The mindset will not change; a depressionary relapse may be coming

When former Morgan Stanley chief Asian economist Andy Xie comments on the United States, he focuses on a bailout nation keen on perpetuating a bubble economy predicated on malinvestment and overconsumption.  In this he sees parallels with Japan and its long malaise.

Japan has experienced two decades of economic stagnation since the collapse of the infamous bubble it suffered in the 1980s. The most popular explanations are that Tokyo wasn’t aggressive enough in stimulating the economy after the bubble burst, or that it withdrew its stimulus too early – or both. This line of thinking is popular among elite economists in the US, where it is rarely challenged. But few Japanese analysts buy it…

The argument to "stimulate until prosperity returns" is popular because it doesn’t hurt anyone in the short term. When a central bank prints money, its nasty consequence — inflation — takes time to show up. When a government spends borrowed money, repayment is in the future. Nobody feels the pain now. Indeed, when debt is sufficiently long-dated, nobody alive need feel the pain. So analysts who advocate stimulus are popular with politicians because it sounds like a free lunch. Japan’s tale is just a nice story that seems to support the argument…

Japan has run up the national debt equal to 200% of GDP — the greatest Keynesian stimulus program in history — all in the name of stimulating the economy back to health. It has failed miserably. Japan’s nominal GDP is about the same as when the stimulus began. Those who advocated the policy blame Japan’s failure on either the stimulus being too small or not being sustained for long enough – that is, the dosage, not the medicine itself, was at fault.

The bankruptcy of Japan Airlines is a sobering reminder of what is still wrong with Japan. It stayed with unprofitable routes for years without its creditors or shareholders being able to do anything about it. And by making credit cheap and easy, the stimulus prolonged the airline’s business model — actually, an anti-business model — for a long time. Zombie companies that have first claims to resources have trapped the Japanese economy in stagnation for decades. The lack of shareholder rights has given the moribund companies the luxury of being able to disregard capital efficiency. The government stimulus has prolonged this inept business practice.

What ails Japan is a lack of reforms, not stimulus. The prolonged and massive bailout has only allowed a bad situation to continue. As governments around the world look at their own problems, this is the lesson they should draw from Japan – not the wrong one that insists Japan should have spent more.

Exactly right. Stimulus is no panacea for excess capacity and malinvestment. The problem in Japan is that it propped up zombie companies and asset prices in a quest to prevent a Great Depression-like deflationary bust. This has discouraged capital investment in the business sector because zombie competitors reduce returns on investment. And it has trapped some in debt-laden assets.

I was thinking about this in the U.S. context. What would happen to a neighborhood where house prices declined just enough that it created financial distress for the house debtors but not enough that they were foreclosed on or walked away?

The answer I came up with is low property maintenance. I liken it to what happened at RJR Nabisco post-leveraged buyout. The company was so indebted that it focused on debt reduction to the expense of capital investment and maintenance. This ended up hurting their brand and reducing profitability.

The same is true for neighborhoods in distress where houses just aren’t maintained and fall into disrepair. You see similar patterns with elderly people living on fixed incomes. So this is my guide of what to expect.

Then I asked myself what would happen with price discovery – a more rapid fall in asset prices to their previous long-term trend level – in that same neighborhood. The answer is default, foreclosure and bankruptcy – effectively reducing debt levels. The question then becomes whether those houses would remain empty and abandoned and fall into disrepair because of excess capacity or whether they would eventually be bought because of the now lower price.

On the whole, I think we need price discovery. This would stress the system and reveal many banks to be insolvent. However, if done with enough fiscal force to prevent a deflationary spiral, we could actually get through the period quicker and with a lower increase in public sector debt.

As for Xie’s views on the U.S., optimistically, he entitles his latest piece “A Change of Mindset,” as if to say the bailout mentality has come to an end:

We are hearing the first major departure from the mainstream consensus; US President Barack Obama has just announced a proposal to limit proprietary trading on Wall Street. This is his first major step to address the root cause of the crisis.

The crisis happened because financial professionals had incentives to bet other people’s money in a game they could not lose. With so many getting in on the act, the liquidity they threw into the trades made them effective, turning bankers into heroes, but only for a while.

The crisis showed that their behavior was indeed rational: while the losses to shareholders and taxpayers surpassed all the accounting profits that Wall Street reported during the bubble, those who made the trades are still rich, because they paid themselves bonuses in cash, not derivatives.

Obama has not been well-advised. His so-called accomplishment — stabilizing the financial system — comes from throwing trillions of taxpayers’ dollars at financial firms. He has behaved like a Wall Street trader: spending other people’s money with no thought of consequences. Anyone can do that. Hopefully Obama has fundamentally changed his approach.

Reform, not stimulus, is the solution. Only by limiting financial speculation can the foundations be laid for a healthy recovery, and to prevent another crisis.

I am glad he is hopeful that Obama sees the folly in more bailouts and malinvestment. Perhaps he is on to something.  However, I do not expect the mindset to change whatsoever. Bank profits are back at record levels and the worst of the panic is now over. You don’t get a change in mindset in that environment. More likely, you get a victory lap.

I expect the following to occur:

  1. Public pressure to withdraw monetary and fiscal stimulus will work and stimulus will be reduced quicker than many anticipate – beginning sometime in early 2010. The Fed has already said it will stop buying mortgages in March and the Obama Administration is now focused on deficit reduction as evidenced by the paltry jobs bill just passed.
  2. The fiscally weak state and local governments will therefore receive little aid from the federal government. This will result in budget cuts, tax increases, and layoffs by the end of Q2 2010.
  3. At the same time, the inventory cycle’s impact on GDP growth will attenuate. By the second half of 2010, inventories will not add considerably to GDP.
  4. Meanwhile, the reduction of Fed support for the mortgage market will reveal weaknesses there. Mortgage rates may increase, decreasing housing demand.
  5. Employment will be weak in this environment, leading to another spate of defaults and foreclosures.
  6. The foreclosures and weak housing demand will pressure house prices and weaken lender balance sheets, especially because of second-lien exposure. This will in turn reduce credit growth.

I expect the weakness in GDP from this scenario to be evident sometime in the second half of 2010. The only thing in this sequence of events which is supportive of asset prices, credit and GDP growth is that the government will still be manipulating mortgages even after the Federal Reserve stops buying MBS paper. Fannie and Freddie are the only game in town in securitized mortgages, buying the vast majority of paper.

As they are now government entities with an unlimited backstop from the U.S. Treasury for losses, the nationalization of America’s mortgage problem I had foreseen can begin. I understand Fannie and Freddie have been shifting their excess funds from the term Fed Funds markets to Treasury Bills. This may be because of a regulatory mandate to achieve more liquidity and may help explain why the Fed Funds rate is creeping up to the upper bound of the Fed’s policy range. Whether this liquidity policy is in anticipation of the need to use Fannie and Freddie’s balance sheet is unknown. In any event, if Fannie and Freddie are used to forestall weakness in the mortgage market, they will eventually suffer huge losses.

Will this be enough to prevent a double dip? I think not, but you can bet the Obama Administration will try.

  1. demandside says

    Changing the mindset is right. Expecting stimulus or reform to work that does not address the immense private debt is not changing the mindset. PCE trickles along at 0.1-0.2 per month. How is that going to lead to anything on the private side other than continued stagnation?

    The Japanese example comes with another parameter, the feeble social safety net which requires households to suck up whatever they can, hoarding against old age and want. The Japanese housewife is a prime mover in global bond markets, for example.

    No amount of stimulus currently politically feasible will increase effective demand in a condition where citizens feel exposed like this. No addition to effective demand from investment is in prospect when we are in asset price deflation. Does the Japanese experience contradict this?

    The hysteria over the federal deficit and debt is at a minimum ill-timed. Like calling for the fire department once the house has been reduced to ashes, after years of toasting wienies on the flames with good cheer.

    An unreconstructed banking sector is an off balance sheet liability that is ballooning by the day. Gutting state and federal spending is failing to till the soil and plant the seeds and then expecting a crop anyway. When the debate is about things that don’t matter, we are in a pile of ….

    One more thing, as long as I’m ranting. In the 1930s, the best minds of a generation went to work on economics. Today the best minds are frozen out by entrenched academic and financial interests. The mistakes are ignored and amplified, really, by legalized campaign corruption and by mass media propaganda campaigns. I mean, really, the CFPA is even debatable?

    1. Edward Harrison says

      Good rant. Interesting that you mention the social safety net and the CFPA. The brainwashing done to Americans who have bought into extreme versions of the free market ideology is immense. Common sense would tell you that an erosion of the social safety net is destabilizing for a society, particularly in periods of economic distress.

      Automatic stabilizers go a long way toward reducing that stress. But, proponents of the free market want to reduce automatic stabilizers rather than increase them. We see that during this recession, Germany, a country with a greater social safety net, actually had a lower increase in unemployment. So, it puts the canard that the ability to fire quickly is key to inducing firms to re-hire quickly.

      I also see the increasing complexity of financial transactions as a tool through which the playing field is tilted that further erodes the social safety net by harming consumers and increasing economic distress.

      Marshall has been a big advocate of simplicity as a solution to our problems in financial services. I am beginning to see more and more merit in that argument across the board. However, the proposed CFPA is not only now going to be emasculated by being domiciled at the Fed, it won’t even make plain vanilla contracts part and parcel of its core mission.

      It’s hard not to have the view that complete economic collapse is the only thing which will bring true reform in finance and economics.

      1. demandside says

        Just so. Sadly.

  2. Paul Francis says

    EXCELLENT analogy of Price Discovery. Yesterday I was in a neighborhood with an out of state investor that commented on how much it has changed from when we first started looking at homes in the same neighborhood in August of 2008.

    August of 2008 — Clearly a lack of pride in what were homes sold by the builder in the $500,000+ range. Over 80 distressed (foreclosures & short sales) to choose from at that time. Trash, unkept yards, dying trees, etc, etc.. Prices were averaging around the 250,000 range.

    March of 2010 — A Major turnover of ownership has transpired as homeowners with huge loans have exited and new owners with tolerable loans have entered. Clearly evident from the amount of new landscaping, spotless yards and thriving plants. It’s turned into a solid neighborhood with little to choose from and buyer interest is high. Price range = around $250,000.

    Not to discount the First Time Home buyers Credit and artificially low interest rates which possibly have kept prices from falling lower during the transition.. but the main attraction is the neighborhood now looks like somewhere you would want to live.

  3. Element says

    Debt is the stresser but the shocker will be exploding input costs for exporters – and Beijing seems to agree that this is the real danger for them.

    Some observations about the rapidly rising cost of raw materials for manufacturing and export.

    We are in a rapidly building commodity price-cycle that will create sharp input price shock.

    The problem is purely that the potential Asian demand is far larger than that of the developed world, and ramping up sharply every year. It’s growing much faster than most or the developed world realise (or are willing to face), and only some of the demand is due to credit froth. Most of it is non-linear secular demand growth, increasing faster than new production of raw material PRODUCTION AND SUPPLY CAPACITY can keep pace with DEMAND GROWTH.

    The problem is NOT a lack of resource reserves (and is not about oil).

    It takes many years to build new mines, ports, railways, roads, and engineering businesses (especially with chronic industrial skill shortages due to past serial malinvestments and under investments).

    Commodity supply countries can not do it fast enough to meet the accelerated global demand-growth. The growth in demand is much faster than the (slow) growth of supply capacity.

    So we’re going to see repeated sharp price spikes and busts (2004 to 2008 style), for the foreseeable future, due to the general rise of Asia, with serious impacts for manufacturing and exporting countries, especially the giant export economies, China, Germany and Japan and the US.

    Here are some recent excerpts that bare this out; “Global manufacturing continued its expansion In January” – Credit Writedowns posted by Edward Hugh, 3 February 2010.

    Russia; “Commenting on the survey, Dmitri Fedotkin, economist at VTB Capital, reported: “…The input price index rose to 61.4 amid higher commodity prices and freight charges while the output price index rose to 54.0 as companies tried to pass rising costs on to customers.” …”

    “In Spain … Companies offered discounts to clients in an attempt to boost sales, despite input costs rising again during the month.

    Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker, economist at Markit, said: “Manufacturers were again forced to cut prices in January as weak demand made it difficult to pass on higher raw material costs to clients.” …”

    “Turkish manufacturing sector … Higher input cost inflation however droves a further rise in output prices.

    Commenting on the Turkey Manufacturing PMI survey, Dr. Murat Ulgen, Chief Economist for Turkey at HSBC said: “…On the other hand, the ominous outlook on cost pressures remained intact in January, as input prices continued to rise much faster than output prices, possibly because of soaring raw material prices. This tells us that inflationary pressures are in the pipeline and businesses may pass on rising costs to their end prices when they feel more comfortable about aggregate demand conditions.” …”

    “Commenting on the India Manufacturing PMI survey, Robert Prior-Wandesforde, Senior Asian Economist at HSBC said: “At the same time, however, price pressures are clearly intensifying. The rate of increase in input prices was the largest since the PMI began nearly 5 years ago, while the survey suggests that companies are more willing to pass on these rises in the form of higher output prices …” …”

    Commenting on the Markit/CDAF France Manufacturing PMI final data, Jack Kennedy, economist at Markit, said: “However, staffing levels continued to be cut as manufacturers targeted cost savings and productivity gains at a time when input price inflation reached a sixteen-month high.”

    Commenting on the Greece Manufacturing PMI survey data, Gemma Wallace, economist at Markit said: “… Meanwhile, firms were struggling to cover rising costs, as strong competition and unfavourable demand conditions rendered them unable to raise charges.

    Commenting on the China Manufacturing PMI survey, Hongbin Qu, Chief Economist for China at HSBC said: “Industrial activity continues to accelerate, implying stronger GDP growth in 1Q. But rising input and output prices also point to greater inflationary pressure, which will likely prompt more tightening measures in the coming months.”

    If you want to see what severe commodity price swings and inflationary pressures do to severely debt-stressed or structurally weakened economies from systemic failure read; “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises” – Carmen M. Reinhart and Kenneth S. Rogoff – April, 2008. (Google the 58 page .PDF, if you haven’t already)

    We are going to go along happily with a generally impressive global ‘recovery’, then we’re going to slam into an immovable wall of insufficient commodity supply capacity to meet the higher global demand as an inventory growth surge causes input prices to spike as never before.

    Manufactured products must spike, at some point (even though they won’t), as above quotes make clear. The pressures are already building, only consumers will be missing in action, due to credit over-extension, and high under-employment, and the fact that bankers are NOT lending like they used to.

    Watch what happens when manufactures realise their production costs are way out of balance with what they were expecting in order to make their investment repayments.

    No credit = no consumer = no sustained recovery = broke manufacturers = commodity price crash = stressed miners = insufficient investment for expanded supply capacity for sustained global recovery, and less stable commodity prices in future.

    The only thing holding back commodity prices now is the consumer weakness and debt uncertainty in almost all economies. Any sustained GDP upturn will see prices rocket upward to shatter manufacturing (and perhaps this is what’s necessary).

    So will Sovereign Govts issuing fiat bucks buy the products (because they can), and hand them out for free instead, to save jobs? i.e. via direct stimulus payment to private bank accounts (as Australia did in the first half of 2009). Because that’s probably the only way these manufacturers won’t go broke and shed jobs all over weak economies.

    But it still doesn’t fix the problem of cyclical commodity supply under-capacity to meet demand growth in a ‘recovery’. Asian demand is now FAR bigger than it was in 2006 when the last price bubble really took off and next year it will be FAR larger again (if froth continues that is).

    This is exponential demand growth. Supply capacity growth is fast but nowhere near fast enough to keep up, with a growth trend closer to linear.

    What can not continue, will not continue.

    This boom-bust cyclicity will repeat, again and again, until we reach a sustainable ‘new normal’ of economic activity, within a deleveraging and generally deflationary environment. i.e. not the environment needed to inflate away public debts, nor to increase tax revenue, or to sustain productive investments in manufacturing and new employment and new business growth.

    This is serious and the impacts are currently very under-appreciated. And the effect of the extreme commodity spiking in mid-2008 has also not been recognised and fully appreciated for its part in the great trade collapse that followed. It was not just about debt.

    It’s all about AFFORDABILITY.

    Commodity price spiking means unaffordability rapidly spreads everywhere, especially at the bottom of the economy, the subprime end, and the once large lower middle-class. That’s the scenario Reinhart and Rogoff ultimately warns of and I don’t see anything occurring now that will (or probably can) avoid this recurring in 2011-2012 at this point.

    But if we were to do anything useful the number one item would be to avoid commodity price spikes and busts. And that requires the active political participation of all the giant commodity suppliers and all the giant commodity buyers to try and restabilise prices via moderating pro-cyclic supply and demand pressure.

    Ultimately you can only accelerate supply capacity growth so much, the real answer to price stability is in DEMAND stability. The exact opposite of what governments want from their economies right now.

    So I am not optimistic anything can be done to avoid the next spike and mega-bust, but perhaps we will be aware enough to avoid the next one, a couple of years later.

    If we don’t do something, something BIG, the following paper is illustrative of what can occur to even to a great world power, and within a surprisingly brief timeframe;

    “The Soviet Collapse: Grain and Oil”, By Yegor Gaidar (former Acting Prime Minister of Russia, Minister of Economy, and First Deputy Prime Minister of Russia, 1993 to 2003), at American Enterprise Institute for Public Policy Research, April 2007. (Google the 8 page .PDF, or download from

    As of early March 2010;

    Chinese exports remain very weak, and the year-on-year shows the cumulative devastation of the great trade collapse, which has NOT been recovered from (unlike equities). In fact, Chinese exports have fallen sharply since the end of December 2009.

    That’s not a ‘recovery’ nor ‘growth’. It’s a devastating slump. No country can go from major exporter to NET importer in 16 months and be experiencing genuine growth of >10% per quarter.

    China has lost and is re-loosing export volume while export product prices remain weak, plus input costs rise sharply. The cost of iron ore is expected to double (yet again) over the next 12 months, while coal uranium and LNG are all going up sharply, as the next commodity bubble climbs toward it’s next crash triggering an inflation shock in Asia.

    Given the debt-stress, high unemployment, lower export volume, rising tax, high single-digit inflation with interest rate rises and wage pressures will be more than enough to shatter growth and pseudo-stability.

    Even single-digit rates of inflation on top of this are more than enough to trigger collapse.

    Indeed, if markets and consumption are flat or slowly weakening this might actually be the best way to avoid the worst-case outcome, of a major double-dip in world trade.

    But as Mohamed El-Erian has pointed out, markets and business have largely not priced-in a flat market, let alone a double dip. There’s a need to risk it all, in order to recoup on investments (debt), in order to repay debts, which seems to be the driving factor.

    If you had factored in flat conditions, you’d be admitting that you’re going broke, and we can’t have that. Business is all about taking the risks and living with the results. You make of those risks what you can-you have no choice. You take the risks, or one way or another, you get out of business. But at the moment, the risks are unmanageable and everywhere, and businesses are simply trying to make what they can of it. But I doubt many will like their results.

    (real) banks go broke because their clients go broke.

    The problem in 2007-08 was not in the (real) banks or in toxic assets.

    Small businesses were dying then and they’re still dying now. It’s really simple for the business operator. It’s UNAFFORDABLE to remain in business and commodity prices made it so then, and are making it so now.

    And that is the lesson that’s still being ignored. We need less demand growth and much higher commodity supply-side volume and capacity growth.

    Global supply growth and demand growth are drastically out of balance, and almost all are ignoring it. So no one is focused on how to rebalance it.

    We still want more demand, from more growth, from more debt, with low-inflation, whilst ignoring that these conditions have already transitioned to becoming mutually incompatible outcomes. We’ve only seen the beginnings of systemic break down if we don’t see a general improvement in manufacturing affordability and exports rising.

    Unaffordable = no NET new jobs.

    March 14th 2010 – China’s Premier,Wen JiaBao warned the GFC is not necessarily over (yeah, right! official ~9% GDP growth in 2009 from a low of about 6.4% qualifies as a ‘recession’? What is he talking about?) and that a double-dip recession is possible. Again, WTF? He cited a double-dip potential on the grounds that bulk commodity prices (input costs) and major currencies were not stable.

    Commodities are going to be crushing and cyclic for the foreseeable years.

  4. fresnodan says

    Excellent analysis.
    We will have problems until people understand that debt is not wealth, and borrowing is not income. But you get the sugar and sweetness instantaneously, while the cellulite doesn’t show up for a while. And than to get rid of it, no ice cream and you have to work harder!

  5. J. Powers says

    Fantastic, if grim, post. Against the backdrop you’ve painted, I’m tempted to read public opinion as the ultimate arbiter of “credibility” in the aggregate. It’s useful in many instances to quantify credit, but ultimately, you can’t get a loan if lenders don’t believe you’ll pay it back.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More