Monday, August 31, 2009

The Dire Position of the US Economy

Yes, cheer up everyone, the 'Great Recession' has come to an end. Or so says the New York Times, in yet another positive article:
Even as evidence mounts that the Great Recession has finally released its chokehold on the American economy, experts worry that the recovery may be weak, stymied by consumers’ reluctance to spend.
Here we go again. The 'mounting evidence' that all is well in the world after all. The problem is that, having told us that all is well, the article goes on to say the following:

Given that consumer spending has in recent years accounted for 70 percent of the nation’s economic activity, a marginal shrinking could significantly depress demand for goods and services, discouraging businesses from hiring more workers.

Millions of Americans spent years tapping credit cards, stock portfolios and once-rising home values to spend in excess of their incomes and now lack the wherewithal to carry on. Those who still have the means feel pressure to conserve, fearful about layoffs, the stock market and real estate prices.

So what of the recovery? With consumers quite reasonably digging in their heels and refusing to spend, and consumer spending having been 70% of economic activity, where exactly is the recovery coming from? The basic contradiction between the opening of the article and the content is completely lost on this author. He even highlights one of the artificial props to the so-called recovery, writing:
In recent weeks, spending has risen slightly because of exuberant car buying, fueled by the cash-for-clunkers program. On Friday, the Commerce Department said spending rose 0.2 percent in July from the previous month. But most economists see this activity as short-lived, pointing out that incomes did not rise.
If this is a recovery, then I would really like to see how they might define a bad economic situation. As such, a brief review of some of the highlights of the US economy....

Let's start with the banking system. It is all tickety boo, is it not? The first problem is that, at the commanding heights of banking, there are the zombie banks with portfolios filled with toxic waste. Whilst the world appears to be sunny, this is largely down to the accounting fiddle of FASB 157 (Financial Accounting Standards Board), in which the standard of Mark-to-Market standard 'fair value' of assets was watered down. What this means in plain English is that the valuation of assets has been moved from being what they can actually be sold for in the open market, to what they might be able to make if the world was a wonderful place again.

The excuse for this change to the rules was that there was no market for the assets, due to a collapse in banking liquidity...but even at the time of the change, there was a massive pool of liquidity 'out there', for example in sovereign wealth funds (who are estimated to have over $US 3trillion in assets). If the toxic waste on the bank balance sheets were of any value, then there were plenty of potential buyers out there, so there has always been a market for these assets in principle. The problem is that they are junk, and the change to the accounting rules has simply hidden this.

As if this were not bad enough, the meltdown of retail mortgages is now going into the new phase, which is the rise of prime mortgage defaults:

The percentage of loans on which foreclosure actions were started was 1.36 percent, down from 1.37 percent in the first quarter, driven by the decline in subprime loans. New foreclosures on prime loans increased to 1.01 percent from 0.94 percent, while subprime loans dropped to 4.13 percent from 4.65 percent, Brinkmann said.

The delinquency rate for prime loans rose to 6.41 percent from 6.06 percent, and the share of prime loans in foreclosure increased to 3 percent from 2.49 percent.

To add to the misery to come, we have this from the Economist magazine (the chart referred to shows the growth in resets):
Just as worrying is the possible recurrence of “payment shock” as interest rates on adjustable-rate mortgages reset higher. Resets on subprime loans have mostly taken place, but the worst is yet to come for some other loans, especially the “Alt-A” category between prime and subprime and a nasty type of mortgage called an “option ARM” (see chart 3). The impact may be muted, but only if the Fed can keep short-term rates very low for the next couple of years—or if the borrowers can refinance as the reset approaches.
As a final addition to the nasty state of retail mortgages, there are new problems being stored up for the future, with Ginnie Mae racking up new dodgy loans:
This extraordinary resilience reflects the widespread political lust in America for subsidising housing. Anyone who doubts this should look at Ginnie Mae, another fully state-owned agency which guarantees and bundles mortgages, usually of below-average quality, that are insured by the government. Fannie and Freddie are now being conservative about writing new business, but Ginnie is enjoying its own bull market, issuing guarantees at a furious rate. It is expected to have a trillion dollars outstanding by next year. “We are seeing a gravitation of the subprime universe from Fannie and Freddie to Ginnie”, says Mr Setia. It will be a miracle if taxpayers get their money back from Fannie and Freddie. Worse, there is a chance the disaster will be repeated.
What this means is that there is an ongoing attempt to reflate, or at least stabilise the housing market, and the US taxpayer will be on the hook for the fallout. Without such irresponsible lending, the crisis in the housing market would no doubt be even worse, but the future liabilities are undoubtedly racking up.

Then there is the commercial real estate meltdown that is finally arriving. I have spoken about this in the past, but it has taken longer than expected:
Defaults of multifamily and commercial real estate loans from banks climbed to their highest rate since at least 2003, as lenders gave up hope of being repaid in full, according to a report by research firm Real Estate Econometrics.

The default rate of bank loans for shopping centers, office buildings, warehouses and hotels rose to 2.88 percent in the second quarter, up 0.63 percentage points from the prior quarter, according to the report released on Monday.

The default rate for apartment buildings rose 0.68 percentage points in the second quarter to 3.13 percent.

The results of these ongoing crises is an endless stream of bank failures, with many more to come yet. The Federal Deposit Insurance Corporation's (FDIC) latest report makes ugly reading, and there is widespread speculation that the solvent banks will shortly be tapped for huge sums of money to fund the depositor insurance for the failing banks.

Bove said the FDIC will likely levy special assessments against banks in the fourth quarter of this year and second quarter of 2010.

He said these assessments could total $11 billion in 2010, on top of the same amount of regular assessments. "FDIC premiums could be 25 percent of the industry's pretax income," he wrote.

It appears that all is not so tickety boo in the world of finance. In fact, the crisis is just being buried away. We then have the problems of rising unemployment, which is further feeding into the downwards spiral of the US economy. Whilst there have been a few slightly positive signs of late, the trend is still firmly downwards:
The government announced that the jobless rate had fallen one-tenth of a point to 9.4 percent in July on narrowing job losses but analysts say the rate could soar to about 10 percent by year end even with an improving economy.
Perhaps the most worrying aspect is that there is no expectation of recovery in jobs in manufacturing. This from the President of the Atlanta Federal Reserve:
'Unfortunately, time may not return manufacturing employment to pre-recession levels,' he added. Between 1965 and 2000, manufacturing employment generally fluctuated between 16.5 and 19.5 mln jobs. But in the first years of this decade, the number of manufacturing jobs have fallen to just over 14 million and have continued to drift downward, Lockhart said. 'The harsh financial constraints of this recession appear to have accelerated this secular decline.'
The picture already looks pretty bleak, but the real unemployment rate is considered by many to be far higher than the headline figures suggest, according to the Economic Policy Institute:

The real unemployment rate nationally is nearly 17 percent, instead of the official 9.4 percent, when discouraged workers and part-timers who want full-time employment are factored in. Other workers have seen their hours cut or been forced to take furloughs.

Meanwhile, the number of Americans out of a job for six months or more is at a 70-year high.

The result is a huge labor glut at a time when net job gains are scarce or nonexistent. Observers celebrated when the national economy lost only 247,000 jobs in July. (Washington state even added 4,000 new jobs in July.) The U.S. number would be a catastrophe in most circumstances, but was better than the more than 700,000 lost in January. Yet the American economy must add 127,000 jobs a month just to keep up with natural population growth.

At this stage I will halt with the state of the real economy. For each harbinger of recovery touted by the media, there is a mass of data that suggests the real depth of the underlying problems. Furthermore, even where there are upticks, what we are viewing is the artificial life support being provided by the government, such as the 'cash for clunkers', the absurd lending of Ginnie Mae, or the so-called federal stimulus. That this comes at huge future cost is simply forgotten by the cheerleaders for the view that the economic crisis is at an end.

Perhaps the surest indication of the scale of the underlying problem can be found in how those outside of the US view the state of the economy. The chart below shows net capital inflows into the US, and that there is now the start of a dramatic outflow of capital.

It seems that overseas investors are not too impressed with the recovery, or the prospects for the US economy. It is no wonder really that they are reacting this way, with fiscal deficits climbing to shocking levels, monetization of government debt through money printing by the federal reserve, and an economy still in free fall. The overseas creditors can clearly see that there is no sustainability in the US economy.

The bottom line is this. Trying to borrow yourself out of a recession caused by too much borrowing is just plain silly. It would be laughable, were it not such a tragedy. The actions of the US government are attempts to turn back time. They are trying to support an economy that was always unsupportable. Consuming more than you produce is just unsustainable, and no matter how many economists line up to tell you otherwise, it is the underlying reality that must be addressed.

Perhaps the most shocking part is that the borrowing binge is not even managing to support the economy. All of the costly measures are still not enough to brake the US economy from a downward spiral. This begs the question as to how bad the US economy really is. I am guessing, and it is no more than a guess, that the answer might start becoming apparent towards the end of the year. At some point, the great unwinding must take place, and then it is time to reach for your hard hats. The ride has only just started, and it is going to get very bumpy.


  1. Lemming (comment on the last post):

    I will admit that, as far as inherited wealth goes I am in two minds. On the one hand, the libertarian side of me objects to removing freedom to disburse wealth as an individual sees fit, and on the other side I would like to see a more meritocratic system. These are contradictory views that I have not resolved.

    With regards to your second point, this is a question of how a welfare state should operate. I do not believe that it is right that people should live in perpetual fear for the future, but also believe that we can not afford the profligacy of the current system. It is also unjust that one group of people should remain idle at the expense of another group.

    This is why I proposed a reform that managed to offer a safety net, but also prevents people from using the welfare state for permanent support.

    I do not believe that it is necessary to have an 'either/or' system. It is possible to balance the two aims. It is simply a return to the original idea of the welfare state, where it is a safety net, rather than a comfort blanket.

    Red and Anonymous (from the last post):

    Interesting comments. I am not sure whether it will be possible for the US to fade. I think that this might have been possible, had the US government and Fed acted responsibly. However, they are growing rather than shrinking the imbalances. The longer this goes on, the more likely a crisis. However, as I pointed out in the last article, I got it wrong before, so am now more cautious.

    On the other hand, as I point out in this article, the overseas creditors appear to be pulling out. If enough do so, what will hold up the US economy? They are left with just printing more money....

    Lefty Feep (also from the last post):

    Good to see you commenting again. An excellent link which I would like to pass on to other readers:

  2. Having posted this, I found this article in the Times:

    It is about a collapse in confidence in the Chinese stock market. I have been meaning to review China for a while, so may do so for the next post. There are lots of conflicting views out there, so I will do my best to make sense of them.

  3. A fundamental weakness in your analysis is why debt deflation is making, and will continue to make, the situation worse.
    See Steve Keen's recent post:

  4. Another very good article about the reality that lies below most peoples perception due to being avoided by most mainstream media. I wonder when the true state of commercial and residential real estate will finally manage to filter through to the populous, and how they will react when they realise the lies being told to them?

    The Ginne Mae thing is scandalous – Karl Denninger in a memorable rant,-STOP-THE-LOOTING-NOW!.html compared it to subprime, and really it shows just how little has changed and how little has been learned.

    Meanwhile in the fantasy world of finance, the bubble is now in full view and ready to bust.

    While rallies happen for several reasons even in bad economic conditions, I suspected that the money floating around from all the QE would have an effect, so kept a look out for signs of things that would indicate something other than normal market behaviour (which is hard considering that most of the past 30 years have been very overblown on low interest rates, weak dollar etc)

    So when I saw these articles I knew we had a smoking gun.

    That several bailed out and bankrupt institutions stocks such as AIG Fannie Mae and Freddie Mac had been raising in price out of proportion to value was known, and analysis (which I cannot find atm) had indicated a lot of the rises to POMO days – when the QE was injected into the market.

    However the fact that on days 4 stocks were providing the volume for up to 40% of the entire NYSE was an eye opener to just how much liquidity had been rammed into stocks that shouldn't even be listed as proven insolvent.

    It is safe to say that for at least a month, most of the US stock market has only kept its rise though 4 or 5 main stocks, all of which have been fed liquidity by the government and suckers, sorry speculators hanging on the coattails.

    I found a very interesting article yesterday that talked about this, with interesting parallels to the South Sea Bubble, although of course we cannot say that the government this time around is pumping the money in for the same reasons, the comparison is interesting and the article is good at explaining the reasons why POMO is indicated in these stocks.

  5. As far as other things that indicate Fed interventions, one of the methods which indicates that they are monetizing the debt is detailed here.

    Others such as changing the rules for indirect bidders (so that statistic is inaccurate as indicator of foreign demand) and swift buying back of items sold in an auction only a few days before (which could indicate collusion with bidders to keep auction figures good) I cannot find the links at present,
    but along with graphs you and I posted, cast a doubt about how much demand is really there for US debt. (although treasury demand is high and could get higher if things de stabled)

    I would like to point out that while there has been attention paid to the QE in treasuries and stocks,
    there is considerable amounts of cash being used in mortgage based securities as well – I would have to dig around some more to find statistics, but a rough guess is around 4 times the amount in other areas (also it has been noted that this sector has not been confirmed to stop at the same time as the other QE sectors in October)

    I am still trying to get my head around the implications, as have only started to read about it, but it is another indicator of the sheer mess the housing market has done to the economy.

    Here is a link that indicate foreign abandonment of MBS, showing how they are favouring treasuries.

    Also of interest from yesterday, on the following two links there are a couple of graphs by the user RobotTrader that show some interesting things, such as: “WASHINGTON (AP) -- Interest rates on six-month Treasury bills fell Monday to the lowest point on records that go back more than 50 years.” , Bonds exploding higher. And a large spike in the graph of the put/call ratio that shows that traders are very shaky and looking to cover themselves. News from China spooking the market?

    One last thing – the election of the DPJ could also stir the pot with the US as one of their election promises was to demand us treasuries in yen. If this and the rumours about China defaulting on debt have any substance, things are going to be interesting.

    More on Japan here

  6. The_Rational_MartianSeptember 1, 2009 at 8:31 AM

    CE, a good post,but I'd suggest avoiding dramatic or mocking terms such as "meltdown" or "tickety boo". These may cause your objectivity to be cast in doubt.

    Can I also solicit your views on the possibility of setting up an alternative to the currently preferred (and flawed, IMO) GDP figure, taking in the full picture, and not equating genuine invention which will enhance the prospects of humanity, with the consumption of yet another TV serial or ice cream bar?

    I refer in particular to my definition of wealth (the hard resources and the abstract knowledge and skills to control our environment and destiny).

    I know the difficulty of subjectively evaluating all kinds of activity, but the misdirection caused by the current GDP method is unbearable.

    P.S: What is your view on Paul Krugman's argument that the US deficit is easily manageable?

  7. A couple of things I forgot to mention on my posts above (there are so many things wrong over there, its hard to keep up)

    Sales figures negative – when the back to school sales should have sent it strongly positive

    "Insider selling is 30x insider buying, while corporate stock buybacks are non-existent. Companies are saying they don't want to touch their own stocks." While the general sentiment is strongly – extremely strongly bullish, the more savvy are selling like mad.

    Banks threatening meltdown if Fed has to disclose information

    Pardon the link spam – It is usually easier and quicker to point to the important points than for me to stumble around trying to explain them – I do not have the gift for oratory and explanation of complex matters that you and some of my fellow commentators have.

  8. At the danger of monopolising this thread (Ill stop now I promise :) )

    Here are some developments.
    AIG Freddie and Fannie down 15% so far (AIG closer to 20%) Since a hell of a lot of trading has been after hours recently and the trend going into the close is down it could be a lot lower tomorrow. Looks like the articles I collected yesterday that showed traders were very edgy were spot on - ofc it could just be a reaction to the news, but worth keeping an eye on the next few days.

    Even the old Vampire squid Goldman Sachs dropped sharply today - a sure sign of trouble.

    European countries announce that they voluntarily increase the IMF´s funding
    Alistar Darling announced an increase in IMF funds on behalf of british tax payers just hours after the German and French Finance ministers agreed to do so.

    There have been rumours going around of an unexpected default of a large bank today - the IMF suddenly needing more funding could indicate a vulnerable country that could be harmed by it.

    Quantitative easing beginning to show in M4
    The Bank of England has produced the first apparent statistical evidence that its programme of quantitative easing may now be successfully boosting the amount of money flowing around the economy.

    Finally a very detailed analysis of the US CRE using data not normally seen

  9. Thank you CE, I really enjoy this blog and it is a breath of fresh air to have some contrarian thought regarding what our lords and masters have decided to do with the imbalanced world economy.

    I doubt that I will add much new to the debate but I do have one question which I have never seen answered or even asked much. What would actually happen if we just left the recession to run its own course? That is instead of following the policy of QE what in your opinion would be the advantages of just sitting tight, the government only stepping in to nationalise a collapsed bank (I suppose they would have to, am I wrong?) and allowing the whole mess to play itself out. I guess I am asking why we are not allowing the free market to handle it as the free market has created the mess?

  10. China ditches the dollar

  11. To Mr Carl,

    The fact is that, free market has three essentials. These are:

    (a) Production.
    (b) Distribution, and
    (c) Exchange.

    Now, as concerns (a) and (b) they are in the hands of the private sector. However, when it comes to means of exchange, it is in the hands of state. This cannot be said to be free market.

    There are three types of communists. The first group, i.e. proper Marxists, believe the state should control all industries.

    The middle of the road communists believe some industries at least should be in the hands of state.

    The right wing communists, the most dangerous of all since they call themselves capitalists, believe in the Divine right of state to control means of exchange. If we are to have an semblance of free market, we must overthrow these right wing communists. And, this will be a tough battle, as you can see here:

  12. The middle of the road communists believe some industries at least should be in the hands of state.

    So people who (for example) think that the post office or a few key industries related to defense should be state run are "middle of the road" communists in your view?

    Do you believe that all roads, bridges and high-ways should be privatised as well?

  13. In response to Lefty:

    You also have to look at the recent issues of 283 Billion SDR's by the IMF, which came out of thin air and were distributed to the various countries according to their quota.


    So the the following countries received in Billion,

    UK 13.98 SDR = 13.46 GBP
    DE 16.92 SDR = 18.59 EUR
    FR 13.98 SDR = 15.36 EUR

    Exchange rates are here

    These countries simultaneously made the following contributions to the IMF.

    UK 6.8 GBP
    DE 25.05 EUR
    FR 18.45 EUR,awert,topthemen,id,29696112,sektion,uebersicht.html

    So, it looks like the Brits have received a "bailout" of 7 Billion GBP, and the French and Germans donated more than they received. Business as usual, the Brits on the take.

    However, the issuing of cost free SDR's by the IMF is basically a Quantitative Easing process by a helicopter drop of cash over all countries. And effectively debases all currencies. This has not really been reported in the mainstream press. But this unprecedented re-erection of the IMF is certainly a process to watch.

    BTW India has also announced that it is buying into SDR's as well as China.

  14. Thank you to the Anon commentator above for filling in the gaps on the story about the IMF that I didn't have time to expand.

    Would be nice if CE would have a closer look at the IMF and SDR's - the example above by anon could be seen as a sneaky way of the UK getting money from the IMF by "donating" to it, and then withdrawing all its reserve for a net gain, while other countries cover the difference - But only if the SDR fund works in practice a certain way.

    It is still a little unclear as to what the role of SDR's are. Are they another form of QE that is working on a more global scale? Are they a defacto reserve currency as some think they are developing into?

    Is the theory above possible and the donations being used to shuffle money around or are certain countries trying to increase their quota and thus their relative power and influence?

    I tend towards the latter as it also increases voting rights in the IMF as is evidenced by China wanting to be among the first in by putting in $50 billion

    I think that although there has been talk about SDR's when first mooted another look now we know how the powers are reacting could be useful.

    News - especially from the orient - has been fast this week, so I look forward to your China article.

    A couple of links that might help -

    The last has an interesting viewpoint about the threatened defaults - that the companies that could been given permission would most likely deal with oil based rather than mortgage based derivatives - which puts another angle on things.

    The US stocks stayed up despite a slump. (Sometimes I get the feeling the whole US could fall asleep for a few days and it would still go up providing the machines were still switched on)

    The amount of insider selling went to another all time high in the past week. The previous link showed that for August the ratio was 30 time sellers to buyers which was the highest that had been recorded since they started in 2004. In the past week, it doubled to 61.8 times!

    Meanwhile the problems for the future US economy keep building up. Nothing is changed to stop predatory practices - some of the victims are the same, other vultures are eyeing up new targets.

    More on Ginnie Mae

    Wall street turning to securitizing life insurance policies. This is likely to increase premiums for all holders as Wall street would be buying and keeping going policies that would naturally be abandoned.

  15. Cynicus,
    You say that you plan to review the China situation sometime soon so I thought this paper (arXiv pre-print) might be of interest to you. It allegedly predicted the Chinese stock market crashes. The maths isn't too hard so maybe you would like to see if you can firm up your prediction of the $ crash ;o)

  16. East Asia Moving to Tighter Capital Controls

    Asia is facing a flood of capital from Western investors who think Asia is a better place for investment. However, this will cause asset bubbles and instability in Asian financial markets.
    The solution? Just as I have argued in my blog, the solution is capital controls (or in China's case, increased control over capital inflows):

    What should Asian central bankers do ...? Much more likely is what is now being whispered about in the corridors of financial power — beginning to consider ways to tighten capital controls, i.e., limit the amount of capital that can come into a country, or force investors to commit to stay in the country for longer periods of time.

    See also my blog:

  17. On the subject of China, this will be fun.


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