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Worse than Recession

December 13, 2001

Tags Booms and BustsBusiness Cycles

How do you to turn a recession into something worse?

Easy. The same way you turn a drunk into an alcoholic: keep dragging him back to the bar, filling his drink, and telling him to forget all his cares.

U.S. personal consumption expenditures rallied strongly in October--so much so, in fact, that, adding back the spurious $60 billion deducted in September for insurance payouts (the money was still spent, after all!)--the August-October period was a record in dollar terms. November, however, showed a record collapse of the same.

Once again, we must open our eyes to the dangerous misconception that an economy's strength can be assessed by looking at "effective demand."

Economies do not subside because demand wanes--we could all use a shiny new car, or a beautiful new house pretty much any time. However, in a world where means, unlike wants, are not infinite, we have to be able to offer something in exchange. We do that by first profitably producing things other people require, at a price they are willing to pay, not by stamping our feet and making demands like a petulant 5-year-old.

Here we are, eighteen months and two million or so extra jobless off the peak of the labor market, and yet "demand"--as expressed in consumption--is still (more or less) holding up. Keynesian and monetarist gurus on the airwaves remain blind to this simple fact, begging the Fed and the State to restore "effective demand." The Fed, in its statement reducing rates to 1.75 percent, complains of forces restraining demand.

However, production--crucial, essential, sine qua non production--whether at home or abroad, is undeniably in rapid decline. U.S. industrial production has fallen 7 percent--so far--from its peak in June 2000, significantly worse than the 4.7-percent drop in 1990 and already matching 1980's decline, if still some way short of 1982's 10.5 percent, or 1973-1975's 14.7 percent.

Meanwhile, U.S. merchandise trade in goods has fallen sharply, with imports off 10.6 percent (year on year), the sharpest contraction since 1975--which, with exports minus 12.6 percent (their poorest since December 1982), means overall trade is also suffering its steepest decline since that last global recession, nineteen years ago.

But how can consumption hold up for so long in the face of a falloff in the generation of the means to support either its supply or its demand? There are only two routes--capital consumption and credit expansion--and both are currently being vigorously promoted by the major central banks.

But, this, too, is a game which cannot continue indefinitely, because this eventually impairs not just borrowers' finances, but, more significantly, their fractional-reserve, inherently insolvent lenders' balance sheets as well.

That process--if it goes unchecked for too long--is where our friendly, neighborhood barfly becomes a dipsomaniac, and, worryingly, there are signs that the Fed and its peers have run the creaking Western financial system close to the stage where it is knocking off shots of Tequila to chase down its beer already.

Consider the Mortgage Bankers Association of America's latest delinquency survey, which showed the fraction of such loans up 25bps to 4.87 percent in the third quarter--a rate last exceeded at the height of the 1991 real-estate bust, when it hit 5.2 percent.

Incidentally, among these, government-engineered loans to the lower socioeconomic classes remain in a third-world state: one in nine FHA loans is delinquent, as is one in twelve VA loans. (If you can hear an insistent tick-tock sound at this stage, it might be the sound of the multi-trillion-dollar Government-Sponsored Enterprise, or GSE, time bomb counting down to detonation.)

Banks, too, have been doing less than well of late.

Profits were off sharply in the third quarter--well before the full effects of WTC, or any mention of Enron, or the Argentine debt swap--largely as the result of the steepest rise in loan loss provisions since 1990 (not a happy time for U.S. banks!).

This next is where it gets scary: although this belated fit of prudence has raised reserves as a percentage of loans to their highest for 2½ years, as a fraction of their noncurrent loans it fell to its lowest in more than seven, according to the FDIC. Want to bet we have another significant round of provisioning to endure in the fourth quarter also?

The Fed's charge-offs report does not make pleasant reading either. Charge-offs on residential property have quadrupled in a year, to hit their highest in the ten years of disaggregated data. Consumer loans are their worst in four years, thanks to a sixteen-year record in faltering non-credit-card advances. Credit card delinquencies are up. Leases and C&I loans are in their poorest health since 1990/1991, agricultural loans since 1987.

Overall, the ratio has not been this bad since March 1993, while the pace of deterioration over the last six quarters is the quickest since 1990. Consider that the total portfolio is now 88 percent bigger than it was in 1993, and we can see that hunky-dory things are not.

But, no matter, the Fed is hinting it will push rates all the way to zero if necessary to drive us to consume that which we cannot store without it rotting on the shelves. Indeed, the current secularly extreme low in official rates is already threatening a major, unintended consequence.

Money market funds, whether invested in T-Bills at 1.65 percent for three months or nonfinancial CP at 1.72 percent, are not only more than 2 percent below median CPI, but, it seems, they are now barely generating enough to cover the funds' fees.

This has already prompted the SEC to make discreet enquiries about what these funds propose to do should net returns become negative. That this is a matter with far-reaching implications can be seen in that the $2.35 trillion held in this form--$1.1 trillion of that in retail accounts--is marketed with the so-far untested promise that the value of such assets will "never break the buck."

This means that they promise always to return principal intact. and, given that it is usual for them to offer checking facilities, this pledge (whether able to be honored in extremis or not) underpins the widespread perception that these represent money to their holders, thus making these negative returns--i.e., losses--potentially a matter of great significance.

Some funds have said they will temporarily waive fees, hoping for the best, but others intend to return the monies to clients forthwith. Thus, even if a panicked wave of forced redemptions is not forthcoming, a major and possibly disruptive shift in monetary holdings may still be in store.

Certainly these trends are beginning to suggest that, unless Greenspan's Fed is willing to suspend or adulterate a further raft of prudential regulations, the rapidly deteriorating productive structure, being weakened as we write by yet more improvident consumption, will increasingly constrain the credit multipliers in the system. That would throw all forms of risky assets--from lower-grade bonds and paper to equities--into disarray once the cessation of an accelerating money supply forced a renewed focus on the underlying fundamentals.

Then we would be back where we started, having to endure a major relapse in terms of the real economy and a further plunge in the value of our paper collateral, only this time with another several hundred billion dollars in unserviceable liabilities around our necks.

In other words, we would be another step nearer a practical demonstration of how easy money works to turn restorative recession into something worse.


Sean Corrigan is a principal of www.capital-insight.com, a London-based economic consultancy. See his Mises.org Articles Archive, or send him MAIL.  He will be speaking on the "Capital Markets in Crisis" panel at the upcoming Austrian Scholars Conference.


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