No, It's NOT The 1930's

To listen to the media talk about it, the current recession is already the worst since the Great Depression. Well, if you were greedy and/or clueless enough to entrust your money to Bernie Boondogle (that's Mr. Madoff to you), yes, it certainly is. Reserve a place at your favourite ledge and ponder the Perfidy Of Man, if you so desire. But don't launch yourself into the void, because we're just not there yet.

Our western socio-economic model had recently evolved into a perniciously short-sighted "finance-trumps-all" type - and the omnivorous media just loved it. They could - and still do - report every little twitch in prices as if they really mattered, grilling regiments of "experts" for their pithy commentary. They called it value-added content, but in fact it was bull. Not as in bull and bear, but as in baloney.

Likewise, today's media-expert-politician ringlet has a favourite sound-bite of vacuous luncheon meat: "The worst recession since the Great Depression".

Really?

Oh, no doubt about it: if you are caught in the subprime-financial engineering-speculative leverage-hedge fund-private equity vicious cycle, you are definitely having an Anno Horribilis. But that's NOT the economy - you had only convinced yourselves it was, you self-centered navel gazing schmucks. Go ahead and jump if it makes you feel better (it won't), but don't tell US to come along for the ride, ok? We got a world to run and it doesn't revolve around the P&L of your daily trading sheets.

Here's a window to the real economy, then - in my opinion by far the most important one: jobs. The insured unemployment rate (IU: the number of insured unemployed divided by the number of employees that are covered or eligible for unemployment insurance) reached 3.4% last month, a near double from 1.8% in 2006.

Insured Unemployment Rate (recessions shaded)

Yes, things are bad, but not as bad as 1975 when insured unemployment reached 7%, or even 1982 when it went to 5.4%. And, most definitely, NOT the worst since the 1930's - not even close (at least, not yet).

So, why are analysts and the financial press already foaming in the mouth? Because they are judging the world as they see it through their own ash-coloured glasses. A perspective so distorted now as it was back when Madoff was a prince instead of a bum. Amazing what a few thousand layoffs in your closest vicinity can do for your personal view of the world, eh? Yes, a recession is when your neighbor gets fired and a depression is when you do.

All this has consequences for the immediate future, defined as the next six months or so. Contrarians, take note...

Questions: Deflation and "Keynes"

A reader posed two questions which I find interesting (thanks Tiago). I will try to answer them below.

• Do you expect the current "quantitative easing" to convert the deflation scenario to an hyperinflation one?

First of all, deflation is no longer a "scenario" but a reality. Real estate, commodities, shares, capital assets of all kinds are all experiencing sharp price declines. Even consumer goods are being offered at unusually reduced prices (aka "sales").

But let me answer the question..

No, I do not expect hyperinflation. The reason is that the dollar is the de facto global reserve currency, providing America with historically unprecedented global power. I cannot imagine the United States will give up its dollar imperium - at least, I do not think that it will do so willingly.

But can it happen unwillingly? That's not easy, either. There are vast sums of dollars being held abroad which cannot be converted quickly into another currency as one could do with, say, Zimbabwean dollars. The US economy is vast, comprising approximately one quarter of global GDP. Until and unless another country or entity can assume this global role America will maintain it and so will its currency. Whilst the EU does possess the combined economic size to rival the US, it does not have the political and strategic unity necessary to form its own empire - and won't have it any time soon.

• What do you think about the "keynesian" approach being followed by almost everyone (Germany seems to be the single possible exception)?

It's what one would expect, given established academic thinking, past experience and historical references. The "establishment" will first and foremost attempt to perpetuate itself - that's only logical. Nevertheless, I believe this will ultimately prove wrong.

We are fast reaching the limits of the Permagrowth (i.e. establishment) economic model: the signs are everywhere from environmental and climatic crises, to resource depletion - to name but a few. Keynes was a brilliant fellow. If he was around today, facing today's challenges, I'm sure he would be coming up with very different proposals.

Easing Into The New Year

Nothing is more customary and expected in finance than New Year's predictions about market performance in the year ahead. However, this being a confirmed contrarian site, yours truly shall abstain from delphic blather. Instead, let's talk about easing; specifically, the hot new topic of quantitative easing.

Well, what does this techno-babble expression mean, anyway? It means that the Fed has brought the cost of money (interest rates) to zero - and as any micro-economics professor will tell you, when the price of anything is zero demand goes to infinity (in theory, anyway).

As I am fond of saying: "Money for nothing, chicks for free". The Fed is in Dire Straits, indeed.

Two thoughts:

• The Fed is desperately trying to arrest what it sees as a runaway train of deflation from smashing into the entire economy. But which economy is it trying to protect? Obviously, the Permagrowth economy which - in my opinion, at least - is completely past due its expiration date. It would be far more constructive to re-think the entire concept and come up with a radically different economic paradigm: the Sustainable Economy. In such a case, quantitative easing is completely and unequivocally the wrong thing to do.
• Even if the Fed is determined to keep going as it is, we must seriously think of the consequences down the road. The Fed's presumed plan is to prevent future hyperinflation by soaking up the excess liquidity immediately once deflation is reversed. Easier said than done; it's like taking a shower with water of only two possible temperatures: scalding hot or frezing cold. Good luck with that...

Oh, allright... I'll succumb to the usual temptation and risk a prediction, after all: The Fed will keep on its present course until financial markets finally cheer up and signal a recovery, even if such signal ultimately proves short-lived and false. Mr. Bernanke has no choice, really; his entire career has revolved around the study of monetary policy during the Great Depression and ways to combat it using squadrons of moneycopters. In this way he is, very unfortunately, the very definition of the anti-Protean Chairman (*).

May the year ahead prove eventful - or, even better, historic. That's pretty much a curse, I'm afraid...
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(*) Protean: versatile, flexible, adaptable.

From...To..

As this Year of Our Discontent slowly grinds into the (less-than) festive season, a collection of unintended consequences that have occurred in the last 12 months.

• From regulatory hands-off to Madoff (dedicated to the SEC).
  
• From a home to call your own to Home Alone (dedicated to the sub-prime market).
  
• From a bull in China to a bull in a china shop (dedicated to believers in perpetual motion).
• From full of ships to a ship of fools (dedicated to the shipping bubble).
• From copper to cropper (dedicated to the commodity bubble).
• From dear oil to oil, oh dear! (dedicated to Peak Oil - in capitals - and Goldman's analyst who called for $200/bbl).
• From laissez-faire to less-is-fair (dedicated to salary cuts, forced vacations and the job market in general).
• From Friedman to Friedman (dedicated to Milton and Thomas, respectively).
• From BRIC to bric-a-brac (dedicated to developing economies).
• From the yen carry trade to the carry-out counter (dedicated to spread indigestion).
• From correlation trades to poor relations (dedicated to money for nothing).
• From Credit Default Swaps to Schweppes Club Soda (dedicated to indigestible free lunches).

Merry Christmas to one and all and may the New Year bring whatever you wish (so take care what you wish for).

Yours truly is going to abstain from posting for a few days, concentrating instead on friends, family, food and drink - not necessarily in that order. Toodles..

Fishing For Sectors

Two of the largest sectors of the US economy are housing and automobiles. Both are reeling (see charts below).

Looking at the charts, we observe that both industries had been on a more or less continuous uptrend since 1990-92 - until they jumped off the cliff in 2007. What happened? It's quite simple, really: houses and autos are the #1 and #2 most significant purchases people make in their lifetimes, usually financing both. That's where easy-easier-easiest credit came in: in just a few years household debt as a percentage of GDP jumped from 67% to nearly 100% (see chart below).
In other words, between 2000 and 2007 we over-borrowed and over-spent on houses and cars, satisfying future demand for many years to come. No matter how low the Fed takes its rates (a record low 0.0% - 0.25% as of yesterday), people are not going to rush to borrow to buy such big-ticket, long-lasting items anytime soon. They do not need them, because they've already bought them. It follows that household lending - the driving force behind finance in recent years - is also going to be down on its heels for many years.

Conclusion: don't go bottom-fishing in these sectors just yet. Instead, investors will be better off looking for The Next Big Thing. What's that? My bet is on alternative energy and everything that revolves around it, such as smart electricity grids. A wholesale shift from "black" to "green" will necessarily require massive investment and will, also necessarily, lead to a shift from consumption to saving, in order to finance it. This will pose significant challenges to the retail and traditional services sectors, too.

I fully expect a long period of massive Creative Destruction to unfold, i.e. OPPORTUNITY. Any and all ideas from readers are welcome..

Margin Debt Continued

Continuing from yesterday's post, a reader asked to see margin debt as a percentage of account value. This would give a better picture of the degree of leverage. Unfortunately such data do not exist - at least not in the public domain. Instead I have done the next best thing: margin debt as a percentage of total US market capitalization. Here is the chart:

Data: NYSE, World Federation of Exchanges

P.S. I am sure you have all seen the boot-iful Bush video. All I have to say is: Duck and Cover

Margin Debt

The amount of margin debt as reported by NYSE has plunged to $233 billion in October (latest figures available) from a high of $381 billion reached in July 2007. It's pretty certain that it has declined even further in the last 1 1/2 months, given the recent performance of markets.

I must caution that we live in the Age of Derivatives and therefore speculative leverage can be taken on in many more ways than plain old margin debt (e.g. CDS). Still, there is no question that de-leveraging is happening very fast.

Conclusions, anyone?

Zeroeing-In On Deflation

The latest 3-month US Treasury bill auction resulted in 0% rate and was oversubscribed four times. How about that, for deflation and risk aversion, eh?

I am not surprised. This is the hangover following the wild easy-credit party that ultimately saw financial engineering elevated to the same position as real engineering (yes, I was offended). The same party that created the awesome stupidity of $65 trillion in credit default swaps which first allowed piling on much more debt than prudent, and which are now inhibiting the cathartic process of its quick demise.

What's next? Will free money (for the federal government, anyway) result in another Greenspanite bubble? No, no time soon. This development is not something that the government wants, you understand. It clearly underscores the fact that deflation is happening as we speak, that assets carrying even the smallest amount of risk are shunned in favor of mere capital preservation. The debt trap has become - predictably - a deflationary liquidity trap, American economists' and policy makers' greatest phantom menace since 1929.

I will, thus, say it once more: instead of allowing this deleterious process to drag out for years by attempting to preserve debt (as the Fed and Treasury are doing now), we must instead allow it to be destroyed, to be liquidated in as orderly a fashion as possible, as quickly as possible.

Payrolls and Grids

The number of non-farm jobs in the US declined by 533,000 in November, the largest drop since 1974. But because absolute numbers almost absolutely lie, here is a chart of the same number as a percentage of the civilian labor force. At 0.34% the reading is still pretty bad, I'm afraid.

And if this recession is the worst since the Great Depression, as most analysts are now constantly reminding us, this number is going to get much worse in the very near future.

This explains Mr. Obama's haste to announce a vast new program of infrastructure spending, from roads and bridges to schools and "green" projects. No question, this president-elect wants to hit the ground running come January.

The most intriguing, and in my opinion most worthwhile, project in his agenda is the so-called smart electric grid. It would allow power generators to communicate directly with their customers over the same wire that provides electricity, down to each individual appliance. This has the potential to radically transform the entire industry, finally taking it from the 19th century into the 21st. This is also where America excels: the application of modern technology (in this case information and communications) to the creation of an entirely new paradigm.

Mark my words: if the new president is successful in this, the entire world is going to be transformed. And knowing how things work in America it will happen fast. The profit motive will see to it.

The Economy As Schrodinger's Cat

This post is lovingly dedicated to S.

Today, an oblique homage from the dismal science (economics) to Erwin Schrodinger, a real scientist. As you may recall, he was the quantum physicist who discovered the eponymous equation (simplified version below).

Schrodinger's Equation For A Single Particle In Three Dimensions

Are we having fun yet? Is this gibberish not what you signed up for when you clicked on Sudden Debt today? Do try to hold on, however, because Mr. Schrodinger most famously also devised the well-known cat-in-the-box thought experiment - and that's our topic today. (After a fashion, anyway...).



Just like the cat inside the box, is the US economy currently dead or alive? Does it follow quantum mechanics, meaning that the two states are superimposed and the economy is both dead and alive? Finally, does the mere act of observing the state of the economy affect the outcome?

Let's start from the latter: yes, observation does affect the economy - if the observer is a presumed expert like the Fed Chairman or the NBER, whose dicta carry considerable weight. (Well, not so much their actual looking at the economy as what they say about it - the analogy with quantum physics is not perfect, but you get the point.) More significant is the fact that they have to look at the economy and they have to pass judgment on its health. Unlike the physicist running the cat experiment, these experts are obligated to look inside the box and thus collapse the superimposed states into one.

Currently, every expert has quite apparently looked at the economy and pronounced it dead. In fact, the NBER just post-dated their death certificate and now says that the recession started a full year ago, in December 2007. Could it be that the dismal scientists are currently attempting to convince us that the worst is already behind us? I mean, how can one constantly observe a cat and only decide today that it died a year ago, hoping that the pronouncement will bring it to life tomorrow? The mind boggles... even quantum mechanics doesn't allow for such cavalier treatment of time.

For my money, the economy is still inside the box - it is still both dead and alive. Some dead sectors (finance, real estate) are superimposed upon some others that are very much alive (alternative energy, organic farming/food). Yet other sectors are both dead and alive at the same time, like the auto industry which is dead at the combustion engine end, while being reborn at the plug-in hybrid end.

There is opportunity around, that's for sure. Just make sure that your money's on the right cat.

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Note: People are asking for "cat" ideas in the comment section. There are plenty here:Hot, Flat, and Crowded: Why We Need a Green Revolution--and How It Can Renew America, Thomas Friedman's newest book. He may not be a scientist or engineer but he does speak with a lot of important and relevant people.