Have Keynesians Lost the Battle?

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

I'm afraid Paul Krugman maybe right this time. Much of the recovery we have had in 2009 and the first half of 2010 was dependent on government supports around the world. If the stimulus and easy money policy are withdrawn too early the economies may not be healthy enough to stand on their own. We're now facing a real risk of that.

In yesterday's NYT, a piece written by David Leonhardt has some good summary points on the current policy conundrum.

The world’s rich countries are now conducting a dangerous experiment. They are repeating an economic policy out of the 1930s — starting to cut spending and raise taxes before a recovery is assured — and hoping today’s situation is different enough to assure a different outcome. ...

The policy mistakes of the 1930s stemmed mostly from ignorance. John Maynard Keynes was still a practicing economist in those days, and his central insight about depressions — that governments need to spend when the private sector isn’t — was not widely understood. In the 1932 presidential campaign, Franklin D. Roosevelt vowed to outdo Herbert Hoover by balancing the budget. Much of Europe was also tightening at the time.

If anything, the initial stages of our own recent crisis were more severe than the Great Depression. Global trade, industrial production and stocks all dropped more in 2008-9 than in 1929-30, as a study by Barry Eichengreen and Kevin H. O’Rourke found.

In 2008, though, policy makers in most countries knew to act aggressively. The Federal Reserve and other central banks flooded the world with cheap money. The United States, China, Japan and, to a lesser extent, Europe, increased spending and cut taxes.

It worked. By early last year, within six months of the collapse of Lehman Brothers, economies were starting to recover.

The recovery has continued this year, and it has the potential to create a virtuous cycle. Higher profits and incomes can lead to more spending — and yet higher profits and incomes. Government stimulus, in that case, would no longer be necessary.

An internal memo from White House economists to other senior aides last week noted that policy makers “necessarily tend to focus on the impediments to recovery.” But, the memo argued, the economy’s strengths, like exports and manufacturing, “more than make up for continued areas of weakness, like housing and commercial real estate.”

Much of that optimism has faded in recent months. European sovereign debt crisis has proven more vicious than expected. Labor market has shown very little sign of improvement. Housing market may already be in its second dip. Consumers have turned more pessimistic.

And just as households and businesses are becoming skittish, governments are getting ready to let stimulus programs expire, the equivalent of cutting spending and raising taxes. The Senate has so far refused to pass a bill that would extend unemployment insurance or send aid to ailing state governments. Goldman Sachs economists this week described the Senate’s inaction as “an increasingly important risk to growth.”

The parallels to 1937 are not reassuring. From 1933 to 1937, the United States economy expanded more than 40 percent, even surpassing its 1929 high. But the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.

Given this history, why would policy makers want to put on another fiscal hair shirt today?



The reasons vary by country. Greece has no choice. It is out of money, and the markets will not lend to it at a reasonable rate. Several other countries are worried — not ludicrously — that financial markets may turn on them, too, if they delay deficit reduction. Spain falls into this category, and even Britain may.

Then there are the countries that still have the cash or borrowing ability to push for more growth, like the United States, Germany and China, which happen to be three of the world’s biggest economies. Yet they are also reluctant.

China, until recently at least, has been worried about its housing market overheating. Germany has long been afraid of stimulus, because of inflation’s role in the Nazis’ political rise. In responding to the recent financial crisis, Europe, led by Germany, was much more timid than the United States, which is one reason the European economy is in worse shape today.


The reasons for the new American austerity are subtler, but not shocking. Our economy remains in rough shape, by any measure. So it’s easy to confuse its condition (bad) with its direction (better) and to lose sight of how much worse it could be. The unyielding criticism from those who opposed stimulus from the get-go — laissez-faire economists, Congressional Republicans, German leaders — plays a role, too. They’re able to shout louder than the data.

Finally, the idea that the world’s rich countries need to cut spending and raise taxes has a lot of truth to it. The United States, Europe and Japan have all made promises they cannot afford. Eventually, something needs to change.

Double-dip?

Fear of a double-dip recession has returned to the U.S. market. Housing is weak, and looking weaker without more government support. European sovereign crisis has added to the global banking worry. China's tightening to release inflationary pressure has taken away another support for global recovery.

In other words, aggregate demand is weak. And governments are either not able or unwilling to create more aggregate demand.

All these are reflected in the U.S. bond yields. The interest rates for long bonds are heading to new lows, along with the mortgage rates.

We had expected that the private sector to start adding more jobs by now, but the reality seems to point to a discouraging picture of reluctance. Corporations are still waiting. Consumers are still reluctant. Banks claim they cannot find enough qualified borrowers. Every developed country is hoping that external demand will create enough pull for their export sectors. Aging population and pubic debt burden ... all seem awfully hard problems to solve.

It seems no news is good enough. Rallies are now short-lived.

The lack of confidence itself could aggravate the risk of the double-dip recession. The housing market appears already heading that way with the expiration of the home-buyer tax credit. Housing-related stocks have seen a steep selloff in recent months.

The risk of general deflation is much higher now than two months ago. This is the time for the Fed to renew its innovative push.  

At times like this, take it easy

May and June are looking pretty bad for equities. Europe's problems, signs of slowdown and deflation, persistent high unemployment,... not much to cheer for. This is what one expects when government supports are withdrawn gradually from the economies. At least U.S. and some emerging markets are not collapsing.

Gold is at new record. Some say it's a sign of inflation. Not really. It's just a flight to quality when major currencies are having major problems.

Home builders are taking a beating. The expiration of home buyer's tax credit is having a marked effect. But more important than that is the fact that the economy is not producing enough jobs. Momentum seems lost.

This is a good time for patient investors.

We're buying a house, finally.

Non-manufacturing ISM report shows job growth expanding

Service industries in the U.S. expanded for a fifth month and factory orders rose, pointing to a broadening economic recovery that’s generating more jobs. For the first time, the non-manufacturing ISM index's employment component shows expansion at 50.4 from last month's 49.5. Backlog of orders increased 6.5% from 49.5 to 56, also the first exapnsion since the recession started.

Of course, the manufacturing employment has been leading the job growth, expanding for a sixth month in May. But the service sector makes up almost 90% of the U.S. economy. There will be no real job growth if the service sector doesn't employ more people. It's a good sign that it is finally catching up.

Tomorrow's employment report should provide more color to the picture. Consensus is for 540,000 payroll jobs added in May, but this will include around 400,000 temporary Census jobs. More private jobs is key.

Pragmatic U.S. and China versus chaotic Europe

Two-hundred high-level U.S. officials are in Beijing, meeting with their counterparts to discuss a wide-ranging issues from currency to human rights. A sense of pragmatism seems to prevail over anger and finger-pointing.

Both countries have produced bold monetary and fiscal policy responses to comeback the global financial crisis that started in the U.S. As the result of their actions, the economies in the U.S. and China are recovering and providing the support for the global recovery.

More pragmatic, coordinated or joint actions will be needed, to deal with issues that arise from bilateral and multilateral trades. The economic interests of these two leading countries are too-intertwined and too influential to leave them under the emotional influence of sometimes over-blown protectionism.

In contrast, Europe seems to be in chaos. The ECB is consistently behind the curve in dealing with macro crises. This article from the Big Picture has a good summary of the main problems that need to be tackled by European leaders.

Greece's sovereign debt problem must be dealt with as what it is: The country is insolvent; both the Greek and the banks who have lended to them must live with the consequence. Debt restructuring should be done sooner rather than later.

Germany as a big exporter, is benefiting from the depreciation of Euro. As the leader of EU, it should act to provide stimulus to the regional economies.

The lessons from the U.S. and China is clearly that the central bank must act bolding to promote market confidence in the financial system. The fate of the Euro and the ECB are tied up with its member countries. Independence does not mean inaction.

We hope that pragmatism will also prevail in Europe.

When the market is so fearful, get greedy

It is Warren Buffett who stated that “Be fearful when others are greedy and greedy when others are fearful”.

Market has turned very fearful, with the VIX shot up into the 40s over the last weeks. It's all coming from the fear that the Greece crisis may turn into a global credit crisis, Lehman Style. Hedge funds are unwinding the pro-growth trade, a bet on growth oriented countries and companies, with the belief that the concerted efforts of central banks and governements are sufficient to turn things around.

The European sovereign crisis calls the thesis into question. Many have concluded that the economic growth is not going to be very robust. The New Normal thesis is back.

Flight to quality has driven up US long bonds, making it one of the best performing asset classes year-to-date.

The pullback this time is over 10%, more severe than the early February pullback. Yet, other than the European problem, the U.S. recovery is now on a firmer footing.

Perhaps it's time to get greedy.

Wells Fargo has become the largest U.S. bank

Less than four months after my earlier post about Wells Fargo becoming the largest capitalized U.S. bank, it has now overtaken JP Morgan and Bank of America in market cap. At $33.5/share, Wells is valued at about $175B, while BofA is at $172B, and JP Morgan which used to be the largest is now at about $164B.

This change of positions are largely due to the potential impacts from the pending financial regulations which aim squarely at Wall Street and trading operations. Among the large banks, Wells Fargo has the least exposure.

In addition, the recent European sovereign turmoil, and the worry about writedowns that many of these European banks and international banks may suffer from, have added to the change. Wells Fargo is more of a pure U.S. commercial banking play, whereas B of A and JP Morgan, Citigroup all have sizeable international franchises.

It is also interesting to observe that HSBC which has more concentration in Europe and Asia, has seen its market cap drop to about $172B, behind Wells as well.

It pays to be more focused on earnings quality and being truely conservative.

The widening criminal investigation on Wall Street firms from Morgan Stanley, to Citigroup, to JP Morgan in particular may do a lot of damage to trading firm's reputation. Interestingly, Goldman Sachs, being the first to be investigated now may start to gain back its composure because everyone on Wall Street is in the same boat. When Goldman's clients look at this picture, what are they going to conclude? You still go with the "best."