US Industrial Production Continues to Expand

The US economy continues to grow but the pace of expansion is still modest.  Industrial production expanded in June at a 4.7 year-over-year pace.  This put the average rate of expansion for the quarter at 4.7 percent, year-over-year, up slightly from a 4.4 pace of the first quarter. 

Since the current economic recovery began in July 2009, the highest quarterly increase in industrial production came in the third quarter of 2010.  At that time industrial production was increasing at a 7.1 percent, year-over-year rate. 

As can be seen in the accompanying chart, the rate of increase dropped off from that date and seems to have settled in the three-to-five percent range, a rate that is rather anemic for this time in the business cycle, but a rate that is consistent with other current measures of economic growth.

Real GDP, for example, grew at a 2.0 percent year-over-year rate of growth in the first quarter of 2012, and has only average in the 1.5 percent to 2.0 percent range for the past year.

As reflected in almost all of the data, economic growth is taking place but not at a very rapid pace.

There are three reasons for this slow pace of economic growth in my mind.  The first reason is the huge debt overload that exists within the US economy.  I have written on this in "The Debt Crisis Goes On and On."  Individuals, businesses, and state and local governments, overloaded with debt at not able to spend as abundantly as in the past because they are attempting to get their balance sheets back in line.

Second, there is a great deal of uncertainty in the world these days.  Washington, D. C. is in a mess and there seems to be no leadership around, especially in the White House.  As Larry Summers stated during his recent term in Washington, “the parents are not at home.”  This lack of leadership in the US, combined with the economic crisis in Europe and the lack of leadership there, leaves us all wondering what is in store for us in the future.  And, unfortunately, what we contemplate for the future is not very optimistic.

Third, there are some serious structural matters in the economy that still need to be resolved.  For example, I believe that underemployment in the United States is still around 20 percent.  That is, one out of every four individuals of working age are either unemployed, employed in a part-time job but would like to work full time, or, have left the work force.  The workforce participation numbers are now back where they were in the 1960s.

And, we continue to get stories about how the American society is bifurcating.  David Brooks writes of "The Opportunity Gap" emerging in our country, a gap in which “the children of the more affluent and less affluent are raised in starkly different ways and have different opportunities.”  The ramifications of this split has been researched and discussed by numerous people now and it indicates that we need more than just economic stimulus and good intentions to solve the structural problems that are growing worse every day.

This structural problem is also seen in the data on the capacity utilization of American manufacturing.  The data just released indicate that industry is using just under 79 percent of its capacity.  Thus, capacity utilization continues to increase in the current recovery.

However, note in the accompanying graph that capacity utilization was around 90 percent in the mid-1960s and has trended downward every since.  In fact, this trend matches, to a high degree, the increase in the underemployed in the United States.

Most obvious in the trend is that the peak utilization in every cycle seems to be lower than that achieved in the previous cycle.  Capacity utilization continues to increase in the current recovery but is still below the peak achieved in the 2003-2007 period…which was below the peak of the cycle in the mid-1990s. 

There are significant structural dislocations in the United States economy and a policy of government intervention and economic stimulus is not going to correct the situation.

Mr. Bernanke, in testimony before Congress today, seemed to be cognizant of the problems the US economy is facing.  “Mr. Bernanke’s cautious testimony underscored the Fed’s reluctance to ride once again to the aid of a plodding economy. The central bank has intervened repeatedly when the economy appears at risk of sliding back into recession, and Mr. Bernanke’s testimony Tuesday included his standard promise to maintain that vigilance. But the Fed has not acted with similar urgency to reduce the persistently high rate of unemployment when growth is merely lackluster.”

To me, this is about all the Federal Reserve can do right now. (See my post on "The Fed is Doing Enough For Now.") The economy is recovering but not at the speed we would like.  However, sometimes there is only just so much that can be done in terms of aggregate economic policy. 

The Debt Crisis Goes On and On

When it comes to a debt crisis almost everyone seems to quote from the book “This Time Is Different” by Carmen Reinhart and Kenneth Rogoff.  A debt crisis takes a long time to create and it takes a long time for a debt crisis to unwind.

Yet, no one seems to heed this conclusion.

Instead we hear that we need more monetary stimulus, a QE3, before the upcoming presidential election in the United States.  We need immediate tax cuts.  We need fiscal stimulus.  We need an export policy to spur on the economy.

Let me repeat the conclusion written above: it takes a long time to create a debt crisis.

In my mind it took the United States approximately fifty years to create its debt crisis. 

Now, the second part of the equation: it takes a long time to unwind a debt crisis.

How long?

Jamil Baz, chief investment strategist at GLG Partners, a part of the Man Group, suggested that the current debt crisis “will take a minimum of 15 years for the economy to reach escape velocity and attain a level consistent with healthy growth.  This is because debt levels need to come down by at least 150 percent of GDP in most countries.  History suggests that you cannot reduce debt by more than 10 percentage points a year without social and political dislocation.”

Fifteen years!

Geeeeeeeeeee!!!!!!

Over the past five years, the debt situation has gotten worse.  According to Mr. Baz, for eleven the eleven developed countries most mentioned when it comes to the debt crisis, the weighted average of government debt to GDP has risen from 381 percent in June 2007 to 417 percent at the present time.

Deleveraging, at least in the public sector, has not taken place during these sad economic times…in fact, just the opposite has occurred.

And, when you add on the private debt the situation has deteriorated even more amongst these developed nations.

Why aren’t businesses hiring?  Why aren’t people spending?  Why aren’t government policies working? 

Because, Mr. Baz argues, deleveraging has not even started yet! 

All we have heard is a lot of hot air escaping from the balloon.  But, the balloon is not taking off and will not take off as long as there is still substantial deleveraging left…in the United States…and in most of the rest of the developed world.

And, when the debt begins to be reduced…watch out for economic growth.  The International Monetary Fund has estimated that, under current circumstances, every dollar cut from government deficits will lead to a two-dollar reduction in GDP.  This multiplier effect is higher now, the IMF states, than it was before 2008…four times higher!

The policy tools that people are turning to are not effective.  Additional government stimulus, or even the talk of it, points to even more debt being created which, in a cumulative way, just adds to the problem.  Monetary stimulus that creates inflation to reduce the real value of the debt will just result in higher bond yields that would raise the costs of servicing the debt and this just will exacerbate the problem.  And, policies to cause exchange rates to fall to jump-start an export-driven recovery are being tried by just about everyone with no one winning the game.

Fifty years of credit inflation…here in the United States…and in Europe…have created the debt crisis.  More of the same policy will only add to the crisis…not solve it. 

But, for fifty years, public officials would not listen to warnings that more and more credit inflation would result in a situation like the one we are now in.

Another five…or, ten…years of credit inflation will not heal the situation!

Unfortunately, there are no good, painless solutions. 

The ironic thing is that interest rates are so low in this situation!  The ten-year United States Treasury issue is trading just under 1.50 percent.  The ten-year German government bond is trading around 1.25 percent. 

The investment community is so spooked by the debt crisis that the “safe” bet today is in either US Treasury securities or German Bunds.  And, some US Treasury indexed bonds are trading at more than a NEGATIVE one percent rate of interest.  The ten-year indexed bond is trading around a NEGATIVE 0.60 percent.

In economics, everything is relative.

However, officials don’t acknowledge the problem.  Debt is subject that is best not discussed.  For most of the past fifty years, debt has not been present in aggregate models of the economy…academic, private, or government models. 

Still, it takes a long time for a debt crisis to become the dominant factor of an economy.

Unfortunately, it takes a long time for the debt crisis to subside.  This debt crisis will not be over when the next president of the United States is elected.  In all likelihood, the debt crisis will not be over when a president of the United States is elected in 2015. 

Maybe it is time to acknowledge this problem and really start to deal with it.  We have seen what continuing to ignore it does.   

It's About Debt, Stupid!

Much has been made during the recent economic recovery, which began in July 2009, about the excessive debt loads faced by small businesses and households.  The high debt levels have been given as a contributing factor to the economic collapse in the United States that appeared late in 2007.  In addition, these high levels of debt have been associated with the slow economic recovery

One of the major books published during this time period has been the work of Carmen Reinhart and Kenneth Rogoff titled “This Time is Different.”  The research presented in this book highlights the role that debt can play in the collapse of an economy and the subsequent slow recovery associated with debt-related economic crisis. 

Well, some good news is coming to us from the household sector.  It seems as if households are achieving some success in reducing their debt payments, which will allow them to continue to reduce their debt loads and increase their consumption expenditures.

“The Federal Reserve estimates that the household debt service ratio, a ratio of debt payments to disposable personal income, fell to 10.9% in the final three months of 2011 as a result of low interest rates and reduced debt levels.  That was the lowest reading since 1994.  Total financial obligations, which add in rent payment, homeowners insurance and property tax payments, were 16 percent, the lowest since 1984.”  This is an article by Floyd Norris in the New York Times (http://www.nytimes.com/2012/04/20/business/not-exactly-a-miracle-but-us-debt-levels-are-falling.html?_r=1&ref=business). 

Norris writes, “debt levels have fallen.  Over all, households owe about $13.2 trillion, nearly $600 billion less than in late 2008….low interest rates mean that servicing that debt costs less.  The Commerce Department says that mortgage interest payments, in dollars, are lower than at any time since 2005.”

Norris continues, “In this country, the deleveraging process has some way to go, with many foreclosures still pending….”  And, “To get the deleveraging process under way, it is important for lenders to race reality, admit losses and deal with them.”

Not all the reduction of debt has been voluntary: “”The McKinsey Global Institute estimates that about two-thirds of the reduction came from the cancellation of debt, through writeoffs and foreclosures.” 

Debt reductions, however, are debt reductions.  According to Reinhart and Rogoff, deleveraging is something an over-leveraged economy needs.

That is, these statistics are a positive sign. 

Furthermore, commercial bank lending has finally begun to rise.  This may sound contradictory to the above comments, but the crucial thing is that the bank lending is coming in areas that relate to business and not to the consumer and can be a positive contributor to economic growth.  In fact, this kind of loan growth is necessary for economic growth to be sustained, even if at a modest 2.0% to 2.5% rate. (See my post “Loan Growth Continues to Pick Up at Commercial Banks,” http://seekingalpha.com/article/499921-loan-growth-continues-to-pick-up-at-commercial-banks.)  I take this to be a good sign.

Finally, let me just add that I don’t perceive that economic growth will become robust for a little longer.  But, this does not mean that economic growth will not continue even at a tepid pace.  Analysts wring their hands over the latest numbers on the jobless claims and other recent indicators of the employment situation. (http://professional.wsj.com/article/SB10001424052702303425504577353550599537484.html?mod=ITP_pageone_0&mg=reno64-sec-wsj)  The situation in the labor market is very worrisome.

However, the situation in the labor market is not just a short-run problem.  As I have pointed out numerous times over the past two years the un-employment rate is not the crucial one at this time.  The crucial indicator of the situation in the labor market is the under-employment rate.  I place this rate at around 20 percent of the eligible workers in the country.

There have been several articles recently in the daily press that discuss this point.  One of the better ones is “A Workforce on the Wane” in the Financial Times. (http://www.ft.com/intl/cms/s/0/8995b476-887c-11e1-a727-00144feab49a.html#axzz1saIOacDe)

Furthermore, it is not only in the labor market that we find an under-utilization of resources.  The capacity utilization in the manufacturing sector rests below 80 percent.  Before economic really begins to pick up in the future, businesses are going to have to deal with their surplus capacity, something that has steadily been growing since the 1960s. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage)

Dealing with under-employment and with under-utilization of capital is a long-run problem that must be dealt with over time.  The problem is, that as long as there are so many potentially productive resources out-of-line with what is needed in the economy, economic growth will remain slower than we would like it to be.  Re-training and re-structuring must be accomplished before higher growth rates can be sustained. 

The news on debt loads and debt levels is encouraging.  The direction begun must continue.  It is good that the commercial banks have stepped up this business lending for this is needed to underwrite the meager expansion that has already begun.  But, this is a long-term affair and efforts to try and get too much out of the recovery too soon will only make the future more precarious. 

The Credit Markets: Two Apparent Contradictions

The yield on the 10-year US Treasury bond closed at 2.301 percent on Friday.  The dramatic rise in this yield at the end of last week has many analysts worried that the bull market in bonds is over. 

The yield on the 10-year Treasury was 2.384 percent at the close on last October 27 and at the end of July 2011, the yield was around 3.00 percent, where it had been for some time.

Note that a large portion of the time that the yield on the 10-year Treasury had been at these higher levels, the Federal Reserve had been operating under a policy of quantitative easing.

What set off the decline in yields in August and September was a series of things that lead to a rush into gold and a flight to quality in the financial markets. 

The price of gold had remained relatively stable in the May and June period, but began steadily increasing in July and August.  By August 2, the price of gold reached $1660 per ounce and then flew through $1700 on October 8, the day of the S&P downgrade of US debt.  By August 18, the price closed at $1828 and almost closed at $1900 on August 22.

Even more startling, the yield on the 10-year TIPS turned negative in early August.  On August 10, this yield was -0.155 percent!  In late July it had been trading to yield above 0.500 percent. 

The 10-year Treasury yield plummeted from about 3.00 percent on July 29 to 2.40 percent on August 4 and about 2.00 percent on August 10.

The stock market was also highly volatile during this July/August period. 

And, Treasury yields remained low through the whole Greek debt restructuring that took place throughout the fall into the new year of 2012.

My view: over the past month or so, financial markets have calmed somewhat, primarily due to the Greek situation, and this has been leading to a movement of funds out of US Treasury issues and into riskier “stuff”. 

Then we got the news last week from Mr. Bernanke that the Fed was not going to do much in the way of bond purchases in the near future and, in particular, there was no inclination on the part of the Open Market Committee to engage in a new phase of Quantitative Easing. 

These two factors, I believe, are leading to a reversal from the previous “flight to quality” in the financial markets. 

Since January the ratio of the yields on government bonds relative to Aaa-rated corporate securities has been rising, indicating funds were flowing more freely into other sectors of the financial markets.  Furthermore, the ratio of yields on Aaa-rated corporate securities to Baa-rated corporate securities was rising indicating a relative move to less highly rated credit. 

Therefore, I am less concerned about an end to the “bull market” in Treasury securities than I am about a market adjustment that has followed the “flight to quality” that took place last summer. The economy continues to expand (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) and monetary policy will continue to be supportive of a still fragile banking system. 

I am looking more for a relative rise in the yield on US Treasury securities as an indication that funds are flowing back into other areas of the financial markets rather than for a cyclical increase in yields due to a strengthening of the economy. 

There is a second issue I would like to clear up that was brought to my attention by someone commenting on the above mentioned blogpost. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad)

In this blogpost I discussed the continued deleveraging taking place in the American economy and the rise in bank lending, which I took as a positive sign that the economy would continue to grow.  One person who commented on this post stated that the idea that deleveraging was to continue but bank lending was increasing seemed to be contradictory. 

As such, the two pieces of information does sound contradictory.  In arguing that “both” of these conditions can exist within the economy I draw on a point I have made continually over the past several years.  My argument has been that over the past fifty years or so the United States government has conducted a policy of credit inflation.  This credit inflation has helped to bifurcate the society as those with more wealth and better access to advice and consulting have been able to protect themselves from the inflation or even take advantage of the inflation to improve their position in the economy.  The less-well off have not been able to even keep up with what is going on.  As a consequence, the income/wealth distribution in the United States has become even more skewed to those possessing wealth. 

As I have described in other places, the current economic policies of the United States government just exacerbate this movement.  That is, the economic policies of the United States government are making things even worse.  Deleveraging continues, but generally amongst those that are less well off, those who are heavily in debt, those who often find themselves underwater with respect to the ownership of their own home, and those who have little or no savings. 

Lending is picking up to others, businesses as well as households, that are not is such a situation.

Thus, you can have bank loans increasing in the economy while many in the economy still have to reduce their financial leverage to even keep going.  I believe we are in such a situation.