Wednesday, 20 June 2012

The Economy Is Floating On Air

Much of what we see in recent economic growth is caused by one thing: cheap money and credit. This is obvious as we look at two important economic drivers: autos and homes. Both are significant in that they represent the two biggest purchases that most Americans will make in their lifetimes, so their dollar volume is a significant portion of GDP. Auto sales have been strong, and recently home sales have improved. The problem is that these economic “strengths” are floating on air and will not be sustained.

 While auto sales were off in May, 2012, the trend, YoY, has been up: 
Auto Sales
Source: Ycharts
The buzz among auto industry economists is that “pent-up” demand is driving sales. I have reiterated that point myself, and to an extent it may be true, but as I have also pointed out, such sales have defied the data which shows declining disposable income. declining consumer purchasing power, and declining savings. Perhaps this is why sales are starting to sag. Cheap money can only drive sales for so long.
We also see that home sales have been getting stronger lately. Existing home sales have been rising YoY, but not without lots of detours:
Existing Home Sales
Source: Ycharts
Also, more remarkably, new home sales have started up again, but remain expectedly weak. One would think with all the inventory and shadow inventory out there that new home starts would show no life, but it’s starting to twitch:
New Home Sales
Source: Ycharts
There is just one source of cheap money and that is Federal Reserve policies which have brought interest rates down to historic lows. This is what is holding things up, at least for the moment.
Auto loan interest rates (48 mo. new car loans) are now at 4.32%, and keep declining as the Fed drives down short-term rates. Here is the trend shown by the most recent Fed G-19 Consumer Credit report:
The only reason life is stirring in the housing market is because mortgage rates are at historic lows:
30 Year Fixed Mortgage Rates
Source: Ycharts
There was very little life in the housing market until recently when mortgage rates slipped below 5%.
This tells us several things about the economy:
1. Cheap money is driving the economy.
The Fed has been trying every trick in its policy book to get the economy rolling again. With ZIRP, two rounds of QE, and Operation Twist, the Fed has been trying to stimulate the economy by keeping interest rates at historic lows. It has mostly failed as the economy has pulled back after each round of money stimulus wore off. As I described in a February, 2012 article (“Is This Recovery?“):
… QE1, starting in November 2007 and ending in March 2008, brought a huge infusion of new money into the economy, about $1.3 trillion in only 3 months. The Fed, as you recall, went on a massive buying campaign which including a lot of “bad” assets (GSE debt, etc.). GDP is a lagging indicator, but as you can see it was well on its way down by Q1 2007 as real estate values collapsed and Lehman went under. By Q4 2009 GDP started to pick up which was a 6-month lag from the end of QE1.
As the effects of QE1 wore off, as one would expect it to do in the face of massive deflationary forces, GDP began to stall out and unemployment continued to climb. By October, 2009 unemployment reached 10%, and people were talking about a jobless recovery. GDP peaked in Q4 2009 and started declining again in Q1 2010. The Fed took action starting in November 2009 through June, 2010, and QE2 brought another $600 billion of new fiat money into the economy over a four month period. GDP bottomed out in Q1 2011 and since then it has been expanding, but at a snail’s pace. On a YoY basis GDP is stagnating, but not declining. Again, there was about a 6-month lag between the end of QE2 and GDP turnaround. [See this chart in relation to this article.]
If one looks at the beneficiaries of cheap money, we find they are things favored by the government: housing, the auto industry and its unions, big banks who make risky bets at low cost, and exporters who benefit from a devalued dollar. It would be a rare event in history if government-directed investments turned out to be lasting profitable ventures. 
2. It won’t last. 
As we had forecast, the economy is stagnating because of lack of real, organic (i.e., unstimulated) growth in the economy. In essence, the Fed has tried to reflate the economy with fiat dollars that have no substance to them. Chairman Bernanke, like most economists, conflates fiat money with real wealth. If the secret to growing an economy were printing more paper (QE), we would have ended poverty centuries ago. Every time the Fed inflates the money supply. it causes investment to flow into things that, eventually, don’t want (e.g., housing). Not only does it misdirect fiat money into bad investments, but real savings are dragged along with it, destroying the thing we need to grow: savings based on real organic production.
The Crash of ’08 was the culmination of prior rounds of monetary inflation. The end product, the overproduction of homes, still weighs down the economy, freezing as it were, valuable resources that need to be redirected to profitable ventures. Yet the Fed and the government are doing everything they can to thwart real growth. The effect of two and a half rounds of monetary stimulus have failed to revive the economy and have further destroyed real savings/capital. 
It is obvious that the economy is stalling out and one would think that the Fed would realize that more of the same will not enable a recovery. Because they have no other real alternatives but to “do something”, we can look forward to more monetary stimulus, soon. The key data that they will watch that will force them to act will be: (i) rising unemployment and (ii) what they believe is (price) deflation. Both are occurring now. If they first choose another round of Twist, that will fail just as the last one did. Eventually they will go for more QE which will barely budge the GDP needle and then fail, again.
We all know how floating on air ends.

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