The Problems in Housing and the Labor Markets Will Not Go Away Soon

President Obama announced a mortgage plan aimed at giving relief to homeowners that are facing problems with their mortgages.  Yet, this is just putting a finger in a hole in the dike.

The problem is that after fifty years of governmental credit inflation many homeowners are facing the reality that their homes were grossly over-valued and that they assumed too much debt to finance their “American Dream.”

One out of every four or five houses has a mortgage on the property that is greater than the market value of the house.  Many of these homes are now valued at only 75 percent or less of their mortgage value. 

Regardless of a government “solution” to this situation, either through debt relief or a renewed bout of government-induced inflation, the attitudes and expectations of homeowners have changed.  These homeowners have been “burned” and are unlikely to expose themselves to this possibility again in their lifetimes. 

Even if the market stabilizes in the near term and housing prices bottom out, many potential home buyers will be much more financially conservative in the future given the experience that they have just been gone through. 

The reluctance to buy a home will also be affected by the situation in the labor market.   And, here again there is a longer-term problem that will not be resolved in a matter of months. 

One out of every four or five people of employment age are either unemployed, employed in a part time job but would like to be employed full time, or are not seeking employment.  The percentage of working age people in the labor market has recently dropped to a level not seen for several decades. 

With conditions in the labor market so tenuous, people will not have the same resources to purchase housing as they have had in the recent past. 

But, how is this under-employment situation in the labor market going to be resolved in the short-run?

The fundamentalist preacher Paul Krugman cries out for short-run government “solutions” to put people back into the jobs that were in existence at another time.  Krugman writes, “We have become a society in which less-educated men have great difficulty finding jobs with decent wages and good benefits.”  For example, “Adjusted for inflation, entry-level wages of male high school graduates have fallen 23 percent since 1973.” (http://www.nytimes.com/2012/02/10/opinion/krugman-money-and-morals.html?ref=opinion)

Maybe, part of this problem is that the government has emphasized putting high school graduates into what have historically been entry-level jobs, jobs that are shrinking as a proportion of the jobs available due to changes in technology and needed training.  And, what about those that do not graduate from high school…they are in an even less-favorable position. 

Elsewhere in the New York Times, we read that “Rich and Poor Further Apart in Education.” (http://www.nytimes.com/2012/02/10/education/education-gap-grows-between-rich-and-poor-studies-show.html?hp) “Education was historically considered a great equalizer in American society, capable of lifting less advantaged children and improving their chances for success as adults.  But a body of recently published scholarship suggests that the achievement gap between rich and poor children is widening, a development that threatens to dilute education’s leveling effects.”

This is a gap that cannot be overcome quickly.  And, it is a gap that cannot be overcome by national tests and government spending.

  

Since the end of World War II, politicians have generally believed that they could get elected and re-elected by keeping people employed and by helping more and more people become homeowners.  This underlying emphasis has resulted in the fifty years of credit inflation the United States has experienced since the early 1960s. 

People were kept employed by short-term government economic programs that put the unemployed back into the jobs that held previously before becoming unemployed.  And, why should someone going through high school be concerned about employment when they knew that the government would continue to stimulate jobs in heavy manufacturing and industry and keep them employed. 

The government continued to promote these kinds of stimulus programs even though under-employment increased steadily over the past fifty years and the capacity utilization in manufacturing was declining over the same time period. 

The federal homeowner programs and credit inflation created in the housing sector over the same time period created a “piggy bank” for many people not only helping them to own their own home, but also to allow them the ability to borrow more and more money to binge on consumer goods.     

So, we ended up with the “less wealthy” being under-educated and hence not readily employable in the labor markets of the 21^st century and with many of these same people owning homes and over-their-heads in debt. 

  

This is a situation that does not have an easy or ready solution. 

Under-employment can only be resolved over an extended period of time.  The same holds for people with too much debt.  Short-run stimulus is not the answer.  In fact, the emphasis on short-run stimulation has created and further exacerbated the situation. 

A safety net may be necessary for many of the under-employed and overly leveraged.  In fact, the efforts to keep people in “legacy” jobs and to put families in homes to make their life better may have resulted in a whole generation of individuals being excluded from the mainstream.  They are going to need some economic support.

But, the only real solution to the labor market situation is a long run one and it begins with education and the environment that surrounds the culture of education. 

The situation in the housing market will only get better as people lower their expectations and get their balance sheets back in order.  This, too, will take a substantial amount of time because it is related to a major change in expectations.  People, in the future, just cannot expect a “free ride.”      

Where is the US Consumer?

“Rising Income is Saved, Not Spent,” reads the Wall Street Journal Tuesday morning. (http://professional.wsj.com/article/SB10001424052970204740904577192702993936344.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

“Personal income increased 0.5% in December from November adjusted for seasonality, the largest monthly increase since March…but spending was flat over the month—actually fell when inflation is factored in.”

“The savings rate, around 5.0% for the first half of 2011, was near 4.0% for much of the second half of the year…. Economists warned that consumers would soon resume socking away cash at the expense of spending, and that appears to be playing out now.”

With unemployment still high and the housing market in the doldrums, consumers are reluctant—and in many cases unable—to increase their spending in a big way.”

The Federal Reserve’s recently released forecast projected unemployment rates remaining at high levels through 2014, declining only slightly throughout the next three years.  And, even worse, underemployment is also expected to remain high with the rate of underemployment staying near to one out of every five people of working age.  No help coming here.(

Furthermore, a large proportion of homeowners still find themselves “under water” with mortgages that exceed the market value of their houses.  This situation is not expected to improve in the near future.

Robert Shiller, the Yale economist, was just interviewed at Davos and responded to questions about home prices by saying that prices will probably continue to decline, although not at the rate they declined in recent years.  He added that even if housing prices did stop declining, there is no reason to expect that they would start to rise anytime soon.  In addition, he added, that even though housing prices were returning to something more like a “fair value” that historically, the tendency was for the market to “overshoot” the “fair value” until all the previous exuberance is wrung out of the market. (http://professional.wsj.com/article/SB10001424052970204740904577192702993936344.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

A White House effort to lessen the impact of these homes that are “under water” seems to have failed in that the program developed by the administration has not reached enough borrowers to have much impact on the market. (http://www.ft.com/intl/cms/s/0/cf9fed00-4a89-11e1-8110-00144feabdc0.html#axzz1l2qSCMaM)

Even more chilling is the report released today by the Corporation for Enterprise Development (CFED) titled “The 2012 Assets & Opportunity Scorecard: How Financially Secure are Families?” (Go to http://cfed.org/.)   This study presents what it calls the households that are in “liquid asset poverty”.  A household is considered in liquid asset poverty if it owns a home, yet has no savings to speak of.  These people are just one significant emergency away from a real financial crisis. 

The emergency could take the form of a major car breakdown or a health problem.  Most of these people are earning a regular paycheck, CFED says, but they don’t really realize how close to the edge they are living.  Many have some other form of debt, but in an emergency would have to rely on very expensive sources of debt to try and carry them through the emergency. 

The study reports that 43 percent of the households in the United States are liquid asset poor.  This amounts to roughly 128 million households. 

Again, we seem to see the country bifurcating.  There are those households that are doing OK and are continuing to spend through these tough times.  Yet, there are a large number of people that have to watch out where every penny of their income is going.  This means that the economic recovery will not only remain week, but it will be fragile and susceptible to unexpected shocks.

Saving and deleveraging are still needed and being sought by many families, but this will just mean that the recovery will be missing any strong support from consumer spending in the near term.

And, it means that banks and other financial institutions cannot be sure of value of many of the assets on their balance sheets, both mortgages and consumer loans, but also face the fact that loan demand will also not be strong in the future.

We are still looking for where the surge in economic activity will come from.    

U. S. Businesses Shop Europe

“As Europe struggles with its debt crisis, American businesses and financial firms are swooping in amid the distress, making loans and snapping up assets owned by banks there—from the mortgage on a luxury hotel in Miami Beach to the tallest office building in Dublin.” (http://www.nytimes.com/2011/12/26/business/us-firms-see-europe-woes-as-opportunities.html?_r=1&scp=2&sq=nelson%20schwartz&st=cse)

Where in our current understanding of macroeconomics does it indicate that a sovereign debt crisis might end up with foreign interests owning large chunks of a country’s physical assets?  How much of Ireland will United States interests buy?  How much of Spain will Middle Eastern countries end up owning?  And, how much of Italy will China possess?

Macroeconomics just cannot pick up the complexity of real economies.  Too much of the reality of an economy takes place at the micro-level and cannot be comfortably incorporated into the simple structures of the aggregate models of the economy. 

Macro-models just cannot include all of the incentives that are created within the total economy that lead to results that can even produce contradictory outcomes to what the macro-economists had been predicting. 

One of the most egregious results of the past fifty years is the prediction of the macro-economist that inflation can help the working classes and the middle classes.  Yet fifty years of credit inflation in the United States produced exactly the opposite effect in that the income/wealth distribution in the U. S. became highly skewed toward the wealthier in the society.

For one, the economists used aggregate models to show that there was a favorable tradeoff between employment and inflation.  The policy implication: if a little more inflation can be created then more people will be hired and unemployment will decline.

These models did not pick up micro-behavior that indicated that the “less wealthy” could not protect themselves from credit inflation whereas the “more wealthy” could not only protect themselves from credit inflation but could actually benefit from it.

Furthermore, these models did not include the fact that the credit inflation would provide incentives for manufacturing companies to move more into financial services while shifting their focus away from their historically productive enterprises.  Who would have thought in the 1960s that General Electric and General Motors would, by the end of the century, be earning more profit from their financial wings than from their manufacturing capacities?

Another macroeconomic idea that I have repeatedly used in discussing international financial arrangements has been that of the “trilemma”.  The “trilemma” analysis concludes that a country can only achieve two of the following three policy objectives: a free international flow of capital; a fixed exchange rate; and the ability to follow an independent economic policy.

Since 1971 when the United States went off the gold standard, many countries floated the value of their currencies in foreign exchange markets.  This had to occur, the argument went, because in the 1960s, capital began to flow freely throughout the world. 

Therefore, if governments wanted to gain the favor of those that worked in manufacturing and the labor unions by conducting a policy of credit inflation to keep unemployment low and, in many countries, housed in their own home, they had to be able to conduct an independent economic policy.  Within this effort, popular pension programs were also expanded to encourage people to retire earlier and governments became a large supplier of jobs to the economy.   

Thus, the value of the currency could be allowed to decline as governments created massive amounts of debt often financed by foreign interests.  Governments were able to keep the pedal to the floor during this period by generating a relatively steady flow of credit to their economies.

And, what was the micro-impact that the “trilemma” models did not pick up?  It was the declines that occurred in labor productivity that made many nations uncompetitive in world product markets. 

Here we see Greece…and Spain…and Ireland…and Portugal…and Italy…and, others...

And, corporate interests in the United States…and elsewhere…have lots of cash available…either on their balance sheets…or through financial markets that have been generously supplied by the Federal Reserve.

“At Kohlberg Kravis (Roberts), Nathaniel M. Zilkha, co-head of the special situations group, is expanding his London team to eight, from two, and hoping to take advantage of opportunities in Europe.  The firm is even considering potential investments in the country where the crisis began, Greece, despite headlines warning of a default by Athens or the possibility that Greece may withdraw from the eurozone…

Besides Greece, Kohlberg Kravis bankers have also been looking for deals in Spain and Portugal, where private companies are having a similarly hard time winning new credit or extending existing loans.”

As we see over and over again, the excessively loose monetary policy of the Federal Reserve is not helping the “working people”, those 20- to 25-percent of the labor market that are under-employed.  The Fed’s largesse is going to those that can use the money to “do the deal”.  Now, it seems that the flow of funds is going into the acquisition of assets formerly owned by Europeans.  Earlier, we saw Fed injections creating bubbles in commodity prices and in the stocks of emerging markets.   Even earlier than that, we saw Fed injections creating bubbles in the U. S. housing market and in U. S. stocks. 

The macroeconomic models are becoming less and less useful because the world works at a more micro-economic level.  It is at this micro-economic level that we can really observe the complexity of human behavior and also see how markets can self-organize and emerge to take on a life of their own.  Until governments become more sophisticated in their analysis of economic problems, they will continue to create opportunities that the wealthy and the better connected can take advantage of.  And, a Fed guarantee that short-term interest rates will remain at levels that are close to zero only exacerbates the situation.      

An Economic View from the Supply Side

As I have written before, the United States economy is recovering.  It may not be recovering as fast as some would like, but economic growth is positive.  Economic growth is not as rapid as some would like because there is still a massive debt overhang that must be eliminated, one way or another.

Furthermore, unemployment and under-employment are not dropping as fast as some would like.  The labor market is not improving with any speed because the economic policies of the last fifty years has resulted in a large amount of the United States manufacturing capacity being unused.  As physical capital is unused so is human capital.

Both of these situations took a long time to get to their present state and will take a long time to regain higher levels of economic growth, capacity utilization, and employment. 

The background for this situation can be examined from the following chart.

  This chart contains a graph of real Gross Domestic Product beginning in 1960 and ending in 2010.  I start with the year 1960 because that is the year before the United States government, both Democratic and Republican, introduced a “new” economic philosophy into its policy considerations, one that emphasized the inflation of credit throughout the economy. 

To me, the important thing about this chart is that real GDP is almost continuously rising.  Yes, there is a sizeable bump at the far right-hand side of the chart, and this is associated with the Great Recession, an apt title.  Otherwise, there are other little deviations from the upward trend, but these are relatively minor movements along the way.

This is where I take my stand with the economic growth proponents.  In the United States economy, growth is almost always positive.  The annual compound rate of growth for the period covered in the chart is 3.1 percent.  The annual compound growth rate of the United States economy, ending the calculation in 2007 (the Great Recession began in December 2007) the rate of growth rises to something around 3.25 percent.  But, growth is dependent upon the private sector, not directly on the government.    

I define credit inflation as a period in which the rate of growth of debt in the economy exceeds the rate of growth of the economy.  Over the past fifty years, the debt of the United States government has increased by more that a 7.0 percent annual compound rate of growth.  The debt of the private economy has risen in the range of 11.0 to 12.0 percent every year.  This meets my definition of credit inflation because these growth rates are far in excess of the rate of growth of the economy. During this period, the purchasing power of the dollar declined by about 85 percent.  In other words, a 1960s dollar could only buy 15 cents worth of goods and services today versus a dollar’s worth in 1960.

Side note on credit bubbles: when the annual compound rate of growth of the debt being created in a subsector of the economy exceeds the annual compound rate of growth of the economic growth of the subsector, a credit bubble can be said to exist.  The housing market bubble of the early 2000s fits this definition.

Credit inflation can have a detrimental impact on economic growth.  Credit inflation creates incentives that cause manufacturers to move away from the producing of goods and to move into the creation of finance.  Two examples of this are GE and GM: for example a couple of years ago GE was earning more than two-thirds of its profits from its finance wing.  In terms of the whole economy, there has been a huge swing over the past fifty years from the manufacturing sectors of the economy to the financial services sector of the economy.

Some of the consequences of this re-allocation of capital is that the employment of capital declined: capacity utilization is around 77 percent now relative to more than 90 percent in the 1960s.  Under-employment is over 20 percent now and was under 10 percent in the 1960s.  And, the income/wealth distribution is more skewed toward the wealthy than it was 50 years ago.

This has impacted economic growth.  For example, the annual compound rate of growth of real GDP has only been 2.5 percent over the past twenty years, down substantially from the rate of growth for the whole period.  Credit inflation, as an economic policy of the government, seems to have exactly the opposite impact on the economy that is desired by policy makers.

But the other important thing to notice in the chart is the “bumps in the road”.  In my opinion, all of these “bumps” resulted in some way from dislocations in the growth of credit instruments as a result of the monetary or fiscal policies of the United States government.  In most cases, the dislocations were relatively minor. However, as the debt load expanded and the private sector devoted more and more resources to financial services, the ability to carry the load grew greater and greater.

The debt burden cannot keep growing: it has to collapse sometime and along with it the economy.  In most cases the “bumps” were relatively minor.  I know it is never fun for anybody to be un-employed or under-employed, but in the aggregate sense, the “bumps” were not large. 

During the Great Recession and following, the “bumps” were much larger because the build-up of the debt dislocations were greater than ever.  However, since the debt burden must be worked off, it will take more time for the economy to achieve the longer run rates of growth that were achieved earlier in this fifty years of economy prosperity.  But, it will come. 

We must be aware of these dislocations and the things that must be done to re-structure the economy and get back to the economic growth performance we are looking for.  For example, we cannot ignore the state of the banking industry in this recovery. (See my post from last Friday: http://seekingalpha.com/article/295630-why-banks-aren-t-lending.)  Resolving the “bumps” just means that the previously created dislocations in finance and economics must be resolved.    

The Case Against the Obama Taxes

Yesterday, President Obama proposed a tax plan.  George Shultz has replied: “rich people and large companies like General Electric Co. are the beneficiaries of a complicated tax system.”

“It’s wealthy people and the GEs of the world that know how to manipulate these preferences and get their tax rates down,” said George Shultz, an economist and former dean of the University of Chicago’s business school. “The average Joe doesn’t have access to those lawyers.”

George Shultz, also former United States Secretary of the Treasury and Secretary of State, made this statement in an interview with Bloomberg press when arguing for a complete change in the tax code to reflect the realities of the 2010s. (http://www.bloomberg.com/news/2011-09-20/shultz-says-it-s-time-to-clean-house-with-u-s-tax-code-to-boost-economy.html)

One could also say the same thing when referring to the ability of “wealthy people and the GEs of the world” to handle the inflationary environment created by governments that are aiming to sustain “high levels of employment” as designated by the full employment objectives of the United States and many other western nations. 

The wealthy and the large corporations can protect themselves or even benefit from inflation.  The “average Joe” cannot do this.  In fact, the “average Joe” ultimately “gets screwed” from inflationary policies aimed at keeping him employed.  Having under-employment rates in the 20 percent plus range is not what was planned as policies of credit inflation dominated the past 50 years. 

Furthermore, credit inflation creates a wonderful stage for financial innovation, shifting jobs from manufacturing and production to financial services and other support industries…like the legal profession.  We can only look at the shift in jobs in the United States over the past fifty years to see the consequences of this development.

The financial innovation of the last fifty years points to another change in the world that not only allowed the financial innovation to take place but provides insight into the world of the future.  The change I am writing about is the advent of the Age of Information.  Financial innovation thrived upon the new technology and the new technology was underwritten by the growth of the financial innovation. 

“Wealthy people and the GEs of the world” (along with the JPMorgan’s, Goldman-Sachs, and others) are able to use this technology “to manipulate” things so as to benefit themselves as much as possible.  They have the tools.  Why did GE come to earn two-thirds of its profits from its finance wing?  And, the same can be said for General Motors and many other “manufacturing” companies. 

And, people are concerned about the fact that over the past fifty years the income/wealth distribution of the United States became so skewed toward the rich.  The credit inflation and social policies of the past fifty years created the conditions for those that could “manipulate” things and get their tax rates down and profit from the inflationary environment that was created by the politicians. 

The “average Joe”? 

The “average Joe” could do little or nothing.  If he “stayed employed”, kept the job at which he was already working, he fell behind.  The “average Joe” needed to become educated, needed to become more technologically savvy, needed to find the “lawyers” and financial advisors to “manipulate” the system.  But, that was not the way the incentives were aligned!

Unfortunately, the objective of the politician does not mesh with that of “the average Joe.”  The objective of the politician is to get elected and then to get re-elected.  Consequently, laws and regulations aimed at keeping “Joe” fully employed in his current job have been crucial.  Empathy with “Joe” was good politics.  The fact that “Joe” was constantly falling behind was not the issue.

The world has changed.  Yet, we can’t seem to get away from the same election strategies that have been followed over the past fifty years.  In my mind, we are going through a cultural shift that is painful and disturbing.  It is a shift that is going to take place, one way or another, and just pursuing the same goals over and over will only exacerbate the pain and the disturbance over time.  And, the constant advancements of information technology will just add to this.  

Shultz is arguing that the “Tax Reform Act of 1986” needs to be revised and reformed, not extended and made more complex.  He argues that “a simplification of the code would allow Congress to lower rates on a ‘revenue-neutral’ basis, while economic expansion would boost tax receipts.

“You’ll get a gusher,” Shultz said. “If you get this kind of stimulative tax policy and other things into effect, there will be a response and revenue will come in.”

 It seems as if “wealthy people and the GEs of the world” will play ball with you when they feel that they are not being singled out and picked on.  Otherwise, out will come the lawyers and the financial advisors and we get results similar to the ones described above.  The problem is that in proposing these changes in the tax codes as Obama has done or creating an environment of inflation, things just don’t stay the same. 

The politician is subject to the same fallacy that is faced by the economist conducting his deductive reasoning.  It is the problem of “ceteris paribus”, the assumption that “all else stays the same.”   When you change the tax code or the inflationary environment, all else does not remain the same.  As a result, you often find yourself facing the problem of “unintended consequences.”  You get results that you didn’t intend to get.  In the case of the economic policy over the past fifty years, you get higher levels of employment and under-employment than you wanted and greater inequality in the distribution of income/wealth. 

The current Obama tax plan is a journey into the past.

Does Getting Out of Debt Mean that People Should Start Spending More?

From the Wall Street Journal this morning:

“U.S. families—by defaulting on their loans and scrimping on expenses—shouldered a smaller debt burden in 2010 than at any point in the previous six years, putting them in position to start spending more.

Total U.S. household debt, including mortgages and credit cards, fell for the second straight year in 2010 to $13.4 trillion, the Federal Reserve reported Thursday. That came to 116% of disposable income, down from a peak debt burden of 130% in 2007, and the lowest level since the fourth quarter of 2004.” (See “Families Slice Debt to Lowest in 6 Years,” http://professional.wsj.com/article/SB10001424052748704823004576192602754071800.html?mod=WSJPRO_hps_LEFTWhatsNews.)

The logic in this is that people reduce debt so that they can spend more. I think that is called a “non sequitur”.

If people (and businesses) get more and more in debt over a fifty year period (as they have since 1960) and this contributes to the worst recession since the Great Depression the objective of these people (and businesses) getting out of debt is so that they can get more in debt once again?

I thought that if people (and businesses) got themselves so leveraged up and so “over-extended” that they found themselves in serious financial trouble and were faced with foreclosure on their real estate and personal (or business) bankruptcy that what they would try and do is bring their debt more in line with their incomes so that they could manage their debt.

I thought that maybe people (and businesses) would become more prudent and try and manage their debt in a way that would allow them more “peace of mind” not having to scramble to make principal or interest payments every month.

And we read that there are 11 million people who find themselves owing more on their mortgages than their home is worth on the market.

And we read that about one out of every four individuals of working age is under-employed.

And, we read that the income distribution is skewed toward the high income end worse than it has ever been in the history of the United States.

And, we read that America is bifurcating more and more based on education and race.

And, we read that many state and local governments can’t meet their pension commitments and can’t balance their budgets so that they are cutting jobs, cutting pensions, and cutting education.

Some people are spending. Some people are using credit again. Some people are buying very nice homes. Some people are paying for very expensive educations.

But, this spending and credit extension is not across the board.

The inflation over the past fifty years created the ideal environment for debt creation. The inflation was not large enough to create a panic. From time-to-time, the inflation was not enough to really see.

Yet, from 1960 to the present time, the purchasing power of the dollar has fallen by 85%. The dollar that could buy a dollar’s worth of goods in 1960 can only buy about fifteen cents worth of goods now.

This was the perfect scenario for the creation of credit, for financial innovation, and for the growth of the finance industry.

This could not have been a better environment for the consumer culture to thrive where people could feed their insatiable appetites for goods and think that things were great.

And, now a substantial part of our economy is mired in this debt and struggling hard to get their heads above water. They don’t need to pile on more debt…they need some stability and consistency to their lives.

Yet, many are pushing to get the “credit machine” going again. The federal government is setting the standard (as it has over the past fifty years) by living way beyond its means and threatening to increase its debt by $15 trillion or more over the next ten years.

The Federal Reserve has pumped almost $1.4 trillion in excess reserves into the banking system in order to get the banks’ lending again.

We want families to be “in position to start spending more” as the Wall Street Journal article stated.

A credit inflation is just what is needed.

Each time we restart the “credit inflation” button again, more and more people seem to be in a position in which they are excluded from its benefits. They are under-employed, substantially in debt, and excluded from benefitting from further increases in prices.

This means each time the “credit inflation” button is pushed again, only a smaller proportion of the population can participate in subsequent expansion.

Maybe this is why it is taking us so long to get the economy “moving again.”

History has shown that this “show” cannot go on forever. The difficulty is in knowing just when the “show” is over.

The government is trying to start the music playing again. And, those that can are supposed to begin dancing. But, maybe this time only the financial industry will be dancing (http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone).

Why Debt Is Going To Continue To Be A Problem In The United States

Officials at the Federal Reserve and in many other leadership positions around the world believe that liquidity is the solution to our current woes. And, if the amount of liquidity that is in the anking and financial markets is not enough to resolve our problems then more liquidity is certainly the answer.

This is behind QE2, and this is behind most of the effort to resolve the sovereign debt crisis in Europe.

What does liquidity allow you to do? It allows you to sell assets into the marketplace.

However, selling assets into the marketplace does not solve your problems if the price at which you sell the assets is substantially below the accounting value of the assets on your balance sheet. In such cases, having liquid markets in which to sell assets may allow you to more than wipe out your equity and leave you unable to pay off your debts.

There are two ways to counter this problem. The first is to inflate prices so that the real value of the debt declines which reduces the amount of leverage you have on your books. The second is to create income and wealth so that equity increases relative to the debt outstanding thereby reducing leverage.

The people advocating the injection of more liquidity into the financial system hope to spur bank lending and thereby stimulate economic growth. Those that are concerned with the creation of more and more liquidity argue that this first group of people really just want to create inflation and reduce the real value of the debt.

The problem I see unfolding is that the economy is expanding and will continue to expand in 2011, but it will not expand in such a way as to stimulate sufficient income growth and wealth creation so as to lower the debt loan many people are bearing. As a consequence, the further liquefying of the banking and financial markets will just benefit those who are not too highly leveraged…generally the financially better off in society…and continue to depress those who are highly leveraged.

In terms of economic growth, the economy is expanding. However, by historical standards, the year-over-year rate of growth of real Gross Domestic Product is substantially below the general recovery pattern. In the year-over-year rates of growth in 2010 were 2.4%, 3.0%, and 3.4% in the first, second and third quarters, respectively. Historically, at this stage of the recovery, the growth rates are usually much greater.

The problems come when we observe some very basic facts with respect to economic performance. First, although Industrial Production has recovered from the lows reached during the recession it has not come close to reaching the peak it attained before the recession set in. Second, the capacity utilization of our manufacturing has recovered, yet it still lies well below its previous peak (which is the lowest peak achieved since the statistical series was begun in the 1960s). Finally, even though unemployment dropped last month, under-employment continues to be extremely high as I estimate that one out of every four or one out of every five individuals of employment age are either unemployed, working part time but would like to work full time, or have dropped out of the work force. This phenomena is captured in the data on the Civilian Participation rate. Note, that this rate is substantially below the level it was before the Great Recession began in December 2007 and is also even further below the level reached before the 2001 recession. Under-employment in the United States has been growing, almost steadily, since the latter part of the 1960s.

Even though corporate profits are rising dramatically, even though many large corporations are acquiring other corporations at a very rapid pace, even though commodity prices are going through the ceiling, even though the big banks are doing very well, thank you, there seems to be a real structural problem in the United States. Liquidity is helping a lot of people but it is not the people we are talking about in this

Questions for a Monday Morning

Beginning in 1961 with the inauguration of President John F. Kennedy, the United States government has basically operated from a “Keynesian” economic philosophy. The economists that Kennedy brought into his administration were avowedly Keynesian and the Kennedy tax cuts that followed were developed from a Keynesian model.

This has been a bi-partisan effort and Republicans are as guilty as anyone in terms of the emphasis upon stimulative government budgets. President Richard M. Nixon confessed in the early 1970s that “we are all Keynesians, now!”

Government economic policy was written into legislation beginning with the The Employment Act, Act of Feb. 20, 1946 which was followed by the Humphrey-Hawkins Employment Act, the Full Employment and Balanced Growth Act, enacted in October 1978. Congress enacted laws that required the government to produce economic growth policies that were aimed at high levels of employment.

A growing economy and high levels of employment became a necessary goal of any presidential candidate running for election (“Get the economy growing again,” and “It’s the economy, stupid!”) or for re-election.

And, what was the result?

Since 1960 through 2009 the United States economy has grown at an average annual compound rate of growth of around 3.2%. Economists in the 1960s calculated that full-employment growth in the economy was about 3.2% and so economic policy was targeting a potential for growth in the United States economy of 3.2%.

If, after 50 years, these economists were to look back they might be astounded that the economy grew roughly at what they presumed to be the rate at which the economy could potentially grow during that time period.

Yet, not all is well with the world.

These economists could argue that fiscal policy really worked. The gross federal debt grew at an average annual rate of more than 9% during this 50 year period. Fiscal policy must have worked?

Financial innovation in the United States government was astounding during this period. As Niall Ferguson has claimed in several of his history books that governments have always been the number one innovator in finance historically. The United States government certainly proved this to be true over the last 50 years.

Certainly, credit inflation was the name of the game during this time period as the private sector came to emulate the government sector in terms of creating financial innovation and financial leverage became the necessary means of competition for firms to gain an edge in financial performance.

On the way to the bank, however, certain other things happened…and these raise some serious questions.

During all of this time period, in the United States industrial sector, capacity utilization went from over 90% of capacity to about 75% of capacity. If growth was proceeding at 3.2% a year, how come our industrial base has been used less and less over this period?
Also, the big concern in terms of unemployment was that we reach and sustain a 4% unemployment rate. Yet the unemployment rate has progressively increased and the under-employment rate, hardly different from the unemployment rate in the 1960s, is now above 20%. Why hasn’t the economic stimulus put more people to work?

Housing, which used to be the backbone of the private sector is now primarily the realm of the federal government. Who owns most of the mortgages in the country?

In the 1960s there were over 14,000 commercial banks in the United States. Now, there are less than 8,000 and, in my view, we are going to 4,000 in the next several years.

We had a vibrant sector of thrift institutions in the 1960s. By the end of the 1980s the thrift industry was almost gone. By the end of 2011, the thrift industry will be gone. This was the result of sound fiscal policies?

Income inequality has risen dramatically over the last 50 years. We have found out that the wealthy or the financially savvy can protect themselves during times of inflation and credit inflation. The blue collar worker, the less financially sophisticated, the middle class cannot protect themselves nearly as well during times when hedging or speculation becomes the way to financial wealth. Weren’t the Keynesian policies supposed to help the less well off by keeping them employed?

The “piggy bank” that the middle class and finally the less-well-off were supposed to exploit and protect themselves against inflation and lead them into a better financial future eventually busted. Housing was the “piggy bank” that many were supposed to ride to retirement leisure. But, falling house prices and foreclosures are turning the dream of many into nightmares? Couldn’t credit inflation keep this ball in the air?

There are many other question going around right now. The concern is the validity of the economic model that has been the foundation of our economic policies over the past 50 years. It appears as if we got the economic growth. What happened to all the other benefits we were supposed to receive once we achieved this economic growth?

Where Economic Success is Going to Come From

One piece of economic information that I have focused on over the past 18 months has been the Federal Reserve’s figures on capacity utilization of the industrial sector of the United States.

The story that can be read from this information is that capacity utilization in the United States has fallen from the middle of the 1960s to the present time. In 1967 when the data series was started, capacity utilization was about 90%. Over the past fifty years, every cyclical peak of capacity utilization has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85% while in the middle 2000s the peak dropped to 82%.

Currently, although capacity utilization has risen above its recent cyclical trough of about 68%, it is still languishing around 74%. One should note that as cyclical peaks during this period have been at lower and lower values, cyclical bottoms have also been at lower and lower values.

The conclusion one can draw from this is that United States industry does not seem to be “tooled-up” for the right output.

If the United States is going through a major secular restructuring both economically and financially, as some of us believe that it is, then United States industry will be restructured so as to shed some of this excess capacity.

There are many indications that such restructuring is taking place and will continue to take place over the next few years. This, of course, will mean that the economy will not recover real quickly which will mean that it will take just that much longer to resolve the “under-employment” problem.

The evidence of this restructuring can be observed in places like the front page article in the New York Times, “Industries Find Surging Profits in Deeper Cuts”: See http://www.nytimes.com/2010/07/26/business/economy/26earnings.html?_r=1&hp. The gist of the article is that companies are producing very good profits, not through revenue growth, but through the reductions in their cost structure, predominately through cuts in labor costs.

Of course, the real “economies of scale” in this effort are found in the larger companies. Smaller companies can reduce labor costs but they don’t have anywhere near the impact that large companies achieve when they go through a major restructuring.

Rod Lache, of Deutsche Bank: “These companies cracked the code of a successful turnaround. They’re shrinking the business to a size that’s defendable and growing off a lower base.”

Over the past fifty years industry did not downsize in this way because success seemed to come from “hoarding” labor and getting the company positioned for the next surge in sales revenue. This attitude was re-enforced by the federal government that underwrote the “nest surge” in consumer spending through fiscal stimulus programs created through deficit spending and the expansion of the money stock.

The “artificial” underwriting of economic growth by federal government largesse can only go so far. Throughout this period, the question that always lurked in the background concerned the burden of the debt being created, both private and public debt, and the economic mismatch that was being created between where the country should be technologically and where it was both in terms of physical and human capital. The growth in labor under-employment and the decline in capacity utilization over this time pointed to the fact that at some time an economic and financial restructuring would have to take place.

And how are these companies that are doing so well using their profits? They are building up their cash reserves. Jamie Dimon at JPMorgan Chase has indicated that it is not time to pay these profits out in dividends. There are just too many uncertainties present in today’s economy…and there are just too many other possible ways to use the funds in the future. Many other CEOs agree with this assessment.

The New York Times article contains a chart that shows the relationship between “Corporate Cash as a Share of Corporate Assets.” The most recent data show this relationship to be 6.1%. Guess what? One has to go back to the middle of the 1960s to find this figure at such a high level. Through most of the last fifty years the share of cash ran between 3% and 5%. This shift is huge and is taking place primarily in the larger, better positioned companies.

This same thing is happening in the commercial banking arena. The larger, more successful banks are piling up cash reserves. The smaller banks are not the ones with the profits or with the cash resources.

What does all this mean?

It means that the next few years will see a massive restructuring of industry, in manufacturing, financial services, and in other services. Reconsolidation will be in vogue, not expansion. The cash will be used for mergers and acquisitions, for rationalization of industry, for capacity reduction, and for control.

The one caution about this is that these companies cannot get too far ahead of the financial markets for investors will punish those that seem to be “jumping-the-gun”. In the Wall Street Journal we observe the warning, “Markets Say No to Expansionist Companies”: See http://professional.wsj.com/article/SB10001424052748704719104575389172070900184.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj. The economy, in the near term, does not look strong. Profit performance is not seen as coming from increasing revenues, but from continued cost containment or cost reduction. Companies that appear to be moving too quickly in this environment are getting hurt by investors that believe cash should be conserved for use on another day at a different time.

Financial markets seem to want prudence now and not outright aggressive behavior.

Yet, people are getting prepared for the time when action is called for. But, the action will not be toward expansion, but toward containment. In the Financial Times we read of the return of “merger arbitrage funds”: See http://www.ft.com/cms/s/0/d74a2fa6-980c-11df-b218-00144feab49a.html. These funds attempt to profit from the spread between the price of a merger target after a deal is announced and the closing price at the completion of the deal. The funds “smell” something in the wind and they want to be ready when the time is right.

Gerard Griffin of GLG Partners’ event-driven team is quoted as saying: “Companies have built up large cash balances and the economy is not looking particularly strong, so earning growth will have to come through synergies.”

That is, consolidation will have to take place within industries reducing industry capacity and thereby increasing capacity utilization. For the time being, however, this rationalization of industry will reduce the number of jobs that are available and will also result in changing the nature of who is employed in these more technologically advanced and productive firms.

The evidence is growing that a massive restructuring of industry is taking place. This restructuring will not speed up either economic growth or the reduction of unemployment or under-employment in the near term, only over the longer term. But, the types of things managements and companies are doing are similar to what has happened at other times. However, these restructuring events are captured in the economic writings of Joseph Schumpeter, and not in the economic writings of John Maynard Keynes.

The Long-Term Jobless in the Current Economic Malaise

I have been concerned for some time about the changing nature of the United States economy and the structure of the United States labor market. There seems to be a tremendous mis-match between the two and this portends an unhappy near term for economic growth and employment.

An article in the Monday New York Times by Peter Goodman, “After Job Training, Still Scrambling for a Job” captures the whole dilemma (http://www.nytimes.com/2010/07/19/business/19training.html?_r=1&scp=2&sq=peter%20goodman&st=cse). In this article, Mr. Goodman presents a well-developed argument that even after job training, many people in today’s economy cannot find jobs. One of the individuals Mr. Goodman interviewed stated in extreme frustration, “Training was fruitless. I’m not seeing the benefits. Training for what? No one’s hiring.”

Yet, Mr. Goodman argues that some industries are hiring. Some experts point out that “even with near double-digit unemployment, some jobs lie vacant, awaiting workers with adequate skills.”

“’There’s plenty of jobs in health care, in technology,’ said Fred Dedrick, executive director of the National Fund for Workforce Solutions.

Some of the aggregate figures point up this mis-match between labor and industry. First, the capacity utilization figures tell a dismal tale. Since the 1960s, capacity utilization in the United States has fallen. Every cyclical peak of capacity utilization over the past fifty years has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85%; in the middle 2000s, the peak was around 82%; and currently it is languishing around 74%. United States industry does not seem to be “tooled-up” for the right output.

Second, the under-employment of the working-age labor force has grown constantly over the past thirty years or so. The “measured” rate of unemployment indicates that about one out of every ten workers is currently unemployed. My estimate for the under-employed is that about one out of every four workers is under-employed in today’s economy.

How did we get this way?

I believe that the economic policies of the United States government helped to create this employment situation!

The reason I give for this conclusion is that every time economic growth started to slow over the past fifty years, the federal government stepped in to stimulate the economy and put people back into the jobs they had just lost. This was the Keynesian approach to the problem of unemployment.

This approach to stimulating the economy worked well in the short-run but in the longer-run failed to take account of shifting technologies and the job skills of the work force. This mis-match did not show up so much in the short-run because, especially in the earlier years, technology was not changing rapidly. However, as the last fifty years moved along changes in technology occurred at a faster and faster pace. The dislocation between the new technology and the “legacy” industrial capacity in place grew, as did the chasm between many in the labor force and the skills needed to handle the new technology in the new industries being created.

This is an unusual happening for it is nothing more than the working out of Joseph Schumpeter’s concept of “Creative Destruction”.

Applying Keynesian fiscal stimulus to this problem over and over again just exacerbated the situation. Why? Because people were either put back into “legacy” jobs or were given minor training and shoved back into the job market. Goodman writes, “Most job training is financed through the federal Workforce Investment Act, which was written in 1998—a time when hiring was extraordinarily robust. Then simply teaching jobless people how to use computers and write résumés put them on a path to paychecks.”

Goodman quotes Labor economist Carl E. Van Horn: “A lot of the training programs that we have in this country were designed for a kind of quick turnaround economy, as opposed to the entrenched structural challenges of today.”

The conclusion to this story is that over time the continued application of these Keynesian stimulus efforts causes a loss in impact. Each cycle this policy prescription seems to be less and less effective as the cumulative effect on industrial capacity and human capital grows. Capacity utilization declines and more and more workers become under-employed.

Given this conclusion, one can ask whether or not there comes a time when the fiscal stimulus program becomes almost totally ineffective? Have we reached a point where the cost/benefit tradeoff of more fiscal stimulus becomes almost all cost and very little benefit?

This, however, is not the only point that needs to be mentioned at this time. Most of the advocates of Keynesian fiscal stimulus policies are very concerned about the growth in income and wealth inequality over the past thirty years or so. The continued application of Keynesian-type fiscal stimulus packages during the past fifty years, I believe, has contributed substantially to the greater inequality in income and wealth that has occurred in the United States.

There are three primary reasons for this growth in inequality. First, the fiscal stimulus programs put people back to work in the jobs that they formerly held. The largest number of the short-term unemployed came from large firms so that the stimulus had to encourage the growth of these companies so that the workers that were laid off could be re-hired. The fiscal stimulus packages “subsidized” the growth and wealth of the big, already implanted companies. Thus, the salaries and employment packages in these areas could continue to grow over time even as the capacity utilization in these industries continued to fall.

Second, as more and more people in these industries became under-employed, their incomes dropped relative to other sectors of the economy and their future prospects also fell. This, however, did not keep these people from piling up debts to buy cars and houses and other consumer items. These people felt confident that over time, they would continue to generate income, even if it might be somewhat sporadic. Furthermore, the inflationary environment of the past fifty years made it sensible for these people to go into debt for the inflation depreciated the value of their debt over time.

Third, the wealthier segment of the economy took advantage of the continued fiscal stimulus of the past fifty years (gross federal debt rose at a compound rate of seven percent every year) and the fact that, on average, inflation rose at a compound rate of more than four percent per year over this time period. Wealthier people have always been able to position themselves better than the less-wealthy, especially when macro-trends become as predictable as the economic policy proscriptions of the United States government, whether Republican or Democrat.

Furthermore, wealthier people have always been able to find their way into the professions that provide, over time, the greatest opportunities to earn income and create wealth. Certainly these professions would include medicine and health, legal, finance, and management some of the biggest gainers over the past fifty years.

Given these factors, how long will it take for the United States economy to re-structure itself? In the 1930s it took a long time. Will it take that long this time around?

Jobs and Skills: the Current Mismatch

For at least 18 months, I have been arguing that the United States economy is going through a transition period that is more than just a cyclical slowdown and recovery. My argument has been that the economy is going through a period of restructuring that will take an extended amount of time to work out all the changes that are necessary.

As a consequence, “blunt-edge” efforts to stimulate jobs by means of the fiscal policy of the federal government will not achieve a great deal of success.

The reason for this in many cases is that the fiscal stimulus of the past 50 years has caused companies to keep aging physical capital in use and has resulted in these companies hiring people to perform jobs related to “legacy” technology.

The evidence I have provided for this is the increasing amount of unused capacity in the manufacturing realm and the growth in the number of employable Americans that are under-employed. To be under-employed, one is either unemployed, not fully employed and looking for full-time work, or discouraged and not seeking a job.

I have argued that this is not unlike the 1930s when the United States economy was going through a transition period in which jobs and employment were shifting from rural and agricultural areas to cities and industrial areas. The restructuring that took place accelerated during World War II and did not really calm down until the 1950s and 1960s.

Two reports came out toward the end of last week that support my claim of an economy that is in the process of restructuring. The first was an article by Motoko Rich that appeared in the New York Times on Friday July 2, with the title “Jobs Go Begging as Gap is Exposed in Worker Skills.” (http://www.nytimes.com/2010/07/02/business/economy/02manufacturing.html?_r=1&scp=2&sq=motoko%20rich&st=cse) Rich writes that “Plenty of people are applying for the jobs. The problem, the companies say, is a mismatch between the kind of skilled workers needed and the ranks of the unemployed.” The subheading to the article reads that “Shifts in Manufacturing are Leaving Many as Unemployable.”

The second report came from the Labor Department on Friday, July 3. Although the unemployment rate declined in May to 9.5 % from 9.7% in April, this was because the labor force shrank as more people left the labor force than were added to payrolls: the labor force shrunk by 0.3% while the number of individuals employed dropped by only 0.2% (due to the loss in jobs connected with the collection of Census data).

The official statistics report that the “underemployment” rate has been in the 17% range for the past year or so. I estimate that, currently, about one out of every four or five individuals that are in the employable age group are under-employed. The reason is that there is a tremendous mis-match between what employers need to be competitive in the future and the pool of skills and experience that are available in the labor market. Products are being made differently now than they were several years ago and this trend will continue. The current downturn has provided additional justification for manufacturers to make the changes that they need to make.

Why do they need this added justification?

Well, over the past 50 years, every time there was a recession (and even in periods when there was not a recession), the federal government provided fiscal stimulus to get people “back-to-work.” Back-to-work, however, meant putting people back into jobs that they were in before the workers were laid off. This is what the government wanted to happen.

However, putting people back to work in “legacy” jobs did not contribute to modernization and improved productivity. It did increase employment and reduce unemployment which is what the federal government wanted to achieve.

Now, businesses can use the excuse of the extreme downturn in the economy to justify the changes in who is hired to meet the reality of changes in training, skill levels, and experience that have occurred. And, this transition will not be completed overnight.

We see the same thing in the use of physical capital in the United States. Since the 1960s, the capacity utilization of manufacturers has declined steadily. As with the increase in the underemployed, the employment of the physical capital in the United States has fallen over time.

In January 1965, American manufacturers were working at 89.4% of capacity. The next peak in manufacturing usage (capacity utilization is very cyclical) came in February 1973 at 88.8% of capacity. The following peaks were: December 1978 at 86.6% of capacity; January 1989 at 85.2% of capacity; December 1997 at 84.7% of capacity; and April 2007 at 81.7% of capacity.

Note that the troughs of the cycles in capacity utilization also fell since the 1960s. In December 1982, manufacturers in the United States worked at 70.9% of capacity and in June 2009, they worked at 68.2%. Currently, manufacturers are working at 74.1% of capacity.

In essence, businesses in the United States have been utilizing less and less human and physical capital over the past 50 years relative to the amounts of these productive factors that have been available. And, the policy makers just don’t seem to get it.

From Rich, in the article cited above, “Christina D. Romer, chairwoman of the Council of Economic Advisers, said the skills shortages reported by employers stem largely from a long-term structural shift in manufacturing, which should not be confused with the recent downturn. ‘I do think that manufacturing can come back to what it was before the recession,’ she said.” So, manufacturing will return to the new, lower level of capacity utilization that was achieved at its previous peak level, roughly 82% of capacity. And, this is good?

My guess is that capacity utilization will hit, maybe, 80% at the next peak. We are still talking about 20% of the manufacturing capital of the United States being underemployed, right in line with the 20% to 25% of employable labor in the United States being underemployed.

The fiscal stimulus proposed by “fundamentalist” Keynesian economists will not do the job. Additional, “blunt-edge” governmental expenditures may alleviate some of the current worker distress, but at the cost of postponing the adjustments that need to be made to restructure the economy, the restructuring that is now going on.

The problem with the “fundamentalist” Keynesian view is that it is constructed from a short term perspective. The basic attitude is that which is attributed to Keynes: “In the long run we are all dead.” This approach leads to a focus on only “current” problems. What is not explicitly stated is that we will deal with the longer-term problems when they become current problems.

The difficulty with this: the longer-term problems may require a different “medicine” than did the short-run problems.

Well, one could argue that the longer-term problems have become current. The short-term solution of forcing many companies to continue to employ people in “legacy” jobs and to continue to use “legacy” plant and equipment has resulted in higher and higher rates of worker under-employment and lower and lower rates of manufacturing capacity utilization.

Just more of the same does not seem to be an adequate answer.