Economic Dreams - Economic Nightmares

Housing Crash Recession Coming, says Dean Baker

Dean Baker joins with others (e.g., here), adding his two-cents worth once again on impending, housing market crash recessionary gloom. From his blog and a linked paper, we find the plot continuing to thicken…

Housing Crash Recession Coming [12/04/06]: …The Commerce Department reported that non-residential construction fell by 0.7 percent in October following a downwardly revised fall of 0.6 percent in September.

This should put to an end silly claims that growth in the non-residential sector would offset plummeting residential construction. The residential sector is twice as large as the non-residential sector, which by itself made such an offset unlikely. Furthermore, there was no basis for any sustained boom in the non-residential sector. There is still plenty of vacant office space, retail stores are cutting back, the manufacturing sector is stagnant or declining -- what would support a boom?

Friday's data also included a release from the Institute of Supply Management that showed the manufacturing sector declining in November and weaker than expectd car sales. In addition, on Thursday we had a sharp jump in weekly unemployment claims (erratic data, but serious cause for concern). Throw in earlier releases showing declining orders for durables goods in both September and October and the continued decline in house sales and prices and you have what could be the beginning of a recession. …

Recession Looms for the U.S. Economy in 2007 [PDF]
November 2007, Dean Baker
[In depth, on: Housing, Consumption, Investment, Exports and Imports, Government Spending, Job Growth, Inflation, Interest Rates and the Dollar, After 2007... ]

Recession Ahead: Krugman and Roach Sound Alarms

December dawns with bad tidings of great foreboding. Both Paul Krugman and Stephen Roach are strident today, reading 'tea leaves' from the bond market and more.

Economic Storm Signals {$], by Paul Krugman, Tough 2007, Commentary, NY Times [12/01/06]:…[T]he bond market, which has a pretty good record of forecasting recessions, is pointing toward a serious economic slowdown next year. …[M]ost forecasters are still telling us not to worry. So whom should you listen to? And how can you avoid believing what you want to believe?

Maybe the best answer is to look at what the financial markets say. Not the stock market, which is a notoriously bad indicator of the economy’s direction, but the bond market. (Paul Samuelson, the Nobel Prize-winning ... economist, famously quipped that the stock market had predicted nine of the last five recessions).

Since last summer, when the housing bust became unmistakable, interest rates on long-term bonds have fallen sharply. They’re now yielding much less than short-term bonds. The fact that investors are willing to buy those long-term bonds anyway tells us that these investors expect interest rates to fall. And that will happen only if the economy weakens, forcing the Federal Reserve to cut rates. So bond buyers are, in effect, betting on a future economic slowdown.

How serious a slump is the bond market predicting? Pretty serious. Right now, statistical models ... give roughly even odds that we’re about to experience a formal recession. And since even a slowdown that doesn’t formally qualify as a recession can lead to a sharp rise in unemployment, the odds are very good — maybe 2 to 1 — that 2007 will be a very tough year. [More (and good commentary) from Mark Thoma's blog, Hat Tip!]

Unprepared in Beijing, by Stephen Roach, Morgan Stanley [12/01/06]: Taking its cue from a powerful liquidity cycle and the frothy financial market conditions it has inspired, the world is not prepared for a meaningful shortfall of US economic growth. …[M]ost remain in denial over the swift and sudden deterioration in the US economy. That's true in China, as well as in the United States and elsewhere around the world. Yet there are now signs of cumulative weakness in the US economy that have all the classic manifestations of a looming cyclical downturn. …

Adding it all up -- housing, consumption, capex, together with an upward revision to 3Q06 inventory building -- and the US economy may be on the brink of its second post-bubble recession in five years. A surging bond market and a weaker dollar appear to be alone among major asset classes in figuring this out. I continue to fear the implications of that realization for other markets -- especially equities and spread products, which remain priced for the veritable absence of any risk.

All this is a long way away from the hustle and bustle of Beijing. China's performance has been so impressive for so long that I sense a growing tendency to take the boom for granted. Reflecting this belief, I am starting to detect an important shift in the Chinese mood, with long-entrenched feelings of self-doubt now giving way to a new-found confidence. There's nothing wrong with confidence -- it can be a critical element of any successful economic development strategy. But confidence must be on solid ground to fuel sustainable growth. Lacking in support from internal private consumption, the Chinese confidence factor is increasingly dependent on a powerful export-led growth dynamic and associated gains in fixed investment -- both very much tied to the open-ended expansion of China's outward-looking export production platform. This could turn into a surprisingly precarious situation. What happens if the narrow underpinnings of China's growth strategy are undermined by the twin surprises of Washington-led protectionism and a sudden deterioration in the US economy? Beijing is unprepared for either of those possibilities -- as is, I'm afraid, the rest of the world.

Inverted Yield Curve Chatter

There has been "much ado" about the Inverted Yield Curve lately. James Hamilton at Econbrowser's has one of the best summaries in his Dec. 29 Who's Afraid of the Big Bad Yield Curve is a good place to start. Hamilton stresses two points:

…The first thing to emphasize about this relationship is that it's not a sure thing. For example, in 1995:IV the spread was near its current low level of 11 basis points, and yet we saw 3.9% average growth between 1995:IV and 1997:I. In 1965:I and 1965:II the spread was 17 basis points, only a little higher than its current value, and the economy boomed at a 6-7% growth rate. Instead, the correlation summarizes an average or typical tendency-- in 84% of the quarters in which we saw a spread as low as its current value or lower, subsequent growth came in slower than the historical 3.3% average.

A second point worth emphasizing (which I also discussed at length here) is that this is not something that only matters when the yield curve completely inverts or the spread becomes negative. Rather, the scatter diagram above suggests a gradual concern-- the narrower the gap between long- and short-term rates, the slower growth we can usually expect to see.

Another good reference is Wharton's Finance and Investment: Don’t' Sweat the Inverted Yield Curve: No On Really Knows What it Means:

...Given all the factors that can be affecting today's yield curve, a looming recession can hardly be considered a certainty. But that cannot be entirely ruled out, either, notes Francis X. Diebold, professor of economics, finance and statistics at Wharton.

In fact, most recessions have been preceded by inverted yield curves, as traders anticipate a Fed rate reduction to stimulate the economy, he points out. "I'm not going around saying there's a recession coming." But he notes that the future is not necessarily rosy, either. "The bond market doesn't seem to be as worried about inflation as I am," he adds, arguing that growing demand for oil by China, India and other countries will continue to put upward pressure on energy prices, contributing to broader inflation. ...

Bernanke to Inherit a Fed Without Good Policy Options?

On this evening’s PBS Newshour with Jim Lehrer, James Galbraith, chair in government and business relations at the LBJ School of Public Affairs at the University of Texas, said that inflation indexing will prove difficult for Ben Bernanke as Fed Chairman due to short term and longer-term challenges.

In the short term twin, competing challenges face the nominated and almost certain to be confirmed, incoming Chairman. The first challenge is to deal with increasing interest rates to choke off inflation while being careful not to invert the yield curve, which could usher in a recession. A competing challenge is that any pause in increasing interest rates to avoid a recession could well usher-in more inflation.

Longer term the challenges are to deal with interest rates, dollar strength, and the worsening outlook and actuality of jobs for US workers in a globally unbalanced world.

Last Friday Northern Trust’s Paul Kasriel dealt with the same shorter-term issue in The Fed: No Way Out? [pdf] Kasriel concludes:

The Fed’s current dilemma is similar to that faced by a central bank confronted with hyperinflation. In the case of a hyperinflation, the real money supply is often contracting because prices are rising faster than nominal money supply growth. The central bank comes under pressure to print money faster in order to get the real money supply growing again. But for the central bank to succumb to this pressure, would only accelerate price increases.

This is not to say that we face the abyss of hyperinflation. We don’t. But it is to say that the Fed is running out of “good” policy options. Such is the destiny of central planners.

Such is the fate indeed, if central planners don’t allow for recessions in their political economic decision-making. And which politicians are going to sit idly by while a Fed Chairman orchestrates public policy to kill ongoing, if irrational, exhuberance? See also, Inflation Targeting—Some Preliminary Thoughts [pdf] , Asha Bangalore, Northern Trust, 10/24/05.

Update 10/25: Mark Thoma has a good post on Bernanke's Inflation Targeting/Inflation Fighting

Excess Liquidity v. Credit Bubbles

In a recent post at macroblog, David Altig makes the point, "Broad money growth in the 4-6 percent range with nominal GDP growing at a 5-6 percent annual rate just doesn't spell excess liquidity to me." Considered in isloation, it doesn’t spell excess liquidity to me either. But can monetary authorities responsibly look at such in isloation? I note in comments on Altig's post that I cant' tell exactly where Altig stands on the matter, but thought I'd attempt to stimulate some further discussion by clouding the waters with "credit bubble" chatter. Here's most of it:

Some argue that despite what appears to be less-than-excess liquidity when viewed narrowly, there are problems with such tunnel-vision. Prudent Bear’s Doug Noland is one of these, as followers of his Credit Bubble Bulletin are well aware. Here are snips from Doug Noland's latest CBB

Broad money supply (M3) expanded $5.4 billion to a record $9.779 Trillion (week of August 8). Year-to-date, M3 has expanded at a 5.1% rate, with M3-less Money Funds expanding at a 6.4% pace. For the week, Currency declined $0.7 billion. Demand & Checkable Deposits declined $9.4 billion. Savings Deposits dipped $3.8 billion. Small Denominated Deposits rose $3.5 billion. Retail Money Fund deposits fell $1.9 billion, while Institutional Money Fund deposits added $0.5 billion. Large Denominated Deposits jumped $10.8 billion, with a y-t-d gain of $147.4 billion (22% annualized). For the week, Repurchase Agreements gained $6.4 billion, while Eurodollar deposits were unchanged.

Bank Credit rose $5.5 billion last week. Year-to-date, Bank Credit has expanded $549.5 billion, or 13.2% annualized. Securities Credit declined $11.3 billion during the week, with a year-to-date gain of $133.9 billion (11.3% ann.). Loans & Leases have expanded at a 14.3% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 17.8%. For the week, C&I loans declined $1.9 billion, while Real Estate loans expanded $7.8 billion. Real Estate loans have expanded at a 16.6% rate during the first 32 weeks of 2005 to $2.802 Trillion. Real Estate loans were up $380 billion, or 15.7%, over the past 52 weeks. For the week, Consumer loans added $1.7 billion, and Securities loans jumped $10.5 billion. Other loans dipped $1.2 billion.

Total Commercial Paper jumped $13.3 billion last week to $1.588 Trillion. Total CP has expanded $174 billion y-t-d, a rate of 19.4% (up 17.7% over the past 52 weeks). Financial CP surged $13.7 billion last week to $1.446 Trillion, with a y-t-d gain of $161.8 billion (19.9% ann.). Non-financial CP dipped $0.4 billion to $141.8 billion (up 15.0% ann. y-t-d and 9.9% over 52 wks). ...

Here is a link to Noland’s encapsuled view of the emergent world, titled “Contemplating the Evolution from the Way We Were to the Way it Is." [pdf]

One snippet:

Nowadays, Federal Reserve operations work mainly by aggressively manipulating rates, yield spreads and, increasingly, market perceptions. In the process, the new 'tool kit' bolsters leveraged speculation and unparalleled Credit Availability. The key analytical point is that the effects of today’s operations are so much more disparate and unpredictable than when the Fed was managing the bank reserve 'anchor.' I would argue that the Fed is now held hostage to the markets – financial and real estate – and particularly to endemic Credit market leveraged speculation. In short, financial and central bank evolution has parented a mutant, uncontrollable Credit System. There is no financial system anchor, while the Fed’s new 'tool kit' emboldens speculators and nurtures excess.

Can one be comfortable these days only looking at M3 when talking about "liquidity?" Aren't these other credit expansion indicators worth considering as well? Noland and others argue that the creation of liquidity is much broader than what central bankers monitor. And that, he contends, is a big problem for us all.

I asked folks at Altig’s site whether Noland's thesis has any merit, and “If not, why not?” I noted that I’ve been looking to debunk Noland’s thesis for several years, but haven’t yet found a credible counterargument. This is not to discredit Noland work which I admire. It is, rather, to admit that I may be in error in believing that Noland's theory helps to better explain today's world.