Day of Reckoning Print E-mail

True genius is rarely appreciated in real time. The 19th century composer and music critic Robert Schumann said “Talent works, genius creates.” This concept is likely at the heart of the matter. The vast majority of us toil daily to attack our “to-do” list and accomplish our goals as set before us by clients, bosses and spouses. We are too enveloped in our daily routines; they provide comfort and continuity, the order we crave. Who has the time to question the reality we construct. It is often the role of genius to disassemble that which we find most soothing and reconstruct it ways that force a reordering of our perceptions and belief system. For that reason many a genius has died a pauper waiting for the world to play catch-up.

All too often we mistake those who add the “secret ingredient” to the existing recipe as genius even before time has proven them worthy of the accolade. We find it easier on our psyches to accept that our belief system is fully rational and functional rather than a facade. We often rather see the disruptive genius as at least foolhardy and at worst mad. When a visionary introduces unsettling ideas we find it less disruptive to ignore that vision than to explore it.

On rare occasions a day of reckoning comes that forces us to step off the treadmill that provides life’s comfortable momentum and seek answers to difficult questions. Some questions demand answers that may shake the foundations of our knowledge. Rightfully we demand proof that new perceptions and beliefs are mandated before marching to a new tune.

Frequent readers know of my respect for and very limited understanding of the work of Albert Einstein. In 1915 Einstein expanded upon the ideas developed in his Theory of Relativity to include a description of gravity. If verified through the scientific process these new ideas would displace the theories of Sir Isaac Newton, theories accepted as “law” for 250 years. In 1915 Einstein released his General Theory of Relativity. His work on this set of ideas was referred to by a colleague of his day as “arguably the most prodigious effort of sustained brilliance on the part of one man in the history of physics.” In spite of this high praise and Einstein’s well respected body of work most regarded his ideas with skepticism. The threshold of evidence was set high by scientists asked to abandon Newton’s “laws”. Einstein’s day of reckoning was provided by a total eclipse of the sun on May 29, 1919. Would a ray of light from a distant star be deflected by the immense gravitational pull of the sun? If yes, than Einstein’s Theory of General Relativity that postulates that gravity warps the fabric of space and time and thus alters the path of starlight would be proven correct and the theories of Newton on the subject would be rendered mute.

With the most powerful portable telescopes of the day set up in both the Amazon jungle of Brazil and on a small island off the coast of equatorial Africa the path of starlight would determine the fate of one theory and one physicist. After a four year wait for just the right conditions to emerge Einstein was proven correct. When the light from a star cluster named Hyades traveled past the sun it was deflected in the exact manner and nearly exact specifications foretold by Einstein. To date experiments performed by the world’s most powerful X-Ray Telescope at NASA’s Chandra Observatory have only reinforced the genius of Einstein. On his day of reckoning Einstein emerged a true genius.

                  Is Keyne's an Einstein?

 Einstein was fortunate to see his work validated in his lifetime. The day of reckoning is fast approaching for the economist John Maynard Keynes. He will not be present when his test score is announced. Keynes departed the scene in 1946. Keynesian theories call for the government to take the place of failing markets in times of extreme dysfunction. Keynes’ ideas have been adopted around the globe. It is hoped that the unprecedented stimulus packages enacted will have provided a bridge from the deceptive madness of the Great Moderation, across the chasm of the Financial Crisis and Great Recession to a new economic order.

Einstein’s genius was exhibited in his ability to correctly interpret an existing order. Keynes’s polemic contains unfathomable variables and potential outcomes. By September 2010 some 70% on the Keynesian stimulus will be spent and the public private handoff will be well under way. To a large degree the global economy will be stepping off the Keynesian bridge with little certainty about where it will land.

 One of our problems as we assess the Keynesian recipe for a dish called “rescue from disaster” is that he didn’t provide a “cook time” so we don’t know when the dish is done. Some say that if the heat of stimulation remains too long inflation will spoil the recovery. Others believe that if stimulus is withdrawn too soon we risk a soupy mess know as the “double dip recession”. Keynes recipe is thus open to interpretation and the errors of human implementation. So it stands that the reputation of one theory and one dead economist and perhaps the fate of the global economy hangs in the balance. Will Keynes emerge a true genius like Einstein on his day of reckoning?  I suspect we will have our answer in the coming year.

  Self Inflicted Wounds

When I’m not busy taking out the trash or making coffee I have the luxury of entertaining new ideas and re-examining the old ones that are at the root of my assumptions. I have long been guided by Schumpeter’s theory of “creative destruction”. We have referred often to Schumpeter’s brilliance when teaching about economic cycles and the causes of meaningful economic evolution. In a nutshell Schumpeter postulates that the spark of new technology will render old business models obsolete. The old business matrix is destroyed in favor of the new matrix. The new technology and matrix become the basis for the next economic expansion and generation of new wealth.

But suppose there is destruction without creation. Suppose the destruction of the existing matrix is the result of severe financial mismanagement. If there is no spark of new technology to kick start the next economic expansion what awaits us when we step off the Keynesian bridge? How do we repair the damage and replace the jobs and wealth destroyed in the financial crisis?  How do we repay the debt accumulated during the stimulation phase? Can private corporations carry the ball after the public to private handoff? What happens to interest rates and currency valuations? What becomes of the American standard of living?

              Our Best Hope 

Our best hope is that the old matrix was not obsolete or afflicted with a fatal flaw. We hope instead the matrix has merely been grossly mismanaged, poorly regulated and run into the ground with free money, foolish leverage and risk management devoid of common sense. In short we hope for an economy in need of a bit of TLC not one on the critical list. On top of that we hope to step off the Keynesian bridge onto fertile economic soil seeded with stimulus and ready to sprout new growth and rapid improvement in labor and housing markets. We have a long row to hoe and limited time to generate a self sustaining crop.

Beware the Head Fake

Our growing concern is that inflation presents a head fake in the aftermath of the global financial crisis and that the real threat comes from deflation. In a rare occurrence there was well coordinated fiscal and monetary action taken by the world’s central banks. An unprecedented amount of fiscal stimulus was pushed into the global economy and ailing banks were shored up with public money. Market support was provided to assure investors that liquidity would not vanish again and leave them and the companies they own stranded. Mountains of cash and tax credits propelled consumption and building. The fear of inflation is the natural knee jerk reaction.

Much of the commodity inflation that we have seen has been driven by the accelerated build out of Asia and particularly China. There is little doubt that there is a real estate bubble in China. And the infrastructure build out is predicated upon the supply side economic theory that has petered out in the debt swamped developed western economies. 60% of China’s GDP relies on construction while consumption represents only 35%. Without western country consumption and a sustained global resurgence China may be strapped with excess capacity in factories and housing and commercial real estate, not to mention an enormous pool of unemployed labor. These factors could easily combine to depress prices and wages while ramping up the need for deficit spending and social support programs. Sound familiar? If this bubble pops economic activity would slow in China and asset deflation could hit the real estate market hard. China’s urbanization policies could leave millions stranded and unemployed among empty commercial and residential structures.

Core consumer prices (excluding food and energy) have risen by a mere 1.5% measured year on year in the 30 nations that form the Organization for Economic Cooperation & Development (OECD).  These nations are predicted to have a 1.9% growth rate, more than 4 percentage points below growth potential. That excess capacity weighs heavily on wages and prices. Japan saw a negative core inflation rate in February. The weakest Euro-nations, the so called PIIGS, (Portugal, Ireland, Italy, Greece and Spain) are flirting with deflation. Core prices have fallen for 12 consecutive months in Ireland, 10 of 13 in Portugal and 7 of 13 in Spain. Greece is already a basket case with falling asset values and an IMF bailout in the works.

While there is $800 billion in excess reserves in US banks it hasn’t moved to loan production. That money was deployed to generate no risk earnings for bankers who have forgotten how to make legitimate money. This stimulus money is parked mainly in investment grade securities. And the stimulus dollars dumped in the economy spurred short term upswings in home and auto purchases but little beyond that. Velocity is the key if stimulus is to have a lasting effect. The greater the turnover of the money from buyer to seller to buyer to seller the more that seed money tends to generate sustainable growth. The transactions should also contribute to deficit reduction through consumption taxes. If instead the seed money is planted under the mattress there is little hope for green shoots to emerge and scant chance for revenue generation.

The steep yield curve engineered by the Fed and so far tolerated by bond vigilantes and inflation hawks is in place to aid the recovery of our still ailing banking system. The financial sector’s return to stability is predicated largely upon borrowing cheap and investing at a positive spread in securities. The first indication that banks are healthy will be decreased investing and increased lending. We don’t look for that scenario to play out for several quarters at the earliest. There are too many shaky loans and investments still hiding on bank balance sheets concealed by accounting shenanigans. The recent SEC suit against Goldman Sacs for alleged derivatives market fraud has financial shares on the run. A contagion of legal action against financial companies would not be welcome by stock and bondholders and could have adverse effects on timelines for future lending. When supply and production capacity exceed demand prices fall. If the imbalance between supply and demand persists then the risk scales tip away from the temporary inflation toward deflation.

     Employment and Housing

      The Heart of Recovery 

At the center of the debate between inflation hawks and deflation doves reside the twin economic headwinds of weak housing and employment. It’s no secret that these headwinds reinforce one another and could join forces to move from gale force to hurricane status. Looking first to employment we acknowledge some firming. The March Non-Farm Payrolls put in the best month on month gain in three years, up 162,000. Factories and construction added 17 and 15 thousand jobs respectively while the service sector added 121 thousand. It will not surprise our reader base to learn that state and local government along with financial firms shed jobs. What may be an eye opener for some is that the Federal Government Census efforts added 48 thousand jobs and from April through June 2010 will distort labor markets by adding 1.15 million temporary jobs.

Here is a cocktail napkin calculation that will shed some light on the long term prospects for employment. The economy shrank by 8 million jobs during this terrible recession. America has an underemployment rate of 16.9% (part-timers looking for full time) and a long term (over 27 weeks) unemployment rate at a record 44.1% of all who are unemployed. The manufacturing sector has been losing jobs at a rate of 21 thousand per month since 1980 and 48 thousand each month in the past decade. Consider that the economy must generate 100 thousand jobs each month to absorb new entrants to the labor market.  The pace of job creation needed to replace the lost jobs and absorb new entrants is sobering. To backfill this employment hole in two years America must create 416 thousand jobs per month. To replace the lost jobs and cover new entrants in five years we need 230 thousand new jobs per month. During the boom years from September 2003 through June 2007 the economy produced jobs at a rate of 171 thousand per month. Gains in profit and productivity have come largely from reduced labor costs.

At ICM we see two problems and long term consequences for the nation. The first is that worker skills deteriorate and then become obsolete the longer they are on the dole. How we deal with these displaced souls will say a lot about our nation and the composition of its safety net not to mention our ability to retrain our manufacturing sector.  The second issue America faces is a career ladder that is clogged at the top. Most worker retirement funds have not recovered and pension funds both public and private are sorely underfunded since the markets crashed. Senior workers are delaying their exit from the workforce. Politicians are considering pushing retirement age qualifications for benefits several years into the future. Graduates reaching for that entry level rung on the ladder are finding it tough to grasp. They know that a fresh batch of competition is released into the market each month. The rising cost of higher education means young people enter the workforce deeply in debt. Less desirable jobs with lower pay await our young workers contributing to a poorer current standard of living for this generation. It goes without mention that this new generation will face a higher tax burden to retire the debt accumulated to bailout their blundering elders and to support us in old age. Be nice to your kids.

The canary in the coal mine for this recovery is the housing market. Strip away the demand created by federal tax credit programs and the picture is dismal. Overlook the weather related bounce in March New Home Construction and Building Permit numbers and the sour market tone persists. The market is clearly off the panic lows of late 2008 and early 2009 but has declined sharply over the last quarter despite an extension of tax credits for buyers. Even with a high affordability index- heavily subsidized low borrowing costs and price declines- demand has slackened. There are plenty of bumps in the road ahead for the nations housing market. Here again it is a simple story of supply and demand. Foreclosures remain near all time highs and represent a shadow inventory of distressed assets. Federal foreclosure mitigation plans have helped about one in ten homeowners in distress. I stress the numbers and skirt the moral issues. More than 5 million homes sit at 75% loan to value ratio, the financial fault line for those considering walking away. There are $250 billion in ARMs scheduled to reset in 2010 through 2012 that may push monthly payments beyond the reach of the mortgage holders. The second liens that produced so much consumption and economic growth this past decade stand in the way of loan modifications as banks resist being wiped out on the speculative bets that housing prices would never fall. Finally the Fed and Treasury Department have discontinued the purchase of mortgage backed securities, agency debt and ten year Treasury bonds. Our guess is that mortgage rates rise in the coming year by 50 to 100 basis points adding to monthly payments for already tentative buyers. This canary looks a bit ill to me.

    The Dismal Non-Science 

In a past quarterly rant entitled Against The Gods (January 2009) and in subsequent presentations I have occupied your time and mine with discussion of the hubris, arrogance and ignorance of the mere mortals occupying positions including: economist, banker, ratings agency, securities analyst and derivatives engineer. The failure of economists in this financial crisis screams out for examination, ridicule and more importantly a redirection of the education process.

Our universities teach advanced macroeconomics based on analysis called Dynamic Stochastic General Equilibrium (DSGE). When educators and their students couple DSGE with the Efficient Market Hypothesis (EMH) they are advancing ideas virtually useless in the real world. John Kay, Financial Times columnist put it well, “Both the efficient market hypothesis and DSGE are associated with the idea of rational expectations, the idea that households and companies make decisions as if they had available to them all the information about the world that might be available.”

We begin and end this tirade with the genius of exceptional men. Einstein sought a “theory of everything. Even he could not capture all the variables of the universe into one all encompassing notion. The combination of DSGE and EMH were hoped to provide exactly that which evaded Albert, an infallible theory of everything economic. These two ridiculous concepts, GSGE and EMH used math calculations done in an emotion free vacuum that ignore one of Keynes’ most important thoughts, that of animal spirits. But by removing the human element from the human world economists and later securities engineers and risk managers could devise universal models that predicted the behavior of market participants and consumers, presumably non-humans guided by the mathematic models devised by these ill taught wiz kids. The models represented Wall Street’s “Golden Goose”

At ICM our list of “geniuses” is short. It includes Einstein and Minsky. We may have reason to place Keynes in this prestigious company one day. There is no room for the model building mathematicians who ignore the human element so clearly evident in all they got wrong. It is time to get off the treadmill and re-examine our assumptions about economics and investing and particularly those we deem “genius”. Yes it may be discomforting to give up the façade that our sharp friends calling from Wall Street really have the answers. But there is wonder in seeing the world as it really is.