Progress of the secular bear market: position as of September 30, 2013
The value for R was 1895 on September 30, 2013.
Stimulus vs. Austerity: A Tale of the Long Wave
I had wanted to write on the issue of stimulus and austerity considering all the recessions of the post-1900 period but the data was too mixed to allow any conclusions to be drawn. It seemed to me that a lesson can be drawn of one looks at just a handful of recessions that are of special significance from the Kondratiev view point. The Kondratiev cycle is an economic cycle that can be characterized in terms of cyclical fluctuations in interest rates, stock market valuation, and prices (commodity prices before 1933 and reduced price after). It falls into two waves, the upwave and downwave.
An upwave begins with a trough in the interest rate and (reduced) price cycles and ends at a peak in the same. Dates for the peak and trough are close to troughs in the Stock Cycle. Given these tools the two most recent upwaves have been 1896-1920 and 1946-1981. The downwave then begins at cyclical peaks in interest rates and (reduced) price and ends at troughs in the same. The two most recent downwaves have been 1920-1946 and 1981-present.
This article is concerned with the downwave, which begins with what I will call the primary recession. The two most recent primary recessions have been 1920-21 and 1981-82, which immediately followed Kondratiev peaks in 1920 and 1981. Partway through the downwave there is another recession which I will call the secondary depression. This recession is defined by being co-incident with a feature I call the "fall from plateau". This feature appears in a plot of reduced price as a sharp drop from a lengthy period during which it had been at a roughly constant level. Figure 1 in my May 2010 article clearly shows that the two most recent fall from plateau events have occurred over 1929-32 and 2008-9. -Associated with these events are recessions in 1929-33 and 2007-9. These are the secondary depressions.
In between the primary and secondary depressions is the plateau period, which often contains more than one ordinary business cycle, meaning at least one recession that is not a primary recession or secondary depressions occurs between these downturns. The most recent plateau over 1987-2008 fell into three business cycles and contained two recessions (1990-1, 2001) that are neither a primary recession nor a secondary depression. The prior plateau over 1921-9 also fell into three business cycles and contained two recessions (1923-4, 1926-7) which were neither a primary recession nor a secondary depressions.
Thus, the primary recession and secondary depression are "special" in ways that other recessions are not. This specialness is defined and characterized in terms of the Kondratiev cycle. An economist who denied that the Kondratiev cycle exists might not see anything special about these recessions. With the exception of the 1937-38 recession during the Great Depression (which was a direct consequence of incomplete recovery from the 1929-33 secondary depression) the highest unemployment rates seen since 1900 have occurred during the two primary recessions and two secondary depressions. That is, not only are these recessions "special" in terms of the Kondratiev cycle, they are also special in terms of severity. And through their severity they have had an impact on views about economic policymaking and on politics. For example, all four of these recessions have been associated with elections in which political power shifted from one party to another. The 1920 and 1980 elections, which occurred just before primary recessions saw a shift from Democratic to Republican rule. Similarly the 1932 and 2008 elections featured a shift from Republican to Democratic rule.
The experience in the 1920-46 downwave
Table 1 shows information about the primary recession and secondary depression from the previous downwave. The annual average unemployment rate is shows as a measure of recession severity over time. Also shown is fiscal stimulus which is defined as the change in the sum of federal, state and local government spending from the beginning of the recession as a percentage of current GDP or GDP at the start of the recession, whichever is larger. Fiscal stimulus during the primary recession was negative throughout, meaning that total government spending as a fraction of the economy never rose in the years after 1920. Such a policy of no significant expansion of total government spending in response to economic downturns is called austerity. Thus we can say that economic policymakers employed austerity in response to the primary recession in the previous downwave. The outcome was a sharp rise in unemployment in the first year of the recession, followed by a rapid restoration of prosperity over the next two years. Austerity was quite successful in dealing with the primary recession. When the secondary depression struck some years later Secretary of the Treasury Andrew Mellon proposed a similar approach:
The government must keep its hands off and let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. When the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. A panic is not altogether a bad thing. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.
Mellon has often been criticized from for these views. Yet what he proposed for the secondary depression was essentially a repeat of the austerity he had pursued during the primary recession, which had been quite successful. Table 1 shows that in terms of unemployment, the post-1920 recession was worse in its initial stages than post-1929 recession. As time moved on it became clear that the 1929 recession was developing along different lines. Rather than bottoming in its first year and beginning a rapid recovery, the secondary depression continued to get worse. By the third year of the recession, nearly a quarter of the workforce was unemployed, and Mellon had resigned as Treasury Secretary in the face of threats of impeachment. Later that same year his boss lost his re-election campaign to Franklin Roosevelt.
Table 1. Recession severity and fiscal policy during the 1920-1946 downwave
What had happened was the reduction in aggregate demand caused by the recession led to falling prices and a corresponding rise in the value of the dollar. Table 1 shows the value of the dollar in each year of the recession compared to the average value in the decade preceding the recession. Both recessions gave a roughly 50% rise dollar value, but they began from very different places. At the start of the primary recession the dollar was worth only 63% of what it had been during the previous decade. At the end of the deflationary contraction it had risen to 100%. That is, at the recession bottom, the value of the dollar was about where is had been when most of the debt obligations in the market had been contracted. Had these contracts been made by competent actors, they would be able to contend with the recession and once asset prices had fallen to attractive levels they would be in a position to stage a recovery. That is, once liquidation had forced the inflation brainstorm out of the people's blood, enterprising people were able to pick up the wrecks from less competent people.
In contrast, at the start of the secondary depression the dollar was already valued at roughly the same level as it had been during the previous decade, when most of the existing debt contracts had been made. The 50% increase in dollar value resulting from depressed demand created risk of default of firms run in accordance with sound financial principles by competent actors. No matter how far asset prices fell, there were few in a position to stage a recovery and so none occurred. It made more financial sense to buy a functioning firm, shut it down and pocket the cash on hand. The message the market was sending with such low prices was that not doing business was preferable to doing business. With such a state of affairs, as long as the deflation continued, there weren't ever going to be enterprising people picking up the wrecks to get a new expansion going. Enterprising people would instead be involved with closing cash-shedding businesses and pocketing the remaining cash.
There could be no recovery until the facts changed on the ground. Given historical Democratic support for free silver, it was rational to suspect that a Democratic successor to Hoover would take the country off gold. If the country went off gold that meant the future held inflation, which meant ditch dollars in favor of real assets. In this world it would no longer make sense to liquidate solvent firms (i.e. exchange real assets for dollars) because the value of those dollars would be certain to fall in the future. As 1932 ground on, it became clear that Hoover was doomed, and so in July 1932, the stock market began to rally.
When the new Democratic administration came to power, the first order of business was to end the gold standard. The recession ended right then, and a recovery began. The smart money in the previous July was right and the rally they began was the start of the largest broad-market bull in history.
Ending deflation and the deflationary depression wasn't enough to bring economic activity back to pre-depression levels, however. Increasingly, it was looking like the ideas propounded by British economist John Maynard Keynes were correct; restoring full employment would require government spending to make up for a persistent reduction in aggregate demand caused by the depression.
Policymakers in the Roosevelt administration employed gradually increasing levels of fiscal stimulus which were loosely associated with a gradual reduction in unemployment rates. Figure 1 shows a plot of percent employment as a function of fiscal stimulus over the years 1932-1945. The data shows a roughly linear response of employment to fiscal stimulus up to a certain level at which full employment was reached. This experience persuaded many economists that Keynes's theory was sound and made Democrats committed Keynesians.
Figure 1. Employment as a function of stimulus over 1933 to 1945
The experience in the present downwave
Table 2 shows information about the primary recession and secondary depression from the present downwave. As before, unemployment rate and fiscal stimulus are shown. Fiscal stimulus during the primary recession was held below 2% throughout. As they did sixty years earlier, Republican economic policymakers employed austerity in response to the primary recession. The outcome was also similar: a strong rise in unemployment in the first two years followed by a steady reduction over the next five years. The primary recession for the current downwave played out more or less the same as the last one.
Table 2. Recession severity and fiscal policy during the present downwave
Policy during the recent secondary depression was different than during the last one. Stimulus was pursued from the start; by year 3 (2010) fiscal stimulus had risen to nearly 9%, compared to just under 1% in year 3 of the previous secondary depression. The story told by unemployment was correspondingly different. Unemployment rate rose by 5 percentage points in the first three years of the current secondary depression compared to 21 percent for the previous one.
The 2010 election led to strong Republican victories at the state level and in Congress. Republicans implemented austerity beginning in 2011 by preventing any new stimulus at the Federal level and by cutting employment in state governments they controlled.. Fiscal stimulus fell 7 percentage points over in the next three years. In comparison stimulus rose by 4 points in the three years after the beginning of New Deal stimulus in 1933. Unemployment fell by 8 percentage points then, compared to a 2 point decline today.
Figure 1 suggests that the 1930's stimulus was responsible for about 5 of the 8 point drop in unemployment rate; the remaining 3 points would then be the result of the natural recovery from recession. By analogy, we should expect about a 3 point decline in unemployment rate resulting from natural recovery for the current recovery, to which the effects of stimulus (positive or negative) would be added. The actual drop in unemployment rate over the first 3 years of recovery was only 2 points, implying a 1 point higher unemployment rate because of austerity.
Figures for total government employment shows this same story in a way directly related to employment. Between the start of the recession in December 2007 and June 2010, total government employment increased by about 0.4 million, reflecting the fiscal stimulus at the federal level, a third of which involved transfers to state governments to help prevent layoffs that would otherwise be triggered by balanced budget requirements. Since June 2010, total government employment has declined by about 1 million. This translates to a 0.7% increase in unemployment. Multiplier effects of this reduction would be expected and so a 1 point rise in unemployment resulting from austerity imposed after 2010 is reasonable. This finding is consistent with the earlier argument made from analogy.
After the end of the gold standard in 1933, more or less permanent inflation has become the norm. The prospect of future deflation making debt harder to pay off is nil, and borrowing decisions reflect this. Leverage ratios will be higher and the stock market is considered undervalued today at dividend yields that previously would have signaled overvaluation. The assessment of prudent levels of debt no longer will reflect the real value of the dollar as it did in the last downwave. Inflation expectations will now indirectly shape such calculations. That is, the value of the dollar relative to what it should be, based on anticipated future inflation.
An example of this might be mortgage securities. Creating securities to meet strong demand required more mortgages, which increasingly made use of higher-risk borrowers. Since the loan collateral was a real asset whose price rose with inflation, it was believed that losses were limited in the event of default. Rigorous testing with computer models developed by very smart people that used decades worth of past data supported the belief of the assets underlying soundness. But since 2008 a world was encountered that had not been included in the tests. One in which $2.8 trillion of money creation in the two years before September 2008 failed to support housing prices sufficiently to prevent a change in the perceived value of the securities that underlie a dense network of highly leveraged derivative products. A change that led to the collapse of Lehman Bros. and the resulting financial panic.
Since inflation reflects monetary policy, the simple price model I used for reduced price gives a prediction of what the price level "should" be. This value divided by the actual price level gives the value of the dollar relative to the future, taking inflationary expectations into account. That is, "dollar value" in Table 2 is simply the inverse of the reduced price. It is essentially a shorthand for financial expectations. As long as dollar value is around one, conditions are "normal" and the sophisticated financial models of the "quants" work. When dollar value shifts away from one, they don't work. When the deviation is to the lower side, as it is during the primary recession, the impact on the real economy is short lived and the financial consequences (the S&L crisis) relatively small. When the deviation is to the upper side as it is during the secondary depression, the impact on the real economy and the financial system are very large.
The investor behaviors and economic outcomes associated with the changes in dollar value are the same between the two cycles. The detailed economic mechanisms involved are completely different. But the underlying cause is the same--the obsolescence of the dominant paradigm employed by economic actors leading to malinvestment.
The situation today is we are in the midst of the aftermath of the secondary depression. Based on the experience of the last cycle, we know that massive fiscal stimulus can restore employment to pre-recession levels and beyond, as shown by the experience in WW II (Figure 1). Smaller levels of fiscal stimulus can be insufficient and recovery can be partial as was the case during the 1933-37 expansion and today.
It is important to note that monetary stimulus alone has not been enough to restore prosperity. Based on the observation that money supply contracted sharply after 1929, Milton Friedman proposed the idea that had the Fed flooded the market with money, deflation and depression could have been avoided, allowing the economy to recover much faster. Fed chief Benjamin Bernanke put that concept to the test and flooded the system with money. Deflation was prevented, but prosperity has not returned over the time it normally takes.
On the other hand, had fiscal stimulus not be withdrawn after 2010, unemployment rate would be about 1% lower, or about the same as it was in year six of the primary recession, and the deficit would be on its way to irrelevance. Instead the recovery has been incomplete as it was last time and the recession that follows should be another serious one, as was the one in the late thirties. In anticipation, I sold out of equities in July. Prematurely, as I suspected, but last time I was too late. This time my motto has been "better too early than too late".