Friday, May 01, 2009

You Can't Handle a Recovery!

You can't handle the truth!

Son, we live in a world that has walls. And those walls have to be guarded by men with guns. Who's gonna do it? You?

I have a greater responsibility than you can possibly fathom. You weep for Santiago and you curse the marines. You have that luxury. You have the luxury of not knowing what I know: That Santiago's death, while tragic, probably saved lives. And my existence, while grotesque and incomprehensible to you, saves lives......

I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom I provide, then questions the manner in which I provide it
. A Few Good Men

Before our economy, generally, and financial sector, specifically, became so "resilient" and "robust", interest rates had to be raised significantly and for long periods to slow credit and economic growth and thus inflation. Over the past 2 decades, however, the same damping effect could be achieved by much more modest and shorter duration tightenings. Unlike previous decades, it seems as if credit can only flow under an ever narrowing set of conditions, with change in flow acting digitally- on today, off tomorrow.

In the late 60s, before we dropped the Gold standard, Fed Funds was raised from just under 4% to over 9%. As we were dropping the Gold standard, in the early 70s, Fed Funds was raised from under 4% to well over 12%. During Volcker's term, Fed Funds rose from an already elevated 9.5% to almost 17%, admittedly during a period when interest rates weren't the fulcrum of monetary policy.

Since the Volcker peak, as noted, and as can be seen in the graph below, a few percentage points increase in the Fed Funds rate has been sufficient to "cool" the economy. Moreover, over a few cycles now, what had previously been considered a normal level for rates, like the 5.5% level during the mid 90s, becomes too high during the next recovery- 5.25% was the peak in late '06 through summer of '07.

The reaction, with respect to employment, of the real economy to the financial has also changed. The pattern of employment growth- with each cyclical trough being much higher than the previous peak- evident from 1962-200 has also changed. For the first time in decades, the trough (thus far) of employment is almost equivalent to the old peak- i.e. the current level of employment is roughly equal to that of early '01. By contrast, the '03 trough was 20M jobs higher than the '90 peak and the '91 trough was 16.5M jobs higher than the '81 peak.

The current pattern of employment growth more closely matches that of 1942-1962 with the caveat that median income gains were substantially higher in the earlier period.

The reaction, with respect to real median household income, of the real economy to the financial has also changed. For the first time in decades, real median household income in a recovery failed to exceed the previous cycle peak- the recovery under Bush the younger was restricted to the upper income class.

The above is a long "winded" (byted might be better given the medium) way of noting increasing income inequality. The quality of US recoveries has changed from one which benefited the middle and upper classes to one which only benefits the upper classes, and given the recent declines in real estate and equity based wealth, many of the upper class are finding that GDP gains may not translate into their gains. Increasingly the beneficiaries of recovery are restricted to the top tier of finance. The trickle down which was used to justify the shift to a financially centric economy in the 80s and 90s has become a trickle up in the 21st Century. To paraphrase Abraham Lincoln, policy increasingly aims to ensure that government of the financial oligarchs, by the financial oligarchs and for the financial oligarchs, shall not perish from the earth.

The question then arises, "why have we forsaken the old faith, which carried us through the tumultuous 60s and 70s, that a robust middle class is good for the stability of the state?" Have we forgotten the lessons of Aristotle's Politics (Book 4: Part XI)? Is it simply a case of self-interest run amok, or are their other reasons behind trickle down becoming trickle up?

On a related note, I wonder how different the results of the '08 election would have been if the trickle had been down rather than up under Bush the younger. The Democrats might want to take note, pandering to the financial oligarchs does not ensure electoral success.

Returning to the main point, why has policy allowed the quality of recovery to change so significantly? It is almost as if the financial oligarchs fear an old style recovery to maintain their grip on power. This fear would not be without precedent in human history. The European Nobility feared the rise of their middle class, fortunately for the Burghers, they often found a friend in the King or Queen.

I suspect, however, an additional reason behind the policy shift- a most insidious reason. As the wealth of the nation has shifted from production to financial it has, as noted above, become increasingly fragile and sensitive to changes in financial variables.

During the 70s the price of oil rose by a factor of 10, settling, if you will, in the 80s at about a 6 fold increase. Interest rates, as noted, fluctuated wildly, ending the decade at double digits across the board. Equity markets too fluctuated wildly, although the Dow Jones was at roughly the same level in 1982 as it was in 1968. While the 70s were no picnic, as I recall, the wealth of the nation, and the well being of many improved.

Back then though the wealth was of a different sort- we made, mined, and grew things. Changes in financial variables were onerous, but they didn't cause the world to stop turning. Even the financial world seemed to take the 70s somewhat in stride, despite the Fed funds rate moving from a low of roughly 3.5% to a high of roughly 16%.

I doubt our supposedly much more resilient current financial system could survive in that environment, perhaps it would be more accurate to say that few of the top tier financial firms would make it through a decade like the 70s. So long as fear of loss of financial wealth drives policy, policy will fight to ensure that discounting (i.e. interest rates) remains minimal. Few changes kill a leveraged long bond position than a hike in rates. Restraint of the middle class then is, in modern terms, collateral damage.

And that, it seems to me, is the insidious problem that trumps all else. We can't handle a broad based recovery because if we do we'd get significant inflation and eventually, substantial increases in interest rates. Just as it isn't the fall that kills you, it's the sudden stop at the end, for the highly leveraged financial oligarchs, it isn't the inflation that will kill them, it's the substantial hike in interest rates at the end. For my money, wealth that cannot survive necessary changes in interest rates isn't wealth at all, it's just a mirage.

George Friedman, of Stratfor, recently argued that the US is worth some $340T (a bold assertion, but let's go with it for the sake of argument) and thus our debts are trivial in comparison. As with any corporation, however, that depends on how the assets are managed. Nonproductive asset is a contradiction in terms. Iraq, too, is, in theory, a wealthy nation. Alas it was and still is crippled by poor management.

We too, it seems to me, are crippled by poor management. The financial oligarchs fear a recovery that would make real world assets, which the US has in abundance, productive. The path to such a recovery does not go through them. It goes through a financial system that is thought of as Alfred Marshall thought of a mature industry- like a forest where individual trees come and go but the forest remains. Forests, by the way, are not a few big trees, but many middle sized (OK sometimes they are all big, like the Sequoia, but they need forest fires to propagate) ones. Currently, a few big trees are seeking protection from a cull.

Seeking the safety of power, the financial oligarchs have made what I see as one last gamble- one that, it seems to me they will soon lose- they are channeling flows into government bonds, after taking a nice chunk off the top, for their trouble. So long as the state can borrow cheaply, the financial oligarchs will be safe. Sadly, for them, decades of open capital markets and chronic deficits means that they are not the final arbiter of price in their last hope market. When the BRICs (Brazil, Russia, India and China) discover (and act thereupon) that real world investments offer greater and more durable returns than US Bonds, the financial oligarchs will lose the protection of the state.

It seems worth noting the example of Russia. They too had their state protected oligarchs, until government finance could not be found. But a few short years after they defaulted on their debt and the oligarchs were removed from power, Russia, whose real sector, due to its reliance on resource exports, is not nearly as vibrant as ours, recovered stronger than it had been in decades.

If Russia can do it.....


Charles Butler said...

A question which bears asking is why the middle class suddenly confused possession of baubles with wealth itself. That might give a clue as to how the business of finance came to predominate.