even the
thoroughly fudged statistics of inflation produced by the Bureau of Labor
Statistics.

It is perhaps disappointing for bears that a crisis may not occur
immediately, but there can be no question that the vigorous monetary and
fiscal medicine administered by the Ben Bernanke Federal Reserve and the
George W Bush administration will have its effect. Indeed, far from
declining in the second quarter, as has been confidently predicted, gross
domestic product may even tick up a bit, boosted by monetary and fiscal
stimulus, perhaps to around 2% or 1% after population increase has been
taken into account.

At some point, a crisis will arrive. Inflation in the eurozone, China and India
is already at levels deemed unacceptable, while even Japan has positive
inflation for the first time in many years. In the United States, the producer
price index increased 6.9% in the year to March, while that for crude goods
increased more than 30%. Like a bowling ball swallowed by a python, that
inflation will move through the economic system and eventually be reflected
in consumer prices.

Indeed, it may already be showing up there; the seasonally unadjusted
consumer price index for March was up 0.9% (an annual rate of around
11%) and only a heroic seasonal adjustment of 0.6%, double the next-
largest seasonal adjustment for any month in the last 10 years, brought the
figure down to an acceptable 0.3%.

The Bureau of Labor Statistics explains on its website that its seasonal
adjustment methodology changed in January; should it be the case that
this is being used to suppress consumer price inflation, even the dozier
members of the media will come to notice after another couple of months
have passed. In any case, it is likely that by the latter part of 2008,
consumer price inflation in the US will be running at more than 10% and
that even the heroic mavens at the BLS will be unable to suppress that
information completely (though on past form they will undoubtedly try.)

There will come a point at which the irresistible force of gradually increasing
GDP and continually optimistic stock market will meet the immovable object
of consumer price figures that can no longer be ignored. At that point, the
US will suffer not merely a monetary crisis but a political crisis. President
Bush, with his refusal to see recession, Treasury Secretary Hank Paulson,
with his background in an institution (Goldman Sachs) and a market (the
Wall Street of 1995-2007) that together bear a very substantial responsibility
for the problem, and Bush’s Fed appointee (chairman Bernanke), with his
continual insistence that inflation is imminently about to disappear, will be
discredited by reality and unable to provide leadership. Awkwardly, it is
more likely than not that the crisis point will occur before November, so
there will be no fresh-faced president-elect to take control of the situation.

Almost certainly, it will prove impossible to put the entire US economy on ice
until January 20, 2009, so the financial markets themselves, probably the
Treasury bond market, will take control. With the US Treasury’s funding
need in the fiscal years 2008 and 2009 already around $500 billion in each
year, hiccups in the bond market have an almost immediate way of making
themselves felt. To avoid a collapse in the bond market and a catastrophic
decline in the dollar as foreign central banks withdraw their money, short-
term interest rates will have to be raised very quickly to at least 3% above
the then prevailing level of inflation. That would imply a level of 7-8%
today, but probably considerably more by the time the crisis hits.

Once interest rates have been raised, inflation will not decline immediately,
but nor will the US descend into a re-run of the Great Depression. There
will be a lengthy and grinding recession, probably persisting throughout
2009 and into 2010, with GDP declining maybe 4-5% from top to bottom
and inflation coming definitively under control only towards the end of the
period.

On the other hand, the dollar will stop being weak, since US interest rates
will be internationally attractive, and the US balance of payments position
will swing back sharply towards balance as US consumption and therefore
imports decline sharply. The US savings rate will also increase, allowing the
country to finance new capital investment from domestic resources, and
giving it once more a substantial capital cost advantage over the emerging
markets with lower labor costs.

The wild card will be politics. It is not yet clear who will be the next
president, and it is abundantly clear that this pretty unpleasant economic
environment will dominate that president’s first two years in office. As
happened to Herbert Hoover, it will be possible for the new president
and/or Congress, through misguided protectionist or anti-capitalist policies,
to make things sufficiently worse that a Great Depression Mark II ensues.

Since none of the three remaining leading presidential candidates has a
firm, well thought-out commitment to economic policies that would alleviate
or solve the problem, and all have tendencies that might exacerbate it, the
safest choice is probably to go for raw intelligence, and hope that the new
president can learn on the job.

Which is as close as this column is going to get to an endorsement!

Martin Hutchinson is the author of Great Conservatives (Academica Press,
2005) - details can be found at www.greatconservatives.com.

(Republished with permission from PrudentBear.com. Copyright 2005-07
David W Tice & Associates.)