Tue May 12th, 2009 at 02:32:40 AM EST
Leo Kolivakis of Pension Pulse posted a very long (17pp?) but meaty discourse, The "W" Recovery?, on the possible directions our economic future could take as a guest post on Naked Capitalism. In the process he quotes several other economists and engages in typical "on the one hand and on the other hand" back and forth on topics such as inflation vs. deflation. But in the end he makes an interesting case for a relatively long and strong bear market rally that will, at its peak, convince most market participants that it is genuine recovery, only to fall back to more recent lows and mostly stay there for another six or seven years. He may or may not be correct in his forecast, but at least he provides a framework for consideration that is more detailed, better reasoned and more thoroughly considered than any I have seen to date and he assembles an intriguing ensemble of supporting arguments. If you are so inclined, just click on the title above and go directly to Leo's post. Below is a seriously abridged collection of the highlights with some comment and continuity by yours truly.
From the diaries - afew
After describing the necessity and benefits of a coming transition to a higher savings rate in the US, the benefits and the downside inherent in the paradox of
wealth thrift, Leo cites a recent interview by TIME's Barbara Kiviat of Robert Shiller, the Yale University economist who helped create the home-price gauge. Shiller doesn't think home prices have bottomed out, but has a couple of interesting ideas to mitigate a repeat of the real estate asset debacle.
People are talking about the housing market bottoming out. Do you believe it?
The conspicuous fact with our [Case-Shiller] data is that prices are still falling, although at a somewhat lower rate. There is also some sign of pick-up in pending-home sales. But to me the dominant fact is that prices are still falling. We've never seen a real estate market turn on a dime. For the longer horizon, though, it's possible that we are picking up. The other thing that is striking is that home prices have come down a lot, so they're no longer very overpriced.
If houses are no longer overpriced, but prices are still falling, does that mean we're overshooting?
That is the issue, whether we'll overshoot and end up being below, in inflation-adjusted terms, where we were in 1997. We're not quite down to where we were before, but we're getting close. Overshooting is typical in the stock market, but in the housing market, I don't know. We've never really had such a big, national bubble in the housing market before.
Are there structural changes we need to make so that we don't have this sort of craziness again?
Yes. This crisis was substantially caused by a failure to manage real estate risk. Notably, we got individual homeowners into a leveraged position typically with their entire life savings in real estate in one city, in one house. That's very risky. I have one proposal for continuous workout mortgages. Right now we think it's a great thing if banks will give struggling homeowners a workout. Why do we only want to come in after the fact? My vision for our future is that it should be planned for and priced into the initial mortgage. We could update mortgages in a way they protect people from things beyond their control-- like high national unemployment.
Home-equity insurance. We want to have homeowners' insurance, which protects against things like fires, updated so that it protects against a loss of market value. Fires were a big problem hundreds of years ago. Houses were burning down all the time. Now we've developed a different problem--the residential housing market has gotten much more volatile.
The company you started, MacroMarkets, just got approval for tradable securities linked to the Case-Shiller house-price index. How does that factor in?
One reason we have bubbles in the housing market is because there's been no way to short housing [that is, to make money when prices fall]. The ability to short is essential to an efficient market, otherwise there's nothing to stop zealots from pricing things abnormally high. If you buy one of these long securities, called UMM, it's like buying a house, except you don't have to go through the real estate agent, take possession of a property, maintain it, rent it out. But we also have the DMM, which is short housing. Markets like this will also create an infrastructure for products. For example, insurers could issue home-equity insurance and then hedge themselves by taking a position in this market.
Later he cites Andy Kessler of the Weekly Standard on Putting the Toothpaste Back in the Tube:
A shadow banking system--Lehman, Bear Stearns, Merrill Lynch--was borrowing short-term in money markets at, say 2 percent, and instead of the classic 10:1 leverage of banks, they were levering up 30:1, sometimes 50:1, creating money out of thin air well beyond the intention of the Federal Reserve. It didn't show up in prices, mainly because of a huge and productive tech sector as well as the waves of cheap Chinese laborers who were providing cheap shoes and toys and furniture to Wal-Mart, "hiding" the over-creation of money. But it did create a shadow economy of home builders, linoleum layers, decorators, Home Depot Expo salesfolks, and on and on.
And that was shadow wealth. The only real wealth is wealth that is productively created. The rest is just paper. After the collapse of the banking system, sunny and shadow, hoarding became the order of the day. The world rushed into U.S. Treasuries. Short-term rates as a result are almost zero. The dollar has been a safe harbor, jumping versus the euro and the yen. No one wants to spend money, on houses, on cars, or even, gasp, on big screen TVs. So the velocity of money has shrunk. To what? Well, no one really knows.
So to make up for lower velocity, to keep the economy from shrinking like a raisin, the Fed has been increasing the monetary base to increase the amount of money in circulation. But it's hard. Even with TARP funds, banks don't want to lend, so their 10:1 increase of Fed money isn't happening, let alone 50:1 Bear Stearns-style money creation. Bernanke has therefore been buying U.S. Treasuries, with cash, to increase the money supply. Which is pretty funny since he is also selling U.S. Treasuries out the back door to fund the $787 billion stimulus package and the $1.3 trillion Obama budget deficit.
The Fed can put all the cash it wants or thinks it needs into the economy, but someday, maybe soon, maybe in a year or two, the economy will start growing again. People will stop hoarding dollars. Their 2004 Taurus will be looking a little old. Baby needs a new pair of shoes. Banks will start lending again to businesses and maybe even to home buyers. As money starts getting spent, all that money's velocity starts increasing. Oops, there goes the price level. With so much money floating around, chasing too few goods, inflation is a-comin'. The Fed will have to start pulling all that extra money off the street and back into its vaults. And in just the right amount.
After discussing the possible reactions of China to dollar devaluation he cites Henry Blodget to substantiate his prediction of a "W" recovery.
Sorry, We're Still Screwed
(Photo included in honor of afew's sig line.)
Yesterday, we explained why Jeremy Grantham, a former bear, is now a short-term bull. Basically, he thinks the fire-hose of stimulus will drive stocks (if not the economy) up another 10%-20% by the end of the year. But please note the emphasis on "short-term."
After our current rocket rally plays itself out, Grantham thinks, the market will once again crash and then stay in the dumps for at least seven years.
Because of the massive declines in our net worth, our debt problem, and compression of price-earnings ratios. Specifically, we've lost our shirts and we feel poor--which isn't conducive to profligate spending. We still need to get rid of $10-$12 trillion of debt. This debt-reduction process will pressure profit margins (lower leverage) and pressure spending--because we'll have to save more instead of spending it. We'll also need inflation to reduce the real burden of the debt.
Leo Kolivakis' final argument comes from Johns Hopkins professor Steve Hanke in his column in Forbes twin recessions.
"Investors watching the recent rally may think that the Fed has stabilized the markets and saved the day but its approach is fraught with danger," says Hanke.
"As the self-regenerative powers of the market system kick in, the demand for money will fall and the velocity of money will correspondingly go up.
"Unless the Fed shrinks its balance sheet by selling bonds and mopping up excess dollars, inflation will roar back with a vengeance."
Hanke fears the Fed will put off such decisions for at least two years, with congressional elections due and Bernanke's term due to expire in 2010, but will "eventually have to bite the bullet and shrink its balance sheet to fight inflation."
This could push up interest rates and cause a 'W' shaped recovery says Hanke.
The second "V" of this "W" appears to have a long bottom and a lazy right hand rise. Seven years in the wilderness after the second crash?