Consumers Spent More Than They Earned In July

Consumer income and disposable spending increased slightly in July 2010, demonstrating that while the US economy remains weak, there are signs that consumer spending will continue to recover modestly. Although wages are rising, job growth remains slow and economists believe that it is unlikely that the current trend will change dramatically anytime in the near future. See the following post from The Capital Spectator.

Disposable personal income (DPI) and personal consumption expenditures (PCE) gained 0.2% and 0.4%, respectively, vs. flat performance in June, the Bureau of Economic Analysis reported today. That's encouraging, as these things go in the summer of 2010. But as usual, the fine print leaves room for debate.

Let's start by looking at recent history in context, as shown by the first chart below. Income and spending rose last month, but nothing's really changed relative to the trend over the past year. Growth is light, compared with pre-recession days. The question is how long it'll stay light? At the moment, the crowd's inclined to err on the side of caution until fresh numbers suggest otherwise, and today's spending and income updates don't do the trick.



One month a trend does not make, but consumers spent more than they earned in July. Higher savings reduces consumption, of course, and that's a risk if the economy isn't growing below trend. But there's a conflict to consider too. On the one hand, higher savings rate are a worry for the economy in the near term, and so today's bounce in consumption is what the bulls want to see. But it's highly likely (if not inevitable) that Joe Sixpack will be saving more in the future to pay off debt and rebalance household balance sheets after the spending binge of past years. As such, to the extent the consumer spends more than he earns today, that implies that future growth in consumption will be lower. There's a price to pay for short-term happiness.

To see a richer measure of the big-picture trend, consider the second chart, which shows the rolling 12-month percentage change for income and spending for the past decade. The trend has turned up since the dark days of 2008/2009, but so far the rebound has been weak, and there's little in the way of persuasive arguments for expecting a material change for the better in the immediate future.



But the case for expecting the economy to muddle through isn't yet lost, or so one economist advised. "All in all, July's report supports our view that consumer spending will continue to recover, albeit modestly, supported by a gradual improvement in labor income," wrote Peter Newland, an economist at Barclays Capital Research via The Washington Post. That's the optimistic outlook, such as it is.

Stephen Stanley, chief economist at Pierpont Securities, echoed that sentiment, telling Bloomberg: "It’ll be a real slog. We’ll see very slow growth, but it’s a far cry from a double dip."

The future for the macroeconomic mystery still depends heavily on the labor market and wages. The good news is that wages are rising, which is critical to fuel ongoing economic growth. The bad news is that the economy's still not adding workers at anything close to a robust pace, although perhaps this Friday's employment report will tell us different. Only the combination of rising employment and rising wages will deliver an end to the challenges that bedevil the business cycle.

Meantime, wages for those who are employed remain in a growth mode, as the third chart below shows. Half a solution is better than none.



The rebound in wages is encouraging, but it's still got a long way to go. The 1.8% rise over the year through last month is a world away from the contractions of the recent past. But we're hardly any closer to the 6-8% annual gains that prevailed before the Great Recession. Deciding how much of a rebound in wages (and job creation) is still the burning issue and it's going to take time to figure out the answer.

This article has been republished from James Picerno's blog, The Capital Spectator.

Is Raising Interest Rates A Bad Idea?

While some economists have suggested raising interest rates as a counter-intuitive but necessary measure to counteract the weakening US economy, to do so without solid empirical evidence is highly risky says economist Mark Thoma. The reaction of the marketplace to a similar move in 1937-1938 demonstrates that making such a move could have disastrous consequences on the livelihoods of Americans. See the following post from Economist's View.

Let me explain, as simply as I can, the underlying reason for the strong reaction to Minnesota Fed president Narayana Kocherlakota's suggestion that raising interest rates would be helpful.

When a Federal Reserve president calls for an increase in interest rates while the economy is still struggling to recover, something that repeats the errors of 1937-38, all of his buddies in academia should expect a reaction. It comes with the job. The fact that he can point to a model that failed to provide much help with the situation we're in to justify the statement isn't of much comfort, and there are serious questions about the validity of the claim in any case.

This isn't just a theoretical exercise where finding novel, counter-intuitive results that may or may not have real world applicability draws the admiration of peers, people's livelihoods are at stake. Real people in the real world are depending on the Fed to get this right, and suggestions that the Fed raise interest rates to help with the recession go against every intuitive bone I have in my body. More importantly, for those who think those bones might be broken, it goes against the existing empirical evidence. This is not a game, actual policy is at stake that will affect people's lives, and we cannot be careless in how we approach it.

If I reacted strongly, it's because I don't want us to repeat the mistakes we made in the past, mistakes that would hurt people who have suffered enough already. Do the advocates of this policy really believe, way down deep, that raising interest rates is the right thing to do in this situation? Perhaps, but I sure don't, and I can't let it pass without comment.

This article has been republished from Mark Thoma's blog, Economist's View.

Should The Fed Raise Inflation Targets?

As the US economy continues to weaken, the risk of double dip recession seems to be rising and has resulted in the Fed preparing itself to launch additional levers to stimulate the economy. One option that the Fed is discussing is raising inflation targets, which could undermine confidence in the economy and create more volatility in the marketplace; however, some experts argue that with inflation currently trending significantly lower than expected, that getting back to a base line inflation rate could be beneficial to economic growth. See the following post from The Capital Spectator.

At yesterday's central banking confab in Jackson Hole, Fed Chairman outlined what the Fed can do to further juice the economy. The initial reaction from the stock market was positive, with the S&P 500 jumping 1.7% on Friday. But in a sign of the treacherous road ahead, the bond market was unimpressed. Bonds sold off yesterday and the benchmark 10-year Treasury Note yield rose to 2.65%, the highest since August 13. Yes, folks, it's going to get complicated from here on out.

The priority, of course, is minimizing the odds of a new recession. The central bank's big guns have already been fired in that pursuit, and so expectations for monetary policy are falling, and rightly so. But there's more to do, if and when Bernanke and company are persuaded that it's time to act (again). As the Fed chairman explained yesterday, the remaining levers include:

1) additional purchases of government debt and other securities to lower long rates.
2) launch a new rhetorical war on the price of money by talking tough on promising (threatening?) to keep short rates low for a longer period than the market anticipates at the moment.
3) reduce/eliminate the already meager 25 basis points the Fed pays to banks for reserves.
4) Hike the Fed's inflation target as a further incentive for banks to lend money instead of sitting on cash.

Based on Bernanke's commentary, buying more debt and talking down long rates are the preferred lines of attack for rolling out a new round of quantitative easing. Cutting Fed funds to zero and/or raising the inflation target, by contrast, are apparently off the table, at least for the moment, according to the Fed chairman. On the higher inflation target option, for instance, he explained:

such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.

But dismissing a higher inflation target seems premature at this point. For starters, inflation expectations have been something less than stable lately. As we discussed earlier in the week, the market has been anticipating falling inflation for the years ahead. Scott Sumner lays out the reasoning for raising the inflation target:

Draw a 2% trend line for core inflation from September 2008. We are now 1.4% below that trend line. Shoot for getting back to trend. I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast [nominal GDP] growth to get 3.4% core inflation over 12 months. Or 2.7% over 24 months.

Meantime, there's the question of whether the bond market is set to throw a new wrench into the machine with higher long rates. Ultimately, the goal is to raise interest rates generally, but for the right reason: higher economic growth. The rise in the 10-year Treasury yield yesterday, by contrast, was spurred by worries that the Fed may still be reacting to macroeconomic events rather than making headway on getting in front of the challenge.

Ultimately, it's all about the broad trend, and on that front there's still reason to worry, as the latest data point reminds. Yesterday's news advised that GDP for the second quarter was revised down sharply. The economic numbers generally are still weakening. The double-dip risk isn't yet absolute, but it's rising. Next week we'll have additional information to digest. The highlights:

• Monday: personal income and spending numbers for July

• Wednesday: the first look at the economic trend in August via the ISM Manufacturing Index update.

• Thursday: weekly jobless claims report will be closely watched.

• Friday: the big number for the week is the government's employment update for August.

On the employment outlook, the consensus forecast among economists is a net loss of 100,000-plus in nonfarm payrolls, according to Briefing.com. What more do you need to know?

This article has been republished from James Picerno's blog, The Capital Spectator.

Should We Balance The Budget While The Economy Is Still Weak?

While some are suggesting that balancing the budget is critical to avoiding a double-dip recession, a premature return to austerity could create more problems than it helps to solve. With the US economy still weak, some economists worry that pulling back stimulus before the economy is growing strongly on its own is a recipe for a repeat of the Great Depression. See the following post from Economist's View.

Watch the PBS NewsHour video clip here.

The discussion starts around the 2:00 minute mark. Via C&L

Holtz-Eakin is encouraging us to balance the budget even though the economy is still relatively weak, and in doing so, to make the same mistake we made during the Great Depression. A quick look at recent data, and all the talk about the chance of a double dip we've been hearing, shows that we are anything but certain we we will be back at full employment anytime soon. Recovery from a financial crisis is often a long, drawn out process, and that may be true this time as well, but that means the economy needs more help over a longer period, not a premature return to austerity that risks sending the economy back into recession.

Why would we want to risk sending the economy back into a recession by beginning to balance the budget before the economy is growing robustly on its own? Republicans believe some sort of confidence effect from the decline in the deficit -- one that cannot actually be observed in the data but is, nevertheless, asserted to be there anyway -- will somehow more than offset the certain decline in demand from the reduction in the government deficit. But the problem is that the decline in demand will have it's own confidence effect on businesses, one that is negative, more certain, and likely much larger than any positive effects from deficit reduction.

And is anyone else getting tired of the "Obama is creating business uncertainty" argument from the Party that is creating most of the uncertainty and uneasiness about what crazy things might happen should they be elected? It worked out so well for the economy the last time they were in power and emphasized growth above all else. We're still trying to get out of that sinkhole -- talk about creating uncertainty. In any case, as noted by Paul Krugman on the video, there's nothing at all to indicate that businesses are, in fact, holding back due to uncertainties created by the administration's policies. Businesses face lots of uncertainties due to lack of demand for their products, and perhaps over what might change if Republicans take power, something that can hardly be blamed on the administration. But balancing the budget as Holtz-Eakin would have us do would reduce demand and cause fewer paying customers to walk through their doors. That makes the uncertainty problem worse, not better.

Putting it more succinctly, the Party in power when we got into this mess wants to be given another chance so it can try policies that failed during the Great Depression. And some people think that's a good idea.

This article has been republished from Mark Thoma's blog, Economist's View.

How Banks Profit From The Slow Economy

Economist Andy Harless suggests that in some ways, banks benefit from the depressed economy which may explain the lack of activity by the Federal Reserve. Americans are keeping their money in banks rather than investing, providing banks with cheap capital that they can use to buy Treasury notes for easy profits. See the following post from Economist's View.

I know how much some of you will disagree with this, but I have a hard time ascribing bad motives to people at the Fed and using it to explain policy decisions. I think people at the Fed believe in their heart of hearts that they are doing what's best for the economy as a whole as opposed to what's best for a particular party or some small group of people pulling the strings, but they are relying on bad assumptions, questionable models, convenient interpretations, etc. To me, some of the beliefs held by the other side are astoundingly unbelievable, but they would, of course, say the same thing about me. I don't deny that those beliefs can be convenient for the person holding them, but the idea that people at the Fed are consciously holding down the larger economy in order to benefit Republicans or some group of people is hard for me to buy into. There are certainly ideological divides that lead the other side to policies that I think are misdirected, or even counterproductive, but the bad motive explanation is hard to swallow. I'm more inclined to think this goes on in Congress where to some, winning the election is the only thing, but even then it's hard to assert this as a general proposition. But perhaps I have too much belief that people mostly try to do the right thing, and I am hopelessly trusting and naive (though see here). I expect to be told that I am.

Here's Andy Harless:

The Real Activity Suspension Program, by Andy Harless: (Think of this as a guest post by the Cynic in me. I’m not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word “recession” to include the period since our inadequate recovery began.)

Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.

How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.

Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.

Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks’ Treasury note holdings and an increase in their cost of funds.

Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.

So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC’s policy meetings?

This post has been republished from Mark Thoma's blog, Economist's View.

What Could Cause An Economic Collapse

Jeff Nielson, writing in The Street discusses the prospect of hyperinflation that could occur if the economy continues to worsen and another fiscal stimulus is passed. While the dollar has been supported by the expectation of more fiscal restraint, an opposite outcome could result in a loss in confidence in the dollar. See the following article from The Street.

Most market reporters, commentators and politicians continue to rely upon nothing but the same short-term "snapshots" which have caused them to be "surprised" by everything. However, it is a safe conclusion that even such rampant incompetence (combined with a strong "herd mentality"), could not and does not mean that the entire U.S. government remains in an oblivious state of ignorance regarding this re-acceleration of the collapse of the U.S. economy.

This begs an obvious question. Given that at least some elements of the U.S. government have known all along that the U.S. economy was not recovering and could not recover, why is it that only now are we hearing of tentative, new plans of more "life support" for the dying U.S. economy?

The answer is also obvious. As I pointed out when I originally denounced the Obama stimulus package, it was never anything more than a bad joke. The combination of the collapse of the U.S. housing sector, massive unemployment, and the largest credit-contraction in the history of the U.S. economy had combined to subtract approximately $2 trillion per year in consumer spending from this consumer economy.

The response of the Obama regime to this scenario was a one-time injection of $780 in stimulus, spread out over more than a year. Obviously, you can't replace $2 trillion with less than $800 billion and call it stimulus.

This brings us to the present dilemma of the U.S. government. The U.S. economy is much sicker than it was when Obama ascended the throne. Wall Street has continued to ruthlessly choke off all credit to the U.S. economy, meaning that tens of millions of American households and tens of thousands of businesses are much closer to the breaking point than they were in January of 2009.

The entire U.S. retail sector is in a terminal death-spiral, and its only response is to eliminate vast numbers of retail outlets, and herd consumers into more online retailing. While this cuts costs for these companies, most of those cuts will be reduced employment -- fueling the next leg lower for consumer demand, resulting in even more store closures, etc.

This means that the trivial "band-aids" being mused-about by government talking-heads are utterly meaningless. Simply, the Obama regime has to "go big, or go home." It must either engage in massive (genuine) stimulus of the U.S. economy -- meaning a multi-trillion dollar commitment, or simply allow the collapse to proceed (and feed upon itself). However, in even contemplating another, massive wave of spending, Obama faces two other problems (which he created for himself).

Throughout this "U.S. economic recovery," the U.S. government has continued to pretend that it was almost ready to begin some actual, fiscal restraint -- halting the exponential increase in federal government debt. That was the only thing propping up the U.S. dollar (putting aside the constant Euro-bashing by the U.S. propaganda-machine). Allow another sickening plunge in the U.S. dollar, and that will drive away the last, few chumps still insane enough to buy grossly over-priced U.S. Treasuries. This is the road that leads to hyperinflation.

If this was not bad enough, the Obama regime has continued to be successful in duping both the vast majority of sheep in the U.S. electorate, as well as Republican knuckle-draggers that the U.S. economy was "strong enough" to begin to curtail runaway spending. This pool of chumps is looking for spending cuts, not a multi-trillion spending spree.

Thus, the U.S. government is facing exactly the same scenario today as the Bush regime faced in the summer of 2008. In hindsight, we all know what choice the previous government made. Lehman Brothers was "assassinated" -- as the first step in a concerted effort to destroy commodities markets. The collapse in these vital markets, combined with the collusion among Western bankers to choke off all credit to credit-based Western economies achieved its desired objective: a global "economic collapse," and the expected panic which such an artificial crisis would naturally produce.

It was only through this panic that frightened sheep (i.e. U.S. citizens and government "leaders") meekly submitted to the largest "bail-out" in history for Wall Street: a combination of hand-outs, loans, and guarantees which exceeded every other corporate bailout in every country on Earth, throughout history, combined. The last estimate I heard of the nominal value of this bailout was approximately $14 trillion, matching "official" U.S. GDP. The number will continue to increase (even without any new bailouts), as all of the 0% money being "loaned" to Wall Street banks is yet another taxpayer subsidy (since even the U.S. government can't borrow at 0%).

Given the current circumstances of the U.S. government, and past history, the "plan" is clear: do nothing long enough for the U.S. propaganda-machine to whip-up public fear into another frenzy, and then (and only then) will it "act decisively" to address this new "crisis." There is a second audience at which this clumsy charade is aimed: the governments of other nations.

While we must presume that a small number of these other governments understand the true state of the U.S. economy (China leaps to mind), most of these governments have been quite content to "drink the Kool-aid" being dispensed by the U.S. government. Should the Obama regime simply announce ("out of the blue") a multi-trillion dollar spending package, these willing dupes would be forced to confront reality: that the U.S. government has clearly embarked upon the road to hyperinflation.

However, create a "crisis" first, and we can expect these "leaders" to instantly transform into a flock of Chicken-Littles -- desperate for some massive prop, to prevent the sky from falling upon them. Understand that for the ivory-tower leaders of our governments that a crisis means nothing more to them personally than being thrown out of their pampered, government posts -- and being forced to survive upon the extremely generous public-pensions they award themselves.

It is such "me-first" selfishness which inspires the most blind-panic in any crisis, and the U.S. government is clearly relying upon such a reaction. They can announce their multi-trillion rescue of the global economy, and maybe, just maybe the self-absorbed leaders of other countries will blind themselves to the hyperinflationary consequences of more print-and-spend insanity. There is no more money for the U.S. government to borrow, thus every penny used as a response to this pending crisis will be newly-printed Bernanke bills.

This sets the stage for another chaotic autumn for the global economy -- and even more chaos for markets. While I have outlined what I consider the most likely scenario, we are so close to the true collapse of the sickest economies that there are many dire scenarios possible.

The one scenario which I totally reject is another commodities meltdown which would come anywhere close to 2008. There are two reasons why this part of the pattern cannot repeat itself. To begin with, there is only a tiny amount of the "leverage" which existed in the rabidly bullish commodity markets of 2008. Secondly, the hyperinflationary consequences of more banker money-printing (and debt) are far more obvious today -- after two years of massive, deficit-spending have been factored into fiscal parameters.

The U.S. economy lurches closer and closer to the "hyperinflationary depression" which John Williams (Shadowstats.com ) first predicted in 2003. The precise effect of this collapse on the global economy cannot be predicted -- only its eventual result. We are heading toward a Great Divide: a division of the global economy into winners and losers.

This is not a new phenomenon. What is new is that most of the losers will come from the "Old Guard" economies (i.e. the U.S. and Western Europe). The citizens of these "loser economies" must act now to shield their diminishing wealth from the death of Western banker-paper which is almost upon us. As always, I remind investors that (for hundreds of years) precious metals have represented the best "insurance" against the depravity of bankers (and their servants in government).

This post has been republished from The Street, an investment news and analysis site.

Affluent Investors' Mood Turns Negative

The weak stock market and the threat of higher taxes may have contributed to dragging down the sentiment of millionaire investors in the US. The Spectrem Millionaire Investor Confidence Index fell to the lowest level in a year indicating that affluent investors are becoming more bearish. See the following article from The Mess That Greenspan Made.

U.S. investors with assets in seven or more figures are not feeling nearly as chipper about the domestic state of affairs as they were over the last year or so, that is, when stock prices were generally rising. Reuters reports on how their mood has soured.

The Spectrem millionaire investor confidence index fell to its lowest level in more than a year in August as wealthy U.S. investors worried about politics and unemployment, according to Spectrem Group.

The Spectrem Millionaire Investor Confidence Index fell 11 points in August to -18, its lowest level since June 2009, when it fell a record 18 points to -20 shortly after the S&P 500 index hit a 12-year low.

The move returns the index to mildly bearish territory after 12 straight months in neutral.

The Chicago-based consulting firm, which specializes in affluent and retirement markets, defines neutral as between -10 and +10 in the index, which ranges from -100 to +100.

“The millionaires’ decline is particularly troubling since it suggests millionaires, typically more sophisticated than the broader affluent population, are reverting to a bearish frame of mind,” said George Walper, president of Spectrem Group.

As you might expect, it’s not the high unemployment rate and the increasingly slim chance that the lives of their children will be better than their own that is increasingly bothering the well heeled-crowd. It’s more the double whammy of a stock market slide about to extend into its fifth month and the prospect of paying higher taxes in the years ahead that have combined to lower their expectations of the future.

This article has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Should The Federal Reserve Address Inflation Expectations?

With expectations playing an important role in economic recoveries and inflation expectations continuing to fall near precarious levels at 1.5%, James Picerno suggests that it is time for the Federal Reserve to do something credible that the market will take seriously. See the following post from The Capital Spectator.

The yield on the 10-year Treasury Note was under 2.5% this morning at one point—the lowest since early 2009 and down sharply from this past April's 4% range. Not surprisingly, inflation expectations are falling too. The market's outlook for inflation slipped below 1.5% yesterday for the decade ahead, based on the yield spread between the nominal and inflation-indexed 10-year Notes. The last time this inflation forecast was so low was July 2009.

Deflation is still a ways off—150 basis points, by the measure of 10-year-yield spreads. But it's not the level per se that's the key worry. Rather, it's the trend. For the last four months, the Treasury market has been telling us that inflation expectations have been falling. Maybe this rising anxiety is wrong. Maybe it's a bubble. Maybe the market's irrational and prices don't matter about the future. Maybe, but maybe not. Unless you're clairvoyant, the trend can't be ignored, at least not entirely.



Clearly, something's up (or down) with inflation expectations. The main reason to think twice before dismissing the market's outlook is that corroboration has been arriving in other economic measures for several months. Yesterday's dramatic fall in existing housing sales is the latest sign that the economic recovery is weakening.

In fact, the drop in home sales provides a timely lesson for divining the future with inflation. One catalyst for the slump in housing sales last month was the expiration for the home buyer tax credit. This one-time stimulus gave the market a boost, or so it seems, but the juice evaporated big time in July.

The lesson is that expectations are a critical factor when it comes to economic rebounds and related matters with prices. It's relatively easy to convince the crowd for a time to spend or to assume that prices will change in a given direction. But if the market thinks the stimulus will soon end, the effect is likely to do little more than borrow future consumption by moving it forward. In that case, today's higher consumption will be paid for with lower consumption tomorrow.

Something similar applies to inflation expectations. If you're trying to raise inflation expectations, or at least stabilize them, the effort must be credible. Quite a bit of economic research tells us no less. To be sure, there's "substantial disagreement" about inflation expectations, as a study from Stanford a few years ago reminds. On the other hand, it's also clear that inflation expectations in various forms provide a fairly reliable clue about the actual levels of future inflation, as shown in a chart from the study that's republished below.



Are inflation expectations always accurate? No, of course not. What's more, there's more than one way to measure the market's outlook on price trends. But given the broad economic backdrop of late, we should be reluctant to ignore the Treasury market's ongoing forecast of falling inflation. This decline isn't an isolated event.

The solution at the very least requires stabilizing the market's inflation forecast. Allowing it to continue falling would eventually lead us into dangerous territory with deflation. Yes, the risk of higher inflation—even runaway inflation—down the road is a threat, and one that we can't forget. And that challenge makes the Fed's job in the here and now all the more precarious. But unless you're willing to overlook the current economic slowdown, inflation isn't a clear and present danger today, nor is it likely to be a pressing concern for the foreseeable future.

If the Federal Reserve has any chance of stabilizing inflation expectations it must do so with a credible policy, which is to say a policy that the market takes seriously. As the housing market's sharp fall reminds, that's not so easy with one-time prescriptions that the crowd recognizes will soon fade from the scene. That suggests that the Fed needs to communicate with the market that it will move heaven and earth to keep inflation expectations from falling any further. Arguably those expectations should target headline inflation at a level that's higher than current ~1.5% outlook for the decade ahead.

Surely no one thinks the central bank should let the market's expectations for inflation fall to 1% or lower. At some point even the inflation hawks will concede this point. The danger is that when they do, it may be too late to arrest the current trend.

Fed chairman Ben Bernanke is scheduled to speak this Friday at Kansas City Fed's annual Jackson Hole conference. This is the next opportunity to lay the groundwork for stabilizing the market's inflation expectations. If not then, when?

Time is running out. The longer the market anticipates that the risk of deflation is rising, the harder it will be for the central bank to dissuade the crowd from this expectation. Remember, too, that it doesn't really matter what actual inflation was last month, or over the past year. The main priority is managing expectations.

The Fed still has enormous power over the market's outlook on general price trends. The question is whether the Fed will rise to the occasion. Don't hold your breath. Indeed, there's quite a bit of internal debate at the Fed these days, as The Wall Street Journal reported yesterday. The "deep divisions" about how to manage monetary policy is unfortunate, but it's reality. No wonder that the market continues to assume that inflation will fall.

Until (or if) the Fed acts convincingly to change expectations—or if economic reports turn sufficiently bullish in the weeks ahead—more of the same is coming: lower interest rates. Momentum is a powerful force in financial markets, just as inertia has been known to dominate central bank decisions at times. This seems to be one of those times.

This article has been republished from James Picerno's blog, The Capital Spectator.

The Surprising Relationship Between Gold And Inflation

The Wall Street Journal points out that the correlation between inflation and gold price movement is extremely small. This suggests that there is a popular misconception that gold in a hedge against inflation. See the following post from Expected Returns.

Regular readers of this blog know my views on gold are unconventional. I've repeatedly said that gold is neither a commodity nor a hedge against inflation. I've instead opined that gold is a hedge against government stupidity and fiscal mismanagement.

Most people believe the conventional wisdom that gold is a hedge against inflation, which is why most people have missed the decade-long bull market in gold. Amazingly, people refuse to amend their errors and continue to call gold "expensive." I, for one, beg to differ- ignorance is expensive.

That being said, the Wall Street Journal finally came out with an article on gold worthy of publication. The article questions conventional wisdom and introduces a radical concept (at least when it comes to the WSJ and gold): analyzing actual data before coming to conclusions! Thinly veiled sarcasm aside, here are some excellent points from the article.

Inflation Hedge?

I recently asked research firm Ibbotson Associates to run a correlation study to determine how closely inflation and gold-price movements track each other. You would expect gold, as a purported commodity, and inflation to move in tandem.

The data, going back to 1978 and capturing an inflationary spike, shows a correlation of, at most, 0.08.

That is low. Really low. Perfect correlation is 1; at minus-1, two assets move in perfect opposition. Near 0 implies gold and inflation barely acknowledge one another, and moves in unison are largely happenstance.

So if inflation doesn't push and pull at gold prices, what might it be? If you believe correlation studies, the answer is the U.S. dollar.

Going back to 1973—a period that defines the modern, non-gold-backed dollar—the greenback's movements closely track gold's direction. The correlation between month-end gold prices and the Major Currencies Dollar Index, as reported by the Federal Reserve, is minus-0.45.

About 1% of the population understands that gold's main role is not to hedge against inflation, but to hedge against the government. Rising gold based on collapsing confidence, and not inflation, is a historical phenomenon. This is a critical point to understand since few would disagree that confidence in government is waning.

Gold as Currency?

...Over the past 30 years, the correlation between the dollar and gold is minus-0.65—a high negative correlation. It means the dollar and gold are effectively on opposite ends of a seesaw. When the dollar is in favor, gold retreats. When it is under pressure, gold prices swell.

Look at the nearby chart. It is like a photo of a mountain scene reflected in a tranquil lake. The rises and falls and horizontal meanderings of gold are nearly the negative of the dollar's.

The implication is that gold isn't a commodity—at least not one that hews to the definition of something that people and industry consume.

Instead, "gold is a currency" whose daily price is a gauge of the market's concern about the "potential diminishment" of the purchasing power of the dollar and other paper currencies, says Paul Brodsky, a principal at New York's QB Asset Management.

I've recently made the point that the big swings in inflation are based on dollar movements. In other words, inflation is not solely an internal phenomenon; it can arise from exogenous shocks in foreign exchange. So a global collapse in fiat currencies will create inflation in America. The bigger the collapse in global confidence, the bigger the inflation. This is why I like to say that inflation is currency-driven.

Those who predict collapsing gold prices are missing the big picture. Collapsing gold prices imply a substantial rise in confidence in government. Let this statement sink in. How anyone can argue for a rise in confidence in government is beyond me.

This post has been republished from Moses Kim's blog, Expected Returns.

The Problem With Bernanke's Leadership Style

While some think that Bernanke is displaying a lack of public leadership by not announcing a decisive stance on what needs to be done, economist Mark Thoma argues that this would limit the ability of other FOMC members to express their views. Unlike Greenspan's autocratic style, Bernanke appears to prefer a collaborative environment, which Thoma thinks is a good thing. See the following post from Economist's View.

Tim Duy emails a follow-up to an earlier post discussing dissent within the Fed at the last FOMC meeting. One part of the WSJ article

reporting on the dissent says:

The meeting was a case study in Mr. Bernanke's management style, which reflects his days as chairman of Princeton University's economics department when he had to manage a collection of argumentative academics with strong personalities and often divergent views. Mr. Bernanke encourages debate and disagreement, and then weighs in at the end with his own decision, which has helped him win loyalty at the Fed, even among those who disagree with him, several officials say.

Tim Duy responds:

Uuhhg – I am too tired to address the WSJ Fed piece, and I don’t have time to tackle the piece, but you can add this if you wish:

I understand why his colleagues appreciate Bernanke’s management style, and why the media likes to ooze quiet praise on that style, but shouldn’t he be showing some leadership in the public as well? After all, the Federal Reserve, last time I checked, was not a University economics department. It is not the same. As we like to say in academics, the disputes are bitter because so little is at stake. Not so for the Fed. As an institution, it serves the public directly, and much, much is at stake. Perhaps it is time for Bernanke to stake out a public position. How exactly does he view the current economic situation in light of his work on Japan? For many of us, that work points to a much more aggressive policy stance. Is this the direction Bernanke wants to take? If so, why is he dragging his heels? If not, then what is different? This is the conversation I want to see him have with the public, on the record. And the sooner, the better.

What good is served by leaving so much uncertainty over what the Fed is likely to do next if various scenarios such as a stronger, weaker, or stagnant economy unfold? What could be the reason for Bernanke's reluctance to take his case to the public?

If Bernanke takes a particular position on future policy, that makes it very difficult for the Fed to do anything else without losing its credibility, and hence makes it difficult for other members of the FOMC to vote against such a proposal no matter how much they might disagree. If the Fed chair indicates one thing, and then the Fed lurches in another direction, that will hurt the Fed's credibility at a time when it doesn't have any credibility to waste. Even if Bernanke tries to make it clear that he is expressing his own views and not speaking on behalf of the FOMC, his views will still set the benchmark for thinking about where the Fed is headed next.

Unlike the Fed under Greenspan where the Fed chair used his influence to determine policy pretty much on his own, Bernanke has attempted to make the Fed a "a collection of argumentative academics" where everyone is allowed to have a say in the outcome. If he goes out in public and binds the Fed in advance, that undermines the more democratic committee process he has tried to create.

Should we worry about that?

I'm not sure I want to go back to the days of Greenspan, the other members of the committee should at least have some say in the policy decisions. It's true that the chair of the Fed should have the most influence over policy, that's intended in the design of the Fed as an institution, but the Chair should not run the entire show.

However, when there is considerable uncertainty due to disagreement on the FOMC, the Fed chair needs to use the influence bestowed upon him or her by the Fed's institutional arrangements, set a firm course for policy, and resolve the uncertainly. That might mean having lots of informal discussions with other members of the FOMC to make sure their views get a fair hearing, and some back and forth in the process, but at some point the Fed chair needs to step up and lead. Right now is one of those times.

This article has been republished from Mark Thoma's blog, Economist's View.

Disagreement Within Fed Over Future Policy

Insight into the August 10th Federal Reserve meeting suggests a divide over the direction of future Fed policy that was concealed by the final vote to reinvest maturing mortgage bonds in treasuries. While some Fed officials are distressed over high unemployment and want to act, the other camp is skeptical of additional stimulus. See the following post from Economist's View.

This gives us a better idea of who to blame for standing in the way of more aggressive policy from the Fed:

Fed Split on Move to Bolster Sluggish Economy, by Jon Hilsenrath, WSJ: The Aug. 10 meeting of top Federal Reserve officials was among the most contentious in Ben Bernanke's four-and-a-half year tenure as central bank chairman.

With the economic outlook unexpectedly darkening, the issue was a seemingly technical one: whether to alter the way the Fed manages its huge portfolio of securities.

But it had big implications: Doing so would plunge the Fed back into the markets and might be a prelude to a future easing of monetary policy, moves that divided the men and women atop the central bank. ... At the end of an extended debate, Mr. Bernanke settled the issue by pushing successfully to proceed with the move. ...

Before the meeting, officials at the Federal Reserve Bank of New York, which manages the Fed's portfolio, had grown concerned ... the ... Fed's portfolio of mortgage-backed securities was about to begin shrinking much more rapidly than anticipated, as low mortgage rates led more Americans to refinance their mortgages. ... A shrinking portfolio in the face of slowing economic growth was unwelcome to many officials, including New York Fed President William Dudley. It amounted to prematurely applying the brakes. ...

The declining mortgage portfolio was the focal point of debate. ... Officials spent very little time discussing the idea of expanding the securities portfolio beyond its current size. ...

Officials were clustered in two camps. In one camp, Mr. Dudley, and the presidents of the Boston and San Francisco Fed banks, Eric Rosengren and Janet Yellen, were distressed that the Fed was far from its objectives of low unemployment and stable inflation. ... This camp was more inclined to act.

The other camp was skeptical. Fed governor Kevin Warsh, a former Wall Street investment banker..., Richard Fisher, president of the Dallas Fed,... Narayana Kocherlakota, president of the Minneapolis Fed,... president of the Philadelphia Fed, Charles Plosser,.., Thomas Hoenig of Kansas City, and Jeffrey Lacker of Richmond...

After listening intently, Mr. Bernanke summed up the debate, acknowledged the disagreements, and then said that the Fed shouldn't allow the passive tightening of financial conditions that was being caused by its shrinking balance sheet. In practice, that would mean taking proceeds from nearly $400 billion in maturing mortgage bonds and buying Treasury debt. The Fed also needed to acknowledge the slower growth outlook, he said. ...

The formal vote—9 to 1—disguised the disagreements. ... [Only] Mr. Hoenig, as he has at every opportunity this year, formally dissented. ...

Now the internal debate turns to the future, particularly whether to do more, and if so whether to make small or large steps. ...

My view is that it will take even more bad news about the economy before the Fed will consider additional moves, and if it does move, it will move gradually.

The Fed has been behind the curve since before the crisis started. It didn't see the crisis coming, when the crisis did come it was going to be contained rather than spread and cause bigger problems, and when the problems spread they were going to be short-lived -- Bernanke saw green shoots long, long ago. Now we have Fed officials hesitating once again based upon their relatively rosy expectations for the recovery.

One of the lessons the Fed thinks it learned about inflation is that when you see it, you need to move aggressively. Interest rates should rise by more than one to one with the rise in inflation expectations (this is called the Taylor principle). If you chase inflation upward with gradual steps instead of getting out in front of it and capping it off, you won't catch it until it reaches a very high level, and you may not catch it at all in extreme cases.

But when it comes to the other half of the Fed's mandate, unemployment, there is no sense of urgency, gradualism is fine. But just like inflation, a strategy of delaying and only gradually responding to signals that a problem exists is asking for trouble. Policymakers learned this lesson when inflation was the big problem in the economy, but they haven't figured out that the same lesson applies to situations like we're in (because it's not a feature of models with Calvo price stickiness, the standard model used to evaluate such questions, but that model doesn't do a very good job of capturing the essential elements of our present situation).

Hesitation and gradualism has already allowed unemployment to move far ahead of policy. We need an aggressive move from the Fed to try to catch up, trying to close the gap with small steps in not going to work. But even if the outlook deteriorates further, I doubt that's what we'll get.

This post has been republished from Mark Thoma's blog, Economist's View.

Why You Shouldn't Dismiss The Risk Of Deflation

The continued downward spiral of the market's inflation outlook does not bode well for an economy that is supposed to be out of recession. James Picerno writes that is would be a mistake to dismiss the risk of deflation although a strong response by the Fed could quickly reverse momentum. See the following post from The Capital Spectator.

The summer is winding down and so too is the market's outlook for inflation. The 10-year forecast for inflation, based on the yield spread between nominal and inflation-indexed Treasuries, dipped under 1.6% last week—the lowest level in about a year.

That's a disturbing sign for a number of reasons, starting with the recognition that this is supposed to be an economic recovery. The recession technically ended last year, or so many economists opine. If so, inflationary pressures at the very least should be holding steady if not rising. And for a while, that was the trend. Through the end of this past April, inflation expectations were on the march, rising to roughly 2.45%, up from something approximating zero in late-2008, when the financial crisis was raging. But as the chart below reminds, something changed in May and the D risk was on the march once more. The recovery hit a wall of turbulence and the macro outlook has been suffering ever since.



The challenge was compounded earlier this month when the Federal Reserve disappointed the market with a tepid response to deflation's mounting momentum. Since the last FOMC meeting on August 10, the Treasury market's 10-year inflation forecast has fallen by nearly 20 basis points. If the Fed's last FOMC statement was designed to arrest the market's worries about deflation, the effort looks like a failure so far.

But talk is cheap. What of the central bank's actions? Is monetary policy reacting to the rising to the challenge of the D risk? Perhaps. Recent data on monetary aggregates suggest a change may be unfolding as we write. The monetary base (defined by MZM money stock) turned up recently after a period of decline. As the second chart below indicates, MZM has been rising in recent months.



So far, however, the increase in MZM hasn't reversed the year-over-year percentage change. As the next chart shows, MZM's annual pace is still negative, as it's been for most of this year.



No wonder that long Treasuries have been soaring in recent months. The threat of deflation has motivated the crowd to bid up prices on government bonds. The iShares Barclays 20+ Year Treas Bond (TLT), for instance, has climbed nearly 20% since late-April, roughly the start of the current worries over the D risk.



For investors, the burning question is whether the D trade has legs? There's lots of positive momentum to argue in the affirmative. But it'd be a mistake to assume that deflation is a done deal. Yes, the Fed has stumbled and let worries about future prices take a tumble. But the game isn't over. The central bank can still change the market's expectations, but it's going to be harder to gain traction and the clock is ticking. Remember, this is all about managing expectations. Let's not forget that the Fed could, if it was so inclined, push long rates much lower by printing money. There are some very good reasons for why Bernanke and company are reluctant to roll out the nuclear option. But events may be set to overwhelm otherwise cautious thinking on matters of monetary policy.

Meantime, there's quite a bit of risk embedded in the D risk trade, on both sides. It's getting harder to dismiss the possibility that inflation expectations will continue to shrink. At the same time, the easy money in going long government bonds may not be so easy if the Fed chooses to get tough with the deflationary momentum. Since no one is really sure how all this will play out, this is no time to bet the farm, one way or another. We're in uncharted territory. Invest accordingly.

This article has been republished from James Picerno's blog, The Capital Spectator.

Reasons Why Deflation Is Not A Threat

Moses Kim lays out his argument for why deflation is unlikely to hit the US in the near future. He points out that deflationists are missing the mark with their assertion that the dollar will increase in value and are discounting the ability of the government to fight deflation. See the following post from Expected Returns.

Based on the comments and emails I'm receiving lately, it appears more and more people are hopping on the deflation bandwagon. These correspondences have exposed to me an obvious misunderstanding of basic facts. While I suppose I am an "inflationist", I'm the first to admit that deflationists have some valid arguments to support their claims. But at the end of the day, their arguments are flawed; I just don't see deflation as a realistic threat moving forward.

There is a constant tug of war between deflation and inflation that hinges on factors such as money supply, credit, interest rates, and inflation expectations. While these variables push inflation in either direction, there is undoubtedly one variable that swings the odds decisively in either direction, and that is the dollar. There can be no sustainable deflationary trend with a falling dollar any more than there can be an inflationary trend with a rising dollar.

So let's get one thing out of the way. Deflationists are saying that the dollar will rise in value, and based on some of the doomsday asset collapse projections I'm hearing, quite dramatically. Now if this isn't already ridiculous to you, I'll examine some of the factors that will make a sustainable rise in the dollar unlikely. To do this, we must explore the last great deflationary period in the U.S, the Great Depression.

Most people think of the Great Depression as one continuous deflationary collapse- but it wasn't. Broadly speaking, we can break down the Great Depression into 3 stages: 1929-1932, 1933-1937, and 1938-1941. The key period is 1933-1937, for this is when we saw the initial inflationary effects of going off the gold standard.

Below I will present some things to take away from the Great Depression. These factors are critical to understanding why a deflationary collapse is unlikely to occur based on present-day conditions.

Agrarian-Based Society

During the Great Depression, farmers accounted for nearly half of labor. The maturation of the American economy from an agrarian to industrial economy created a staggering level of unemployment, which was deflationary. The Dust Bowl of 1933 obviously exacerbated the problem and put pressure on wages.

However, from 1933-1936, the second phase of the Great Depression, unemployment declined from 25% to 11%. Spending power reappeared, as evidenced by a spike in real final sales. Deflation? I don't think so.



Mass Defaults in Europe/Gold Standard

The 1930's were characterized by mass defaults across Europe stemming from a sovereign debt crisis. Defaults were directly correlated to debt to GDP ratios and the percentage rise in budget deficits in preceding years.

The psyche of Europeans was obviously scarred due to world wars, revolutions, and constant conflicts. As soon as sovereign nations started to default, capital sought safety. The U.S. was one of the few countries that remained on a gold standard, so capital flooded into the U.S. dollar, which for all intents and purposes was as good as gold. So the rise in European defaults activated a temporary flood into the U.S. dollar (aka gold) in 1930-1931, which created the sensation of deflation in America. In effect, the deflationary trend was accelerated by the concentration of capital in U.S. dollars.

1933-1937 Deflation?

As soon as FDR was inaugurated he took us off the gold standard, which immediately devalued the dollar and sparked an inflationary trend. This created a spike in asset values that was most notable in stocks. There was some semblance of a recovery, but it was short-lived because of flawed government intervention. But that's a story for another day.

Anyway, how many deflationists will tell you that CPI rose from 1933-1937? I'm guessing none. But sure, go ahead and listen to the deflationists who take a chart of the Dow in 1931 and plot it against a 2010 chart and predict a stock market collapse. Absolutely. Utterly. Ridiculous.





After collapsing in the early stages of the Great Depression, GDP exploded for the duration of the Great Depression. Now obviously this occurred because of massive government spending. But a good forecaster must account for government intervention; otherwise their analysis is seriously flawed. The fact remains that the government won't idly stand by if there is a massive deflationary episode in the U.S.



Debt Destruction

Deflationists constantly conflate debt destruction with deflation while forgetting one tiny fact: The government has a technology called the printing press. A determined government can easily fight deflation. We already got a glimpse of how the government can counteract the forces of deflation by handing out free money in the form of homebuyer tax credits. The spike in sales of homes spurred by tax credits confirms that you can manipulate behavior by giving out free money. This proves beyond a doubt that a determined government can create price distortions.

The most important point I am going to make is this: The coming inflation will result from a loss of confidence in government. A massive deflationary collapse can only occur if: a) our Federal government resorts to full-scale austerity measures (unlikely); b) Americans hoard dollars (unlikely); and c) there is a rise in the value of the dollar that evidences a rise in confidence in government (impossible).

I urge you to consider the aforementioned arguments and stop listening to deflationists. I will add the caveat that there will be huge moves in the dollar in both directions. In other words, we can experience temporary bouts of deflation. But to predict a drawn-out deflationary collapse is just ludicrous. A 90% decline in stocks is ludicrous. So is a 90% drop in real estate. The odds are heavily tilted against those things happening for the reasons I outlined above. The only real threat is inflation- about this I am sure.

This post has been republished from Moses Kim's blog, Expected Returns.

The Media's Confusion About Gold

Whether gold is considered a commodity or currency can depend on who you ask. While it shares characteristics with most commodities, the behavior of gold prices doesn't always follow the path of other commodities. See the following post from The Mess That Greenspan Made.

What you read in the mainstream financial media about gold never ceases to amaze and amuse. About a week ago, in this item at the Wall Street Journal MarketBeat blog, Matt Phillips said he was pretty, pretty, pretty skeptical about the shiny rock save for his belief that it’s a bubble. Today, sitting in for Jason Zweig in writing the Weekend Investor column, Jeff Opdyke thinks that the shiny rock is some sort of a shadow currency.

Rethinking Gold: What if It Isn’t a Commodity After All?

_
This won’t sit well with some people: Gold isn’t a commodity. There. I’ve said it.

But before you fire off an angry response, hear me out. The facts might change your view of gold’s role in a portfolio.

For a long time, we’ve all heard that gold is a commodity—no different, really, from silver or wheat or pork bellies. Its price ebbs and flows (supposedly) with inflation, which historically drives commodity prices.

Odd, then, that gold’s elevated price hasn’t fallen in response to tepid U.S. inflation numbers. The Consumer Price Index as of July pegged inflation at just 1.2% for the previous 12 months, not counting seasonal adjustments. Nor has gold reacted to what Mohamed El-Erian, Pimco’s chief executive, recently called “the road to deflation” on which he sees the U.S. traveling.

The conventional wisdom holds that neither of those scenarios—low inflation or deflation—should be good for gold. And yet it refuses to abandon record highs in the $1,200-an-ounce range. Something seems amiss.

Yes, something is definitely amiss, but it’s not gold. Gold just sits there, waiting to be dug up out of the ground or pulled out of some vault and sent off to some other vault while central bankers run their printing presses non-stop in order to get the ailing economy – its ills widely believed to be a result of too much easy money – back on its feet.

It is truly remarkable that there is such great interest in a metal whose only real purpose in the world is to make paper money look bad in comparison.

Actually, it’s not remarkable at all – unless you’re part of the mainstream financial media.

After seeing only a modest correlation between inflation and gold and the much stronger inverse relationship between gold and the trade-weighted dollar, Opdyke figures the yellow metal is some sort of an anti-dollar or a shadow currency of some kind that is sending off signals about the “potential diminishment” of the purchasing power of paper money.

That sound plausible…

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Are Policymakers Being Too Reactive To The Economy?

Economist Mark Thoma worries that policymakers are waiting too long to take action to help an economy that needs help. He describes policymakers as being reactive rather than proactive, which may result it taking much longer for the economy to return to full employment. See the following post from Economist's View.

At MoneyWatch:

Can Government Help with Structural Unemployment?

I answer yes. I also wonder why we seem to have forgotten about the lags in the policy process:

Policymakers keep making this mistake. Things look tenuous -- and there are plenty of worrisome signs right now -- but then they make excuses, adopt rosy scenarios, and find other ways to wait until they actually see the bad outcome before moving to action. It's like covering yourself up after the blow. Or saying you'll close the barn door if you see the horses running toward it. Who'll get there first? There's plenty to suggest that we need to insure against the chance that things get much worse right now. In any case, we need to try to offset the problems we already have. But yet, there's no action. It's frustrating to see conditions so bad, with signs they could get worse, and have no sense of urgency from policymakers.

Most of the good news on the economic front lately has been about stopping the decline we were in. Presently, we're stuck at the bottom of the valley, and have been for some time now.

Imagine the Sacramento Valley (it's very long north to south, fairly narrow east to west by comparison). We have fallen down one side of the valley, that is the slump, and are now at the bottom (hopefully). The question is, are we traveling east to west so that we'll hit the other side relatively soon, or are we moving north to south with a long, long trek ahead of us before finally climbing back up to full employment? My fear all along is that without more help from policymakers, it would take a long time before reaching the other side of the valley. And unlike what a traveler might prefer, the other fear is that once we finally get to the other side, the climb out of the valley will be a slow and gradual one rather than a steep ascent.

Part of the problem is surely structural, but there's also a large, cyclical component to our present problems. In either case, the economy needs more help.

This post has been republished from Mark Thoma's blog, Economist's View.

Greece's Aggressive Budget Reduction Leads To Severe Consequences

Greece has taken very aggressive measures to reduce their budget deficit by 39.7 percent but the short-term consequences have been relatively severe. Unemployment is expected to reach 14 percent by 2011 while consumer spending has fallen drastically and has led to a large number of store closings. See the following post from The Mess That Greenspan Made.

Der Spiegel reports on how Greek society is adapting to the many “austerity measures” that have been enacted in recent months. It sounds as though the painful (yet much needed) lowered expectations of what government can and should provide are well underway.

The austerity measures that were supposed to fix Greece’s problems are dragging down the country’s economy. Stores are closing, tax revenues are falling and unemployment has hit an unbelievable 70 percent in some places. Frustrated workers are threatening to strike back.
…
The government’s draconian austerity measures have managed to reduce the country’s budget deficit by an almost unbelievable 39.7 percent, after previous governments had squandered tax money and falsified statistics for years. The measures have reduced government spending by a total of 10 percent, 4.5 percent more than the EU and International Monetary Fund (IMF) had required.

The problem is that the austerity measures have in the meantime affected every aspect of the country’s economy. Purchasing power is dropping, consumption is taking a nosedive and the number of bankruptcies and unemployed are on the rise. The country’s gross domestic product shrank by 1.5 percent in the second quarter of this year. Tax revenue, desperately needed in order to consolidate the national finances, has dropped off. A mixture of fear, hopelessness and anger is brewing in Greek society.

They go on to provide a number of anecdotal accounts about how life has changed for both individuals and communities with conditions not likely to improve any time soon given that massive layoffs are expected this fall.

As is the case in the U.S., consumer spending in Greece accounts for more than two-thirds of all economic activity, a statistic that, in itself, should be quite frightening to us ‘Mericans. Come to think of it, that would be an interesting graphic to see for 15 or 20 nations around the world - consumer spending as a percent of GDP. My guess is that, along with the U.K., we already know three of the top five.

Anyway, in Greece, they are now cutting off the source of much of that spending…

Prime Minister George Papandreou’s austerity package has seriously shaken the Greek economy. The package included reducing civil servants’ salaries by up to 20 percent and slashing retirement benefits, while raising numerous taxes. The result is that Greeks have less and less money to spend and sales figures everywhere are dropping, spelling catastrophe for a country where 70 percent of economic output is based on private consumption.

A short jaunt through Athens’ shopping streets reveals the scale of the decline. Fully a quarter of the store windows on Stadiou Street bear red signs reading “Enoikiazetai” — for rent. The National Confederation of Hellenic Commerce (ESEE) calculates that 17 percent of all shops in Athens have had to file for bankruptcy.
…
The entire country is in the grip of a depression. Everything seems to be going downhill. The spiral is continuing unabated, and there is no clear way out. The worse part, however, is the fact that hardly anyone still hopes that things will improve one day.

The country’s unemployment rate makes this trend particularly clear. In 2009, it was 9.5 percent. This year it may rise to 12.1 percent and economists expect it to reach 14.3 percent in 2011. Those, though, are only the official numbers, which were provided by Angel Gurría, secretary general of the Organisation for Economic Co-operation and Development (OECD). The Greek trade union association GSEE considers those numbers far too optimistic. It considers 20 percent to be a more likely figure for 2011.

It should be interesting to see what happens now that the Greek people have progressed through three of the five stages of grief – denial, anger, and bargaining.

Now apparently in stage four – depression – the big question is whether they’ll ever make it to the final stage - acceptance.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Low Real Estate Sentiment Presents Opportunities For Finding Deals

With real estate sentiment at extremely low levels, Dr. Steve Sjuggerud suggests seeking properties that can be purchased for pennies on the dollar in places like the Florida coast. The lack of financing or cash can limit competition for undervalued property. See the following article from Daily Wealth.

"One hundred and sixty-four thousand going once... One hundred and sixty-four thousand going twice... Sold for one hundred and sixty-four thousand dollars!"

I might not believe it if I hadn't been there to see it myself...

But I was there, and it's true: A 50-foot wide oceanfront lot for a single-family home on the east coast of Florida sold yesterday for $164,000. OK, it isn't Palm Beach County... it's in Northeast Florida. But it's still oceanfront.

Just a few years ago, cookie-cutter lots on golf courses 15 minutes away from the coast sold for more. Even today, the county property-tax appraiser's office assessed the value of this oceanfront lot around $500,000.

I wasn't just a bystander at this auction... I was there to bid. But the bidding went above what I am willing to pay these days. I've set an incredibly stringent criteria – I'm trying to buy at 20 cents on the dollar from a reasonable current appraisal today. This oceanfront lot flew by that figure.

That's fine by me. You might think it's not possible to pay as low as 20 cents on the dollar. But I bought two such properties just last week... on the river, a half-mile from the ocean.

Importantly, this strategy works even if prices go nowhere.

As I've told my True Wealth readers, the way to do it is to buy properties up to 40 cents on the dollar and then sell quickly at 80 cents on the dollar. That's essentially doubling your money in a flat real estate market.

It's a classic rule for success in investing: You want to buy when nobody else is buying... and when sentiment can't get any worse.

Right now, real estate sentiment could hardly be worse...

The National Association of Home Builders (NAHB) just released its latest "builder sentiment" survey. A reading of 50 is the midpoint – higher is optimistic, lower is pessimistic. Homebuilder optimism peaked most recently at 72 in July 2005. Guess where it is today...

It's at 13 – the lowest level this year.

The NAHB also tracks "buyer traffic." It's even worse... at 10 – three points from 2008's all-time low (in a quarter century of data). "Sales expectations" are also near an all-time low.

It's hard to imagine how sentiment can get much worse. Keep this in mind...

One year before the housing market busted, homebuilders were extremely optimistic. They didn't see the bust coming. Now, homebuilders are extremely pessimistic. So are we near a price bottom?

Maybe. But I don't expect we'll see housing prices go roaring higher for a very long time.

You've heard my view... We're entering the "sandpaper" stage of the bust, where prices just grind sideways for years. This stage might last a decade. That's why it's so important to pay a big discount.

And make sure it's the highest-quality stuff – something that people definitely want. Also, don't get greedy on the price you sell for. Get rid of it. Buyers are scarce. But they'll appear if you offer a 20% discount from a reasonable appraisal...

If you buy cheap enough, you can sell at a big discount and still make a lot of money.

No doubt, it takes work to find the deals... and cash (not financing). Banks aren't lending for deals like these. Most people don't have cash now, and most aren't willing to do the work. So if you do have cash, and you're willing to put some effort in, you won't have a lot of competition.

If you can muster up those two things, you could set yourself up to potentially double your money in this flat real estate market.

The potential for doubling your money sure is nice... particularly in a zero percent world... so roll up your sleeves and get going on it.

This article has been republished from Dr. Steve Sjuggerud's blog, Daily Wealth.