by Dr. Gary North
THE FORECASTER’S EDGE: AUSTRIAN ECONOMIC THEORY
Date 12/30/2008 • Issue 40
On December 19, 2006, I warned my readers that a recession would begin in 2007. It did, according to the National Bureau of Economic Research. It began in December 2007.
On December 6, 2007, UCLA’s widely quoted Anderson Forecast unit announced that there would be no recession in 2008.
LOS ANGELES — In its fourth quarterly report of 2007, the UCLA Anderson Forecast holds steadfast to the basic tenet of a forecast they have been making throughout the year, that the national economy is not technically in a recession, nor is there a national recession on the economic horizon. Though the economy is experiencing difficulty rooted in the problematic real estate sector, as well as the result of such things as higher oil prices and a troublesome rate of consumer debt, the UCLA Anderson Forecast does not see the possibility of enough job loss to trigger an actual recession.
I did a Google search for “Anderson,” “no recession,” and “2008.” I discovered that these UCLA forecasters reasserted their prediction of “no recession” in March, June, and September of 2008.
On December 11, 2008, Anderson issued a press release.
Anderson Forecast: ‘Nasty recession’ to include 4 quarters of declining GDP. In its fourth quarterly report of 2008, the UCLA Anderson Forecast predicts that the current national economic recession will include four quarters of negative growth, followed by very tepid growth rates, and rising unemployment that lasts through 2010. California will share the national recession, with negative growth through the middle of next year and high unemployment until 2010 as well.
The National Forecast
“The news from the economy is bad,” writes Anderson Forecast senior economist David Shulman in his essay “The Balance Sheet Recession.” “The recession we had previously hoped to avoid is now with us in full gale force.”
The Forecast now expects that real gross domestic product (GDP) will decline 4.1 percent in the current quarter, followed by declines of 3.4 percent and 0.8 percent in the first two quarters of 2009.
In addition, the unemployment rate is expected to rise from its October 2008 level of 6.5 percent to 8.5 percent by late 2009/early 2010. Associated with the rising unemployment will be the loss of 2 million jobs over the next 12 months.
The Forecast lays the blame for what it is calling a “nasty recession” on the financial crisis of 2007-08, noting that the economic circumstances underlying current conditions differ significantly from past recessions.
These guys, all experts, did not sense that the economy was in a recession as late as September 24. But now they have the future charted to the decimal point.
Why am I not impressed?
One reason has to do with semantics. The press release speaks of “negative growth.” I have this view of growth, that it is not negative. Contraction is negative. Collapse is negative. Growth is positive.
My more substantive reason is that when someone cannot see that a truck has been running over him for a year, he probably is not in a good prediction to predict future movements of the truck.
How did I know in December 2007 what expert forecasters at UCLA did not see as late as September 2008? Simple. I quit the graduate program in economics at UCLA in the fall of 1964 and transferred to UC Riverside in 1965, where I majored in history. I could see what UCLA’s program was: a schizophrenic hybrid of Keynesianism and Chicago School economists, united in their ignorance of, or outright rejection of, Austrian School economics. I regard my 1964 decision as one of the better decisions on my career.
“BAD MONEY DRIVES OUT GOOD FORECASTS”
This is my variant of Gresham’s law.
In the final pages of his 1912 book, “The Theory of Money and Credit,” Ludwig von Mises presented a new theory of the business cycle of economic booms and busts. He argued that central bank policy of monetary expansion creates the boom. When central bank policy shifts to tighter money, in order to avoid accelerating price inflation, this produces the bust. I have summarized Mises’ theory here:
This theory is despised by all rival schools of economic theory, for these reasons:
1. It is hostile to central banking.
2. It blames recessions and depressions on a government-licensed monopoly over money.
3. It teaches that a committee of economists cannot successfully guide the economy.
In modern economics textbooks, no criticism of the idea of central banking is allowed, except the 1963 criticism of the Federal Reserve System by Milton Friedman, namely, that the FED did not inflate enough, 1930-33.
Forecasters are therefore self-blinded. They cannot easily see when a recession is coming because they reject the cause of the recession: central bank policy. They cannot see this because they refuse to use Mises’ theory of central banking to analyze the effects of central bank policy.
Some very smart, very misguided experts have been lured into making bad forecasts. I suppose the classic example of a bad forecast in this business cycle is this one, made by Charles Prince, the CEO of Citigroup in July 2007.
When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.
That retroactively juicy statement appeared in an interview in London’s “Financial Times” on July 9, 2007. It was immediately picked up and posted all over the Web. There were many skeptics, but mostly in the hard-money crowd. Then came August’s collapse of the secondary market for subprime mortgages. In that market, the music ended abruptly.
On November 4, 2007, Mr. Prince resigned. He departed with stock holdings worth $94 million to add to his $50 million in pay for the previous four years.
The next day, I told my Website’s subscribers to get out of stocks and short the S&P 500.
For Prince’s sake — and his lawyers’ sake — I hope he sold all of his shares in 2007. Citigroup’s value collapsed over the next 12 months. You can buy Citi at $6.50 a share. In July 2007, when Mr. Prince made his famous statement, City was at $55. In November, when he departed, it was in the mid-$30s. It took a Federal bailout to keep Citi, America’s largest bank, from going bust in November, 2008. The U.S. government and the Federal Reserve System took over $260 billion of Citi’s $300 billion of toxic liabilities. This wiped out $120 billion in shareholder value.
The latest news is that Prince and former Treasury Secretary Robert Rubin, who was on Citi’s board, are defendants in a lawsuit, which accuses them of covering up the nature of these toxic securities. One thing is sure: their defense lawyers will do very well.
It was such easy money in the boom phase of the economy, which was funded by low interest rates created by the Federal Reserve under Alan Greenspan after 2000. Everyone cheered. The people at the top of the financial side of economy were getting fabulously wealthy.
Then Bernanke replaced Greenspan in February 2006, who immediately reduced the growth of the monetary base. That was the signal that the music was going to stop. And so it did.
Prince should have seen this coming. It was obvious to me in late 2006 what was going to happen. Anyone who paid attention to U.S. Treasury debt interest rates should have seen this coming. It was Prince’s job to see it coming. But in the heat of the boom, experts refuse to face the music. The Maestro, Alan Greenspan, had orchestrated the music. He was no longer conducting the orchestra.
On August 22, 2006, six months after Greenspan retired, I wrote a “Reality Check” newsletter, “Greenspan’s Time Bomb.” I wrote this.
There is a time bomb ticking. A major indicator has just appeared: the inverted yield curve. If it lasts for 20 consecutive business days, the U.S. economy is likely to head into recession in 2007. To understand why, click here:
To make things even more dicey, the yield curve is so inverted today that the federal funds rate, the overnight commercial bank rate that the Federal Reserve seeks to control, is now higher than the rate for 90-day T-bills. I will explain why this is a negative anomaly later in this report.
A basic feature of all action hero movie time bombs is a built-in count-down timer. I’m not sure why bomb-designers put these into their bombs. I don’t think there is a Radio Shack bomb count-down timer, but you never know.
Alan Greenspan did not include one in his economic time bomb. He handed it over to Ben Bernanke last February, and quietly departed from the scene. He gives an occasional speech, but his retirement program is fully funded — unique in Washington — and his wife remains gainfully employed by NBC TV.
Greenspan’s time bomb was assembled in stages, beginning in October, 1987, when the Federal Reserve created massive liquidity on the day after the meltdown of the world’s stock markets by over 20%. He continued tinkering with it throughout his time as chairman, culminating in the creation of sufficient fiat money that drove the federal funds rate from 6.5% in mid-2000 to 1% in mid-2003, and then adopted a new monetary policy that allowed the rate to rise to 4.5% in late January, 2006, when he retired. It has now risen to 5.25%.
Why is this a time bomb? Because of the effects of low interest rates in stimulating economic activity. In housing, in long-term corporate borrowing, and in household borrowing, there is only one thing better than low interest rates to get people to spend money: access to the newly created fiat money that forces down interest rates.
The problem comes, in the words of the longest FED chairman of all time, William McChesney Martin, when the FED turns off the money spigot. This takes away the party’s punch bowl.
Bernanke is now the administrator of the time bomb. He doesn’t want it to detonate. He has now been in office long enough to get the blame for any explosion. Greenspan can safely say nothing in the aftermath of the explosion. He need point no finger. He can be polite. The central fact is, it did not detonate on his watch.
Bernanke did not see what was about to hit the American economy. As I pointed out in my report, he denied the significance of the inverted yield curve. “No problem!”
Bernanke said in March that investors should not pay much attention to the yield curve, which was flattening.
What is the relevance of this scenario for today? Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards.
He ignored the obvious: The short-term federal funds rate had risen from 1% to 4.5%, June, 2003-March 20, 2006. Today, it’s 5.25%. The T-bill rate has risen from a bit over 1% to 5%. There is no comparable percentage increase in so short a period in all of American history.
Don’t worry, he told the attendees, “market participants do not harbor significant reservations about the economic outlook.”
They didn’t harbor significant reservations in the late fall of 1929, either.
A week later, I followed with a report on “Bernanke’s International Time Bomb.”
A week ago, I described Alan Greenspan’s time bomb, which he passed off to Ben Bernanke last February. This time bomb is the huge build-up of fiat money that enabled Greenspan to escape the 2001 recession without a scratch.
There are three things that Bernanke can do about: (1) continue the FED’s policy of stable money, which will detonate it within months; (2) reverse course and expand the money supply, which will roll the clock forward but will add to the explosive material; (3) resign.
Bernanke is paying no public attention to this time bomb. He is also ignoring another: the time bomb of international credit.
On December 9, 2006, I wrote this report: “Recessions are Great Opportunities.” I began with these words:
I’ve got bad news and good news. The bad news: A recession is coming in 2007. The good news: A recession is coming in 2007.
There is nothing like a recession to create depression in most people’s minds — good, old-fashioned emotional depression. But for a self-selected minority, a recession is the opportunity of a decade — maybe a lifetime.
Most people watch, helpless, as housing prices fall, the stock market falls, business income falls, and job opportunity falls.
A few people take the initiative, redouble their efforts, and position themselves for the recovery phase, which lasts far longer than the recession.
For the unlucky few, they get fired. In the midst of a tight job market, they are sent on their way. But the debt meter keeps ticking: mortgage, phone, electricity, insurance, etc.
We don’t get recessions often. In my job market career, there have been only six: 1970, 1974, 1980, 1981, 1991, 2001. Some analysts would say 1980 and 1981 were really only one. I would agree. They both had the same cause: tight-money policy by the Federal Reserve System, begun in 1979, after dozen years of monetary inflation.
Because the most recent one was so mild, housing prices continued to rise. What fell was the personal savings rate. In the past, people have saved more during recessions. In 2001, not only did they not save more, they saved less. Fear did not overtake them.
Unemployment rates close to 10% are a dim memory for most Americans. Unemployment always hits the manufacturing sector harder than it hits services. The percentage of the American population involved in manufacturing has been falling for a generation.
Unemployment for white, married males is always lower — no more than half — what it is for single non-white males. So, when we read of rising unemployment, we who are white, married, and male rarely face the threat of getting fired. What we face is falling prices of our equity investments. We see our stock mutual funds fall. Because only the top 20% of wealth owners own stocks, except in pension funds, this loss affects a minority of the population. As for pension funds, Americans still think that somehow, they will be able to retire at someone else’s expense. They believe, because they have been told, that the stock market always comes back.
It hasn’t come back from the fall it took 2000 — not the Standard & Poor’s 500, which reached 1550. But pension fund owners still have faith. Somehow, something miraculous will happen, and their retirement dreams will come true.
They won’t, of course. The next recession will remind a growing number of Americans: They will not be able to retire.
The recession began a year later, in December 2007, according to the National Bureau of Economic Research, which for some unknown reason is the official arbiter of such matters. It is now accelerating.
We are now being told that this recession will be the longest, deepest, and most destructive in the post-World War II era. I think this forecast is correct.
Austrian economic theory teaches that monetary inflation will disrupt the economy far more than recession will. We look at the statistics from the FED, and we see monetary inflation looming on a scale not seen in peacetime America. You can monitor this for yourself in my Website’s department, “Federal Reserve Charts.”
The expert forecasters are telling us that price deflation is the #1 threat facing the U.S. economy and the world.
The experts have it wrong again, and for the same reason: they reject Austrian economic theory.