Starting with the tulip bulb mania in the 1630s, bubble after speculative bubble has been erased from the popular memory: the South Sea bubble in the early 1700s; the Mississippi bubble, which caused a stock market crash in 18th-century France; the Florida real-estate bubble in the 1920s; the stock market crash of 1929; the stock market crash of 1987; the Nikkei bubble, which began in 1991; and the Nasdaq bubble of 2000 [and now the Housing Bubble of 2006]
—from Saving Capitalism and Ending Poverty
The speculative bubble always comes to an end--and never in a pleasant or peaceful way
—John Kenneth Galbraith, quoted in 1999
The rise in oil prices (and commodities generally) driven by speculation that I described in Mr. Market Gets It Wrong Again is now the conventional wisdom among observers who aren't directly vested in blowing a new bubble. The economy is on its knees, but Americans must cope with daily increases in the price of gasoline.
Higher oil prices drive up fuel costs, which dampens consumer spending on other goods.
"People say it doesn't matter until gas gets to $3 or $4 a gallon," said Peter Beutel, an oil analyst at Cameron Hanover. "But every time it goes higher it takes that much more money out of consumers pockets."
Beutel can even tell you how much. For every 10 cent rise in gas price, people can spend $40 million less a day on other things...
"Crude oil prices appear to have been divorced from the underlying fundamentals of weak demand, ample supply, and high inventories," Adam Sieminski, chief energy economist at Deutsche Bank, wrote in a recent note.
So far, so good, but then this CNN Money story takes an odd turn.
The rise in [oil] prices is instead being driven by a falling dollar and investor interest.
A falling dollar is causing oil to rise as investors buy crude as an inflation hedge. Money is also coming out of bonds and other safe haven investments and back into oil, stocks and riskier assets as early signs suggest the economy may be improving.
[My note: The falling dollar/inflation hedge angle is correct.]
While motorists may be miffed to learn that Wall Street is the main driver for the recent run-up in fuel prices, it's probably not such a bad thing that investors are expressing confidence in the economy. Renewed lending and job creation will likely outweigh any pain people may feel from paying higher gas prices.
Whoa, Nelly! Job creation? Renewed lending? This is hogwash. Here's another example from Reuters' James Pethokoukis, who is blogging on money & politics.
"There is a debate going on whether the spare capacity opening up will allow inflation to stay low for a prolonged period of time, but markets don't seem to be buying this view," said Sarah Hewin, senior economist at Standard Chartered.
Markets' inflation fears appear to stem from the potential impact of quantitative easing, as well as the recent slew of positive economic data, Hewin said.
But she added: "We don't buy the view that the extent of QE we have seen will bring a resurgence of inflation -- at least until the end of 2010 and we think U.S. Treasury yields may have backed up too far."
Hewin is probably right to say that a new resurgence of inflation will be delayed until sometime in 2010, but a recent slew of positive economic data? Give me a break!
Although brilliant self-deception allows most of us to get through life, I don't think now is the time to rely on that often helpful quality.
A plausible, albeit unpleasant, view of the future is emerging which explains heightened inflation expectations contributing to bubbly speculation in commodities. Baseline Scenario's Simon Johnson and Peter Boone outline this trend in The Bubble Next Time. I will return to this article, but here is their conclusion.
The balance of global power is shifting. Japan was perceived as a great powerhouse until 1990 — deflation, the lost decade, and demographic decline have ended that. America and Europe both have years ahead of low interest rates, balance-sheet problems, and sluggish growth. Brazil, China, South Korea, Russia and the like used to be called emerging markets; now they’ll be known simply as the New Rich.
This view, if correct, has profound implications for economic conditions in the OECD (developed) nations and future global energy consumption. Let's start with the prognosis for the United States.
Dim Prospects for Consumption
The credit & debt bubble in the United States is unwinding. Many Americans are down for the count, and will likely lie prone on the canvas for some time to come. The economic fundamentals are absolutely clear on this point as shown in the first three graphs.
Figure 1 — The net worth of American households from Calculated Risk, based on data in the latest Flow of Funds Report from the Fed. You can see the bubbles. Net worth has fallen back to a value typical of the period 1987-1995. Will we see household net worth fall to levels last seen in the 1970s?
Figure 2 — Taken from Jobless Recovery Redux? from the San Francisco Fed. Calculated Risk provides data on previous jobless recoveries. Unemployment rose for 15 months after the 1990 recession officially ended. Unemployment rose for 19 months after the 2001 recession officially ended. The official U3 unemployment number is 9.4%, well below recent Blue Chip (and Fed) forecasts. The U6 number, which includes people whose hours have been cut back and those who have given up looking for work, is 16.4%. The current "Great Recession" is far worse than 1990 or 2001. The "jobless recovery" shown is probably too optimistic, but still shows U3 unemployment above 9% in 2012. The San Francisco Fed reports that there are additional reasons for pessimism, for example "[the data] suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates."
Figure 3 — Mortgage debt (blue lines) versus equity (red line) from 1945 to the present, taken from T2 Partners' More Mortgage Meltdown. They estimate that house prices must fall another 5-10% before reaching the longer term (Case-Shiller, Lawler) trend line, but typically in a post-bubble period prices fall below the trend line before bouncing up again.
This data represents a small but significant subset of all the trends showing the deterioration of conditions on Main Street. It is easy to reach the following conclusions—
- Growing mortgage debt driving lower household net worth will depress consumer spending in coming years. It will take at least two more years for house prices bottom-out.
- Growing unemployment through mid-2010 combined with high jobless rates thereafter will also depress consumer spending in coming years. Remember, the U6 (all the unemployed and unwillingly underemployed) is now at 16.4% and will likely surpass 20% before the worst is over. Is the Employment Picture Really Better Now Than in 1933? gives an interesting perspective on this problem.
Personal Consumption Expenditures (PCE) made up 72% of 2009:Q1 Gross Domestic Product (GDP, output) according to the preliminary numbers provided by the Bureau of Economic Analysis. It appears that no significant turnaround in consumption is possible before 2012 in the best case. Even if the NBER were to call (in retrospect) an end to the Great Recession in the 2nd half of this year or the 1st half of 2010, GDP growth will be sluggish at best for quite some time thereafter.
What is obvious to me and untainted economists will also be obvious to analysts getting paid to advise Wall Street banks, hedge funds and private equity.
Future Investments In the United States?
It is hardly an exaggeration to say that when the dust settles, Too-Big-To-Fail Finance will be in better shape than any other segment of our economy. The Treasury (with Congressional approval) and the Fed have paid off (socialized) the bank losses and guaranteed bailouts on future losses. Quantitative easing makes their product—money—dirt cheap. If you can obtain money at little or no expense to yourself and then lend it out at higher rates of interest, the future looks very bright indeed.
There is no compelling reason to believe the trends shown in Figure 4 will not continue after the Great Recession ends.
Figure 4 — Financial profits share of GDP versus debt as a percentage of GDP. T2 Partners made this graph based on Federal Reserve and BEA data as of 2007:Q2. The debt line (red line) may flatten out a bit but is unlikely to decrease. The recent disruption of financial profits (black line) is temporary. Bank losses were covered by the Treasury and the Fed. The remaining banks will be stronger than ever.
When the downturn bottoms out, the banks will be flush with money made available by the Federal Reserve. Quantitative easing and deficit spending will continue because tightening interest rates or cutting government spending would put us back into the Great Recession, Phase II. Our debt will continue to be backed by the Chinese, Japan, oil exporters and many others for the time being. Paul Krugman is urging policymakers to stay the course, and I believe they will.
The rationale of Paulson, Summers, Geithner & Company for saving the banks—we will foster a recovery by getting credit flowing again to over-leveraged consumers—looks like a cruel hoax when viewed in light of fundamental data shown in Figures 1-4. And continuing the spending spree, wherein we borrow from the future to provide artificial lift to the present, is ultimately a Disaster of Biblical Proportions—one can easily imagine a day when 50% of government expenditures go toward interest on the debt, but that's not my main focus today.
Getting back to Big Finance, the only remaining question for them is: where will they invest all that cash? It won't be in the United States.
Many parts of the American landscape resemble a burnt out husk. Take commercial real estate (New York Times, June 8, 2009)—
Talk of American infrastructure tends to focus on inadequacies: roads that need to be repaired or widened, bridges fortified, electrical grids updated. All the more striking, then, that America’s retail infrastructure — its malls, supercenters, big boxes and other styles of store-clumping — has come to be characterized by rampant abundance. This has been a decades-long trend. But it has taken the economic downturn, with chain stores liquidating, mall tenancy slipping and car dealerships scheduled for closure, to focus popular attention on the problem with our retail infrastructure: there is too much of it.
A recent book, Retrofitting Suburbia, by Ellen Dunham-Jones and June Williamson, notes that in 1986, the United States had about 15 square feet of retail space per person in shopping centers. That was already a world-leading figure, but by 2003 it had increased by a third, to 20 square feet. The next countries on the list are Canada (13 square feet per person) and Australia (6.5 square feet); the highest figure in Europe is in Sweden, with 3 square feet per person.
Allow me to repeat Figure 5 from my article Let It Burn.
Figure 5 — FIRING UP the economy. From Calculated Risk’s early report on government stress testing for banks. Note the relative size of residential mortgage + home equity + commercial real estate + credit cards (taken together) as opposed to commercial/industrial loans. The numbers cited are for potential losses, but the absolute sizes can be calculated by using the loss numbers and the percentages.
As with overbuilt commercial real estate, making large future investments in residential mortgages, home equity, and credit cards amounts to throwing good money after bad. Let's return to Simon Johnson and Peter Boone's thesis of a great economic shift in from West to East and South.
The Bubble Next Time
The new credit & debt bubble will take place in Asia, South America and "even Africa."
The next global bubble is already under way. What happens when the most powerful nation in the world, with a reserve currency everyone trusts and holds, decides to push a big credit expansion — again, at the instigation of our financial sector? The creditworthy borrowers this time are not in the United States — they are in Asia, Latin America, and even Africa. They have little debt and great prospects; for a mere 1 percent per year they can borrow American dollars, spend the funds at home, and turn paper money into real assets. Every great bubble begins with a truly convincing shift in fundamentals.
In the 1990s this was called the “carry trade.” You borrowed from the Japanese at 1 percent and bought anything outside Japan that yielded a bit more (including United States subprime mortgages). The coming American carry trade is the same thing: it weakens the dollar, lifts the economy out of recession through exports, and creates inflation that reduces the real value of our debts. This can last quite a while — both the Treasury and the Fed are sure that early attempts to tighten policy prevented serious recoveries in Japan in the mid-1990s and in the United States toward the end of the 1930s.
I could quarrel with the idea that the American "carry trade" will "lift [our] economy out of recession through exports" but the rest—a weakened dollar, inflating away the debt—looks right.
I keep wondering what it is we will export. Software? No, we export software jobs. Cars and auto parts? That part of our shrinking manufacturing sector just took a huge hit. Caterpillar excavators and pipe layers? Probably, yes. Semiconductors, pharmaceutical preparations, and telecommunications equipment? Yes. Farm (food) exports? Yes, again.
But is all of this enough to turn sluggish growth into prosperity? A weakened dollar makes imports more expensive, which reduces them. The same inflated dollar encourages exports. But without a massive infusion of new investment in America's manufacturing base, there are limits on how much our exports can grow. Will these investments get made? (I discussed the importance of exports/imports for the U.S. economy in Real GDP and the Oil Shock of 2007-08).
Mostly, the United States will export credit.
The new bubble remains in its formative stages because the global economy is still in terrible shape, as detailed in Martin Wolf's The recession tracks the Great Depression (Financial Times, June 16, 2009). As the emerging economies crawl out of the muck created by the collapse of the Housing Bubble and the Oil Shock, banks on Wall Street, in London, Switzerland, and Paris, in Tokyo, in Dubai or Singapore, and offshore in the Caymans will be able & eager to provide inexpensive dollars to emerging economies to get them back on a rapid growth track.
Johnson and Boone conclude—
Perhaps this is the greatest foreign-aid package of all time. But are we [in the United States] re-establishing our global leadership, albeit in a strange way, or just throwing all pretense to strategic leadership out the window? And are we laying the foundation for a truly massive international debt crisis?
We're not re-establishing our global leadership, that's for sure.
A Dress Rehearsal
From Main Street's point of view, the current "rally" in oil prices and the S&P 500 is a lot of hot air. The alleged "green shoots" benefit monied interests in New York.
Fed officials take comfort in other developments in financial markets. Though mortgage rates have risen, many other private-sector borrowing rates are coming down. For example, the London interbank offered rate [LIBOR] -- the rate at which banks make short-term loans to one another -- has declined. Rising stock prices are also helping improve financial conditions and bolster household wealth.
I'm sure families who are losing their house—they can't refinance now because of the rise in mortgage interest rates—will be overjoyed to hear that the LIBOR interbank lending rate has declined. Reporters at CNN Money and other fish swimming in the Wall Street water pick up the "green shoots" theme and mindlessly repeat it. I heard one CNBC commentator say he wished consumers would join the rally and spend more money!
Life is pain, and anyone who tells you different is selling something.
Simon Johnson recently posted a Five Point Summary of where we stand. Items #4 and #5 are of interest here.
4. The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before late 2010. The financial markets beg to differ – presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide. In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed. My advice: pay close attention to oil prices.
5. Emerging markets are increasingly viewed as having “decoupled” from the US/European malaise. This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble – based on a “carry trade” that now runs out of the US. The ”appetite for risk” among investors is up sharply. The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.
I do pay close attention to oil prices, and being somewhat knowledgeable about them, I believe a purely speculative play must collapse. To be successful, a bubble must be grounded in reality. You can't have a Housing Bubble if nobody wants houses. You can't have an oil price shock if demand for the stuff is about 4 million barrels-per-day below capacity.
The price may not crash all the way down to $25/barrel as I said in Mr. Market, but come August and September, the blue skies of Spring will give way to the storm clouds of Fall.
Along with Simon Johnson, I believe easy credit (aka. quantative easing) will eventually lead to "dollar depreciation, higher import prices, and potential commodity price inflation worldwide." But not yet. It's illuminating to observe the religious war that has broken out among economists.
Something akin to a religious war has erupted among economists on the next move for the Fed. One camp worries that higher long-term interest rates could choke off the recovery. As a result, they argue the Fed should ramp up its purchases of Treasuries to push rates lower. Others think rising rates are a clear signal that the market is worried about inflation. They want the central bank to check out of the Zero Interest Rate hotel as soon as possible.
To counter the financial crisis, the Fed has raised new reserves for the banking system to almost $900 billion by purchasing all sorts of assets, including toxic mortgages, from the banks. Some economists think these reserves are inflation-rocket-fuel.
Others argue that the reserves are not really money because they are not being used. They think the reserves could be drained before spilling over into the market.
"The Fed is not printing money and passing it out on the street corner so it jingles in everyone's pocket," said Jim Glassman, senior economist at JP Morgan Chase.
[My note: No kidding, Jim. Note to Helicopter Ben: send some of that money our way!]
"There is almost a semi-religious view that money, in-and-of-itself, causes inflation," said Bill Cheney, chief economist at John Hancock Financial Services, in Boston. "Money, sitting it a bank as excess reserves, won't do anything. Half of the problem with the economy now is that consumers aren't doing anything with it," Cheney added.
[My note: Why do you think consumers aren't doing anything with it, Jim? And also, the last time I checked earlier in this article, consumer spending was 72% of GDP.]
The markets don't believe "excess reserves" ($900 billion) parked at the Federal Reserve will be "drained" without being loaned out. I can't take this outcome seriously either. Americans trying to repair balance their sheets don't need more credit, but perhaps would-be consumers in Morocco, Malaysia, Chile, Egypt, Brazil and India might be able to put it to good use.
Nevertheless, commodity traders pricing in their expectations about inflation are doing so too early. Indeed, such trading is self-fulfilling because bidding up oil contributes to inflation. The state of the global economy does not justify bidding up oil.
We are now witnessing a dress rehearsal for The Bubble Next Time. The current commodity inflation foreshadows the real thing, which I expect to begin in earnest next year or the next. Finance types are chomping at the bit to blow a new bubble—Simon Johnson called this a heightened "appetite for risk." Our outsized banking sector, which has been the beneficiary of so much government largess and lack of regulation, will have free rein in this matter.
Johnson notes that "emerging markets are increasingly viewed as having decoupled from the US/European malaise." He believes this is an illusion that will foster the carry trade bubble. It is an illusion, but here's the bottom line for the longer term—
The pain for Asian economies, means they have to rethink the old model of "Asians make it, Americans buy it," and start boosting domestic consumption, Masahiro Kawai of the Asian Development Bank (ADB) Institute said last week.
"This pattern (of US consumption propping up Asian growth) is rapidly changing and I believe that this change is not simply a temporary phenomenon. It is going to be more permanent, or at least semi-permanent," Kawai told a seminar held by the Association of Southeast Asian Nations (Asean).
"Asia should remain the factory of the world, but Asians have to start consuming more. Asians have to start spending more," he said.
The historical convergence is nearly perfect. Finance must find new places to invest, but the United States, Europe and Japan are tapped out. The Asians and others must kick old habits and boost domestic consumption. It's a marriage made in Heaven. On a normal development path, it would take decades for emerging economy markets to reach the size of those in the developed world. The Big Banks can step in to "speed up" the process if they can persuade emerging economies to drink some of the bubbly. I don't think it will be a hard sell.
Assuming the Bubble Next Time thesis is correct, where does that leave us? We will eventually get inflation rates over and above the 1-2% currently priced in. Burgeoning consumption in emerging economies will cause commodity prices to soar again as they did in the period 2003-2008:H1. The sky will be the limit for a barrel of oil. The United States economy will remain in the doldrums for many years. This is a worst of both worlds scenario. We hope for the best, but in 2009, why shouldn't we expect the worst?
Oh, by the way, did I forget to mention that we are now living in the peak oil era? That is definitely going to make all this a lot more "interesting" than it already promises to be.
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