A reader (thanks Debra) chastised me that I have no right to define economic reality. That's very true; but then again, I never claimed that my own definition of reality is objective and absolute. You see, I believe in the non-deterministic quantum universe as defined by Niels Bohr and Werner Heisenberg, i.e. the Copenhagen interpretation. "Reality" is a probability wave function that collapses to a single point when observed. In other words, the cat in the box is neither dead nor alive until I open the box and look inside.
It's the same with the economy: my observation defines my interpretation of it and not the other way round. For example, I was recently at a popular resort area and noticed that it was uncommonly quiet. For me, then, the economy is in sad shape. But then again, it could just be that the winds of fashion shifted and everyone was at another place.
Putting it another, more familiar, way: when my neighbor gets fired, it's a recession. When I get fired, it's a depression.
Apropos of this, then, unemployment statistics are also open to interpretation. Weekly claims for unemployment insurance are adjusted for seasonal effects and are heavily influenced by fluctuations in auto manufacturing. But because of the recent widespread troubles in the auto industry, factories have been shutting down much earlier than usual - some of them permanently. This caused the seasonal adjustment to calculate a smaller than "expected" number of claims for the past few weeks - even as the un-adjusted number rose.
Continued Claims For Unemployment Insurance
We should re-examine all of our seasonal and inflation adjustments with an eye to the new "reality" of the economy, as it exists right now. I will, therefore, ignore adjusted numbers altogether from now on and just look at the raw figures. After all, reality is as we experience it, not as adjusted by someone's theory..
If one is to judge by the terms under which CIT just got a loan from a group led by PIMCO and a bunch of hedge funds, credit is so tight that we should all start making friends with our local loan shark right away - I mean the real one in the ill-fitting suit and brass knuckle bracelets, not the one working at the bank.
The terms are eye-popping:
5% upfront fee paid in cash.
Interest rate at least 13%.
Pre-payment fee of 2% plus 6.5% of the amount retired.
..and get this: posted collateral book value must be at least 500% of the loan amount and its fair value (i.e. market price) must be at least 300%.
All of this for a 2 1/2 year loan of up to $3 billion. No wonder this was immediately dubbed the Don Corleone loan (I'm going to make you an offer you can't refuse..).
I am no lawyer, but I have a faint suspicion that fraudulent conveyance may apply here.. And if it doesn't, because no one else is willing to lend money to a 101-year old company at better than the above Mafioso terms, then the absolute shortest joke for 2009 is: "Green Shoots".
GDP growth and credit creation go hand in hand, at least in modern economies that use fiat currencies. The question is, how much additional debt should be created in order to produce an incremental increase in GDP?
Judging by historical data in the U.S.A., the ratio of debt increase to GDP increase was around 100-200% until the mid-1980's. The ratio briefly rose during recessions as GDP dipped faster than debt - a normal and rather benign situation.
Illusion of Growth
But then things got out of hand: the ratio exploded upwards to 700% even as the economy grew (at least by conventional macro accounting). There is only one explanation for this: the economy was artificially "goosed" by massive amounts of debt in order to create the illusion of growth.
The outcome of this piggish force-feeding was inevitable and pre-determined: a massive credit crunch and a doozie of a prolonged recession. Well, let's not mince words: a depression, though with a lower-case "d".
The Fed and Treasury are desperately trying to forestall the fallout (credit destruction via debt default) by furiously replacing worthless private debt with government obligations, but it is all for naught, really, after the first blush of hope is gone. Debt is debt and a pig is a pig, no matter what color you paint it.
Back From Vacation (but not for long) Special Post
Despite popular belief, summer is always an interesting time in markets. Professionals go on vacation, volumes shrink and therefore prices tend to be more volatile. Take last week: when shares dipped towards the 8000 mark on the Dow, a sharp 10% rally ensued - but with very low volume. It looked like a bearish technical pattern had formed and seemingly confirmed (a head and shoulders, for those into reading such tea leaves), but there was a catch: volume was half to one-third what it was a couple of months ago. It was a perfect "gotcha" opportunity for those looking to throw the innocent into a bear trap ("innocent" being used with tons of salt).
What now? It looks to me like a battle between Mr. Bernanke's Green Shoot Platoon and the real economy's Can't Shoot Straight Brigade. The result is a dynamic stalemate, a bit like trench warfare in WWI.
Until and unless General Volume gets going I think the whole action is pretty pointless.
Vacation time is here. I will be away for the next two weeks, though ever vigilant on markets. As a parting shot, a friendly note to the Fed and ECB. _____________________________________________________________
The Web, July 4, 2009
To: Messrs. Bernanke and Trichet From: A Friend, Dubiously
You have slashed rates to the bone and you are now signaling your commitment to keep them there "for as long as it takes". Assuming your aim is to revive credit markets, i.e. generate a "healthy" amount of credit demand and creation for the greater benefit of the economy, what you are doing is mostly wrong.
Oh, I do understand that your actions and statements are in line with academic monetary policy theories. But, they are misplaced when it comes to what happens in financial markets in practice and work against what we are hostage to: our "animal spirits". You know... fear, greed.. the usual day-to-day stuff.
Allow me to explain in more detail.
I assume that everyone in mainstream finance and government now wants to see credit markets back to normal, i.e. a resumption of borrowing and lending, a rebound in housing and retail sales, global trade. (You know, I am not crazy about this Permagrowth model, but the memo is not about me.) For "growth" to happen, credit demand is of paramount importance: people and businesses must want to borrow. It doesn't matter much if lenders are willing to lend, if there are no willing takers for their loans.
As you know, credit demand from the private sector is very low right now. Apart from the economic crisis which reduces demand, another important factor is pricing, i.e. current and future prospects for the direction of interest rates. If a potential borrower is sitting on the fence about taking out a loan, your statements about low rates as far as the eye can see are creating no sense of urgency at all.
There is plenty of time to think it over, you seem to say. Interest rates are low and will stay low, so no need to rush into a decision right away. Stick around, but you're not going to miss the boat, anyway...
How about this message, instead:
Current interest rates being near zero is an unprecedented event that will not last much longer. We are planning to raise rates in the very near future because such loose conditions are unhealthy for monetary stability and the economy in general. So, if you want to borrow, the best time is right now.
In other words, you should immediately start dispelling interest rate complacency.
I was asked to comment on California's budget predicament. The state has just started issuing IOUs to its suppliers - not exactly a reassuring sign for a borrower that still sports an A/A-/A2 rating for its GO bonds from the major rating agencies.
SAN FRANCISCO (Reuters) - California's lawmakers failed to agree on a balanced budget by the start of its new fiscal year on Wednesday morning, clearing the way to suspend payments owed to the state's vendors and local agencies, who instead will get "IOU" notes promising payment.
Just about every financial spin-master I have read places the blame on government inefficiency, gerrymandering, etc. In other words, they say this is politics as usual - if a bit less so given the current depth of the economic crisis. No one seriously considers the possibility of default, assuming the federal government will be forced to bail out the country's most populous and economically important state. After all, if California was a country it would have the eighth largest GDP in the world.
But.. California in NOT a country, it does NOT have its own central bank and it does NOT issue dollars. It issues bonds priced in dollars, which is an entirely different matter. In that, it resembles Argentina back in the 1990s when it hard-pegged its currency to the US dollar, with disastrous results.
What matters, then, is how the real economy is doing in California. Two charts:
For the three major metro areas in CA, home prices are off 43% from the top reached three years ago. Home prices are crucial because local governments derive a big part of their revenue from real estate taxes.
CA Home Prices Off 43% From The Top
Unemployment is soaring in California. It just touched 11.5% in May, the highest rate in at least 33 years. Payroll and income taxes are collapsing.
Unemployment in CA Soars To 33-Year High
Chart: FRB St. Louis
Quite obviously, then, the budget crisis in California is fundamental in nature; it's not a party-politics stand-off to score points with the voters. It won't be easily fixed in a (non-smoking, surely) back room where deals are cut and backs are slapped. This is REAL and is happening in real-time.
Default probability? Certainly a whole lot higher than the A/A-/A2 ratings would suggest.
Addition: It is instructive to consider facts with all political baloney stripped away. California's general fund revenues are around $100 billion and are derived as follows: 50% personal income tax, 35% sales tax, 10% corporate income tax (see table below, click to enlarge).