Recovery is Impossible

Ouzilly , France

Tuesday, 18 August 2009

Oh woe! Oh woe!

O! Bama! Where is thy recovery?

Yesterday, the world’s stock markets took a hit. The Dow lost 186 points... following a very bad showing in China.

Is this the end of the rally?

Could be. We’re not betting one way or the other. But we’re pretty sure this rally is going to end... and end badly... sooner or later. So far, the rally surpassed the rally in ’29 by a few weeks... but has not quite reached its magnitude. It will need another few hundred points to reach the ’30 level.

But when the rally is over... then what?

Despite the fact that a majority (!) of economists polled by the Wall Street Journal say the recession is already over, there is no durable recovery.

Nouriel Roubini explains why:

“Data from the US—rising unemployment, falling household consumption, still declining industrial production and a weak housing market—suggests that the US recession is not over yet. A similar analysis of many other advanced economies suggests that, as in the US, the bottom is quite close, but it has not yet been reached. Most emerging economies may be returning to growth, but they are performing well below their potential.

“Moreover, for a number of reasons, growth in the advanced economies is likely to remain anaemic and well below trend for at least a couple of years.

“The first reason is likely to create a long-term drag on growth: Households need to deleverage and save more, which will constrain consumption for years.

“Second, the financial system— both banks and non-bank institutions—is severely damaged. Lack of robust credit growth will hamper private consumption and investment spending.

“Third, the corporate sector faces a glut of capacity, and a weak recovery of profitability is likely if growth is anaemic and deflationary pressures still persist. As a result, businesses are not likely to increase capital spending.

“Fourth, the releveraging of the public sector through large fiscal deficits and debt accumulation risks crowding out a recovery in private sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year, requiring greater private demand to support continued growth.”

Roubini thinks the US will climb out of recession towards the end of the year... but then, it could fall back into a ‘double-dip’ recession. Maybe he will be right. Maybe this downturn will resemble Japan’s multiple recessions over the last two decades. Or maybe it will be a single, deeper and longer lasting slump – like the one in the early ‘30s. We don’t know. Either way, it should be thought of as a depression, not a recession. Because it is fundamentally different. And the difference is:

Recovery is impossible.

If the markets were to recover, it means they need to go back to the way they were. That, dear reader, ain’t gonna happen. Because it can’t happen. The economy can’t go back to what it was. In the 2005-2006 period, it was in the throes of a credit cycle blowout... where it took more than $5 of new credit to produce one stinkin’ extra dollar of output.

Consumers had to borrow $100, in other words, in order for the GDP to go up $20. It was a period of madness that couldn’t possibly be sustained... and now, can’t possibly be revived. Who’s going to invest in another condo development in Florida now? Who’s going to buy derivative debt at 2006 prices? Who’s going to build another factory in China to produce more things for American consumers who can’t pay for them?

Well, ha ha... that’s the funny thing; the Chinese ARE building more factories.

But we’ll get back to that later.

Comes word this morning that Florida has lost population, for the first time since 1946! People are leaving the sunshine state because the big boom in suburban sand is over. A large part of the Florida economy was based on building houses for people coming down from the north. Now those people are going home and trying to pay off their debt. The point is, after a bubble... like after adultery... things never go back to where they were before. You can pretend that they are the same. You can act like they are the same. You can try to make them the same. But they never are.

A recession is merely a sprained ankle or a head cold. You can recover. But a depression is fatal. There is no going back. There is no recovery.

Trying to ‘recover’ from a depression is a futile fight with the future. Governments try to restore the old economy – as it was. They prop up the old industries. They bail out the failed executives and speculators. They pass out money to people, encouraging them to make more of the same mistakes that got them into trouble in the first place.

But there is no going back. It’s a depression. The model has to change. The future... whatever it is... has to express itself.

More news… on the miserable outlook for the pound and for stock markets… from our colleagues at The Zurich Club…

“If history is anything to go by, we could be heading for an ugly scenario where sterling is under serious threat and government bond prices crash,” explains Simon Caufield.

“That’s bad news for stock markets and your portfolio. Here’s what’s concerning us about the outlook...

“ Britain’s public sector budget deficit is worrying. This significant gap between spending and revenue means our debt crisis isn’t easing up anytime soon. And if, like me, you are concerned about the sheer volume of government bonds that must be issued to fund this deficit, you must also be nervous that gilt yields will rise and prices fall at some point in the next year or two.

“ UK and US government bonds are both currently around 2% and 1% respectively. They have been held down by a flight to safety by institutional investors in the credit crisis and central bank purchasing (quantitative easing). And such low yields are unsustainable.

“Another concern is that the next government may be unwilling or unable to decrease the deficit. Failure to take the necessary medicine would cause loss of government credibility in the markets and could cause a sterling crisis.

“A fall in sterling’s value against the currencies of our major trading partners means higher future prices for imported goods, increasing inflation expectations. In turn, this would cause government bond prices to fall as foreign investors would demand higher yields to invest in sterling-denominated securities.

“Well this would be a nasty scenario for the prices of a range of asset classes including both equities and government bonds.”

Editor’s note: Simon Caufield is a contributor to The Zurich Club’s monthly investment advisory communiqué. In the latest issue, he recommended a little-known fund that could protect your wealth now and even make you money in the event of a sterling crisis and/or a stock market crash. To review this important research and to take a peek inside this exclusive members-only investment group (you can opt for a trial membership and view all club resources, without obligation), click here.

And back to Bill for more thoughts...

*** The US budget deficit hit a record $180 billion last month. July’s deficit was nearly $30 billion more than total tax receipts for the month. In July, the feds only took in $151 billion in taxes...giving it the worst margin in history. For every dollar of revenue, the federal government spent $2.15.

Not a very good business model. But the feds seem determined to stick with it – they’re going to make it up on volume. Deficits are expected to exceed $1 trillion every year for the next 8 years. And that assumes the economy ‘recovers.’ If it doesn’t recover, the deficits will be much worse... with falling tax revenues and the need for even more stimulus.

The feds are running into the brick wall of the future. They’ve made promises – mainly to older voters – that now have to be fulfilled. And the number of older voters is increasing... as the Baby Boomer generation enters its retirement years. Social Security and health care promises alone will add trillions to federal deficits. By one estimate, US debt could rise to 300% of GDP by the middle of the century.

Of course, this poses a bit of a problem. US GDP is about $14 trillion. Three times that amount would be $42 trillion. Who’s got that kind of money to lend to the US government? No one. First, because the world doesn’t have that much in savings.

Second, because even if they did, they are unlikely to want to lend it to such a huge debtor. Of course, we’re always surprised by what people are willing to do with their money – and anything is possible.

But more than likely the US will be forced to trim its promises... or inflate them away.

*** As dear readers know, we have become suspicious of inflation. Not that we don’t expect it; in fact, we think we’ll see it in its souped-up hyper version sometime in our lives. What we’re suspicious of is the easy assumption that the feds can create inflation at will... and control it. They can’t. They aren’t that good. Even at inflation they are hapless and incompetent. And their hands aren’t completely free.

First, they have to answer to the Chinese bond vigilantes. The Chinese are watching. If it looks like the feds are increasing the inflation rate – thereby reducing the value of Chinese savings – they could send the US government and the US economy into chaos simply by selling their stash of Treasury bonds.

Of course, the Chinese don’t want to do that – because it would mean hundreds of billions in losses. But push them far enough... make them afraid enough... or cause them to get mad enough... and they could strap on their shootin’ irons.

Second, there are also the ineluctable results of a major credit contraction... and a gross oversupply of capacity. Both are pushing down prices and could do so for many, many years. They can be overcome by aggressive use of the printing press. Argentina and Zimbabwe proved that. But neither Argentina nor Zimbabwe depended on credit from the Chinese. Inflation may be a monetary phenomenon, but hyper inflation is a political phenomenon... the feds only resort to it when they have no choice. We’ll get to that point; but right now, it is still far away.

*** Shutters should be added to our list of the world’s greatest inventions. What’s on our list? Crispy duck. Berets. The semi-colon. And now shutters.

It has been hot here in France. The sun beats down; the temperature has risen to the high ‘80s. We have no air conditioning. But we have shutters. We close the shutters, partially, in the morning to block out the sun. Then, in the evening, when it cools off, we open them up and enjoy the cool air. In the winter, you close shutters at night to conserve heat. In the summer, you use them to regulate heat and light. And always, they protect windows, curtains and fabrics.

We still remember the louvred shutters on our grandparents’ house in Maryland. With the shutters closed, rooms were mysteriously dark... even in the middle of the day. When they were opened, it was like the opening of the cathedral doors on Easter Sunday... the light came in and the room was transformed. And in the summer, when it rained, we left the shutters closed and the windows opened. The fresh, moist air was a delight.

And now, with the coming of the credit contraction, real shutters are ready for a comeback.

P.S. If you enjoyed this article you can find out more about our free email, The Right Side by clicking here.

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