[
Crossposted at Bopnews.com]
That there is going to be another recession is a metaphysical certainty. We haven't repealed the business cycle, nor is there any sign that we've repealed human nature. The question is when is the next recession, what happens between now and then, and how bad that recession is going to be.
[Newest post on The Open America Agenda: The theory of the Public Income and Retirement System.]
The basics of the business cycle.
The business cycle has been with us at least as long as fractional reserve banking and the hydrocarbon economy. We can see clear business cycle patterns in the credit economies of the 18th century, and by the establishment of railroads, they are clearly in place. Transportation, by creating a stronger synchronization, has a tendency to create more clearly defined business cycles, because it means that market effects spread more rapidly.
The business cycle, as it has existed over the course of the hydrocarbon economy is usually described from the beginning of a contraction until the next contraction. However, I usually describe it from another point: from the point of injection of stimulus. Thus the classic description of a business cycle is - contraction, bottoming, expansion, inflation and contraction. But this only applies to equilibrium economies with central banks and asset currencies. While this is the majority of the world's economic activity, it is not the majority of time, and thus is a narrow description. One that has broken down recently, simply because it relies on certain macro-economic factors being in place which are not immutable laws of economics, but the results of deliberate legislation or planning.
Hence I describe the cycle differently: from the point of stimulus, and create a tree of possibilities from that point of stimulus - the tree describes the various possible shapes of an economic cycle, but all of them, in the end, reach a new contraction.
The key dynamic is can the monetary authority keep the economy from contracting, while the fiscal authority helps create channels for new growth. The last time around the Bushconomy was "Uncle Alan keeps interest rates incredibly low to stop a big contraction, while Cousin George invades Iraq and tries to get a Reagan style defense boom going." It didn't work. Now Uncle Alan must raise rates, and Bush and company are desperately seeking some way to force people to pay more for things like road transporation, while they hope that technology bails them out. It isn't working either, since they are having to club the consumer - with consumption taxes, stealth gas taxes, base closings and cuts in aid to states for Medicaid - all of which are acting to slow the economy, even as interest rates slow the economy. They want money to stop flowing into housing and commodities- but housing and commodities are where the profit is. Bush is proposing big capital spending on energy, in hopes he can get a big round of borrowing for refineries and nuclear power plants.
At the present time we are in the "landing" phase of the expansion. The landing phase is that point where inflation has renewed itself, and, in an economy with a strong monetary authority, there is an attempt to squeeze out inflation, without squeezing out growth. We had a short "boom" from fiscal policy stimulus last year, however, it created no follow on - since it was all defense driven, and defense driven stimulus must be followed by more defense driven stimulus to keep the economy going. Hence things boomed during the spring when the 90 billion dollar Republican Pork, I mean Iraq appropriation, hit the economy, and there was another short jolt from another jolt of defense spending just in time to make the economy look good for the election.
However, both of these created more energy inflation - since they did not do anything to address the economy's current supply bottlenecks. Thus Uncle Alan was forced to raise interest rates, and the Republican Congress realized that they were borrowing and squandering more than they could do sustainably - they are going to be closing bases and cutting spending on medicaid - making the poor pay.
So we are now moving back into a "landing" phase, where economic activity is being choked off, in hopes that this will force the economy to stop buying those things that are in short supply. A host of policies are being tried - from top to bottom - to increase the cost of that which is in short supply. In our case, that is oil, because oil is what we must import. Until we are only importing oil at the rate that we use for export production this will continue. The US is privileged in that we have a special relationship with the oil exporters, and so we are not being forced into this level quickly, but being forced there we are. There is a temporary region of stability while we burn through the special position we have.
There are then three broad scenarios:
The Bull Case Scenario
The Bull Case is that something produces a large capital build out. The first Bush term's economic policy was to have Iraq and Security be that build out. It failed dramatically. Security is not producing a large domestic or export industry. The "Global War on Terrorism" has neither produced a large boom in "security" for consumers or corporations. Iraq has neither produced cheap oil, nor a place where US corporations can build things for a large profit.
This is why changes were made to the corporate tax bill to force more of repatriated profits into capital expansion. This lead to a modest rebound in business investment and hiring, but the amount directed was so small - in comparison to pure give aways, that it is already trailing off. It is also small compared to the amount of stimulus that is being removed from the economy by interest rate increases.
This means that while it is still possible that the US economy will start a capital build out, what is far more likely is that business will not spend their accumulated cash hoards, but will, instead, simply give them out as stock buy backs, mergers and increased dividends.
According to the Bull Case, housing will slow under interest rate pressure, and the agreements with China to slow its economy, and the oilarchies to pump more oil, will reduce both inflationary pressures and the easy ability to "offshore" to China. This combination will lead to internal growth in the US.
For a variety of reasons, this scenario is unlikely. First because there is insufficient incentive to build out, second because the capital development system - as represented by the NASDAQ ex-Microsoft and Intel - has been broken and nothing has been done to get it going again.
If it occurs, the stock market will finish correcting for higher interest rates, and then begin a rally. The economy will have a two to three year period of strong growth. This will lead to a contraction, but only after there have been significant profits to be made.
The Snake Case Scenario
The snake case has the US economy japanifying - enough stimulus comes in to keep the business cycle from contracting, but not enough to produce inflation. Inflation subsides, and gradually corporations start spending at the replacement level of the economy. This scenario merely requires that energy prices don't continue to go up, and that China slows enough to create replacement demand for capital expansion here in the US.
It is what the Executive hints at when it says things like "slow sustainable growth" and "energy prices are likely to remain high" and "the market will make adjustments". Basically a bet that wage earners will be happy getting none of the increase in profits from any economic expansion, and we can continue a "vacuum up" economic structure, where workers are basically burning through assets to keep consuming.
This scenario is indeed possible, but it is not likely to lead to anything good - it is merely a holding pattern until some bull case can arise - that is, a corporate build out on new supply that eases energy inflation.
If it happens the stock market will rally briefly off the current correction - 6 to 9 months, and flatten and slow as another round of tightening is needed to "land" the economy again. We will be back sitting here next year wondering whether inflation is going to take off again. There will be sector leadership in sin stocks and other forms of "waiting" and there will be one last round of housing boom.
The Bear Case Scenario
The Bear Case Scenario says, in essence, that the current combined round of fiscal and monetary austerity will not be enough to stop inflation, that money wil continue to flow into real estate in order to find some better return than a flat stock market, and the Fed will have to tighten significantly. Since the floor on the 10 year is around 4.25%, this means that the Fed Funds rate will have to reach 4.25% or higher to invert the yield curve as part of the road to recession.
The Bear case scenario - that is, that this is the gasp before a recession - has no more than a 25% chance of being correct at this particular moment. I felt it to be a much higher chance last year, however, there has been a global decision among the G-7 to do everything possible to "snake" the world economy, and hope that China can be forced to join the world economy. This will spread out global growth enough to prevent Japan and Europe from going into full blown recession. The reason for this is that the US, China and the resource producers are currently consuming all global growth. The hope of Europe, Japan and other developed nations is to push China to give up some of that growth, so that they don't slip into recession.
It also hopes that the wage earners in the entire developed world are willing to put up with real wage declines, loss of benefits, job stagnation - while corporate profits soar.
Hence, I believe that the most likely case is that we are going to see a year of stagnation as everyone tries to get China and the poor to pay for the series of monsterously bad decisions - not just by the US, but by Europe which backed, if half heartedly, the Bushconomy. But that at the end of that year, we will see significant inflationary pressures from energy, and that there will be the requirment of slowing the world economy into recession.
Simply put, with current technology, there is not enough growth to keep China politically stable, and provide enough non-inflationary growth for the rest of the developed world.
Thus
Bull - around 10%
Good Snake (snake followed by Bull) - 10%
Long Snake (snake continuing more than 12 months) - 10%
Bad Snake (snake followed by Bear in 2006) - 45%
Bear - 25%
Thus prudent investors should move to cash or cash equivalents, cut all debt, retrench expenses and cut non-essential purchases that do not reduce expenses. They should be prepared in the Summer to take advantage of the rally that will very likely carry the markets upward through the fall, but not create positions which are difficult or expensive to unwind should events deteriorate. Prudent investors should begin researching stocks or sectors that they feel will provide potential leadership in the case of a real boom, and researching stocks that will benefit from continued high energy prices, and a dramatic slow down in home building.
Current policies lead to a very small chance of a good outcome, and investors should expect that there will be no policy changes after the 2006 elections, but, instead, an acceleration of current policies.
Summary: There is only so much growth to go around, and right now it is all going to the US and China. The rest of the developed world is pressing China to slow down, and now the US, because the amount of global growth is slowing. Since the Iraq/Security economy didn't work, the Republicans are now focusing on privatizing the transportation grid, and hoping that Uncle Alan can slow oil consumption enough to get to the next capital build out. The odds are against this happening, just as the odds were against the first Bushconomy producing real growth. The result is that the risks of falling into a recession, either on this slow down, or on the next one in a year's time, are signficant.