Let's Look at the United States rather than Europe for a change

Durable goods orders are up 2.9% in April. New home sales rose last month. More and more statistical releases point to a continuing recovery. More and more it appears as if the Great Recession did end in July 2009 and we are, consequently, in the tenth month of the economic upturn.

However, it still doesn’t quite feel like much of an upturn. But, economic pundits contend that there is very little chance for a “double-dip” recession even with the financial turmoil rocking Europe. One analyst argued that with the European disorder the probability of having a “double-dip” recession has risen, but from about 5% a month earlier to around 20% now. In other words, he believed that it is highly unlikely that we will have a “double-dipper.”

My concern is still focused upon the long-term fact that there is so much un-used capacity in the United States. The efforts to stimulate the economy, as a consequence, represent efforts to put people back into “legacy” jobs (the jobs from which they were released) that will continue to thwart the competitiveness of the United States in world markets and put back to work “out-of-date” plant, machinery, and labor.

If we look at capacity utilization in the United States, we see that we are using more capacity now than we did in July 2009. For April the figure was below 73.7%. However, we are still substantially below the previous peak in capacity utilization, which came in at about 81.5% in 2006. And, the previous peak before that was below the previous high before that, 85% in 1997, which was lower than the previous peak and so forth for the whole post-World War II period.

Furthermore, industrial production remains depressed from the level it attained in early 2008 and also in 2000. Both series are making progress, but we are still running way below levels that were previously attained and although the “catch up” seems to be robust, the question remains as to whether or not these measures will exceed earlier highs in the near future.

Adding to this concern is the fact that the labor situation remains weak. Unemployment in April stayed just under 10%, but the number I am very concerned about is the total amount of workers that are under-employed. I am concerned, not only with those that are out-of-work, but those that are not fully employed but want to be fully employed, the discouraged who have left the workforce, and the people that have taken lower positions, positions that they can fill but are fully qualified to perform in other more challenging jobs. My estimate of these under-employed persons runs around 25%, about 1 out of every four people who could be considered to be in the labor force.

The fact that these factors are running so low relative to “capacity” employment raises concerns about the United States achieving its “potential” any time soon. To examine this possibility we look at a comparison between the estimates of the Congressional Budget Office of potential real Gross Domestic Product and the level that real Gross Domestic Product was actually attained. Not only was the United States economy producing at a level of output only 94% of potential, the rates of growth of actual real GDP seem to lie below the rate at which the CBO is estimating that potential real GDP should grow.

The economy of the United States is recovering, but one can understand why many people really do not seem to be experiencing it. Nothing in the previous stimulus plan, or in the one being developed, or in the current stance of monetary policy, gets the United States back on track. Different types of policies are needed to renew the productive capacity of the United States so that the U. S. can become fully competitive again and fully use its resources…both human and physical. Unfortunately no one seems to be working on these kinds of policies because they rely so heavily on the private sector. Also, these policies take too long to achieve results; politicians have a much shorter employment cycle.

The Chances for a Double Dip

I believe that the probability that we will have a double dip in the economy, a second recession following on the Great Recession, is relatively small and growing smaller all of the time.

The reason that I would give for this is that economies only change directions when there is some kind of shock to expectations. To use the words of one famous pundit with respect to an uncertain future, we just don’t know when something will change with respect to an “unknown” unknown. Even in the cases of “known” unknowns, we know where a change might occur; we just don’t know the magnitude of the change.

A liquidity crisis occurs when something happens in a market, generally a financial market, and the buyers on the demand side of the market decide it is best if they just go out and play a round of golf until the market settles and they know where prices will stabilize. The job of the central bank is to provide liquidity to the market so as to achieve this stabilization of prices. The length of a liquidity crisis is usually no more than four weeks.

A credit crisis occurs when something happens in a market, generally a financial market, and the holders of assets must significantly write down the value of their assets. Banks and other financial organizations may go out of business during the credit crisis because they don’t have sufficient capital to cover all the write downs that must take place. The job of the central bank is to provide stability to the financial markets so that the financial institutions can take their charge-offs in an orderly fashion so as not to cause multiple bank failures. The length of a credit crisis can extend for several years as the financial institutions work off their problem loans and those organizations that have to close their doors do so with the least disruption to “business-as-usual.”

In both cases, something unexpected happens and expectations about asset prices have to be adjusted. Extreme danger exists as long as bankers and investors persist is retaining the old expectations about prices and fail to make the moves necessary to adjust their thinking to a more realistic assessment of the situation. However, as these bankers and investors adjust to the “new reality”, they become more conservative and risk-averse in their decision making and work hard to get asset prices into line with the new financial and economic environment they have to deal with.

As the adjustment to the “new reality” takes place, things remain precarious, but, as long as no new surprises come along, the process of re-structuring can continue to lessen the problem and even strengthen the recovery. This is the state in which the United States is in right now.

The thing that needs to be avoided is a “new surprise”. What this can be of course is “unknown”…an “unknown” unknown.

In the 1937-1938 depression, there was an “unknown” unknown in the form of a policy change at the Federal Reserve System that is credited with “shocking” the financial and economic system into the second depression of the 1930s. The shock here was an increase in the reserves the banking system was required to hold behind deposits in banks, an increase in reserve requirements. The argument given for the increase was that there were a lot of excess reserves in the banking system and for the Federal Reserve to be effective at all during the time, the excess reserves had to be removed: hence the increase in reserve requirements.

The problem was that the banks wanted the excess reserves and with the increase in reserve requirements the banks became even more conservative causing another massive decrease in the money stock. This, of course, has been given as a reason for the “double-dip” that took place in the 1930s.

There are, as is well known, a lot of excess reserves in the banking system at the present time, almost $1.2 trillion in excess reserves. The Federal Reserve knows that they are going to have to remove these reserves from the banking system at some time. Hence, it has developed an “exit” strategy.

Banks and investors know that the Federal Reserve is going to have to remove these reserves from the banking system at some time. How the Fed is going to accomplish its “undoing” is, of course, the big unknown!

The fact that these reserves are going to be removed from the banking system is a “known” unknown!

But, how and when the reduction in reserves is going to take place, not even the Fed knows. Bernanke and the Fed have worked hard to keep the banking system and the financial markets aware of the “undoing” so that although there are still many unknowns connected with this undoing, the fact that the “undoing” is going to be done is a “known.”

The effort here is to avoid a policy “shock” coming from the central bank as in the 1937-1938 experience.

There are a lot of things going on in other sectors of the economy and the world, but these all seem to fit into the category of “known” unknowns: like the problems in Greece and the other PIIGS, Portugal, Italy, Ireland, and Spain. There are the problems of states, California, New York, New Jersey, and so on, and municipalities, like Philadelphia and others, but these are also “known”.

There are over 700 commercial banks on the problem list of the FDIC. But these are “known” and are being worked off in an orderly and professional way that seems to be the model of the world. (See the article by Gillian Tett, “Practising the last rites for dying banks,” http://www.ft.com/cms/s/0/00b740a2-350e-11df-9cfb-00144feabdc0.html.) The FDIC closed seven banks last Friday bringing the total for the year to 33. This is right on my projection of closing at least 3 banks a week for the next 12 to 18 months.

And, what about the United States deficit? Well, I would contend that this is a “known” unknown as well. The deficits over the next ten years or so are projected to be in the range of $9-$10 trillion. I believe that they will be more around $15-$18 trillion, but that is just a minor difference. But, the deficits are “on-the-table” even if the amounts are not quite certain. The deficits will be large and this will be a problem, but they are not going to be a surprise.

This is one reason, I believe, why the Obama administration made the effort they did to talk about the budget deficits publically, particularly with regards to the health care initiative. They are talking about the budget, whether one agrees with their projections or not.

And, just the passage of the health care legislation, I believe, will change the temper of things. This thing has been done and I think just this fact will change the environment…for the better.

There are always “unknown” unknowns lurking. There could be a blow up in the Middle East leading to a full-scale war…or in the east. There could be a political move to boost the price of oil. There could be a lot of things. But, as far as the economy itself and the financial markets: I believe that things are being worked out and things will continue to improve. Thus, the probability of a Double Dip has lessened.