Richard Koo’s latest commentary is not quite as wildly bullish as equity investors have gotten in recent weeks and I fully agree with his outlook. The markets are pricing in a self sustaining organic recovery and I still believe we have anything but that. While we are still very constructive on the economy in H1 (and likely into Q3), I believe we are still mired in a balance sheet recession that is simply being papered over by extraordinary amounts of government spending. In essence, the government has implemented a massive private sector crediting of accounts while their balance sheets remain highly indebted and continue to be worked down. Richard Koo agrees. Mr. Koo notes that the lending market is actually not improving at all:
“From borrower’s perspective, credit crunch is worsening Amid a severe nationwide credit crunch, the Fed is now actively listening to borrowers and trying to build a close cooperative relationship with the National Federation of Independent Business (NFIB), a leading small business organization. This is a major, unprecedented change. Traditionally, the Fed paid little attention to the views of borrowers, and as a result there were no data series like the index of banks’ willingness to lend as seen by the borrowers found in the Bank of Japan’s Tankan survey. Without input from borrowers, the Fed tended to administer policy based solely on the views of lenders—ie, the financial sector.”
“Like the Bank of Japan, the NFIB has been asking borrowers for their views on banks’ willingness to lend for many years. The relevant question asks businesses whether they find it easier or harder to obtain bank loans than they did three months ago. Recent numbers are deep in negative territory, indicating that banks are much more reluctant to lend than they were three months ago. This suggests that the credit crunch is not over and in fact is growing worse.
Koo elaborates on the deep weakness in the credit markets by claiming that mark to market would result in widespread banking bankruptcies if they were forced to actually mark these assets down to their true values:
“If US authorities were to require banks to mark their commercial real estate loans to market today, lending to this sector would be extinguished, triggering a chain of bankruptcies as borrowers became unable to roll over their debt.”
Koo says the weakness in the consumer is best displayed by continuing credit contraction and weak retail trends at Wal-Mart:
“Wal-Mart sales strategy reflects reduced purchasing power of US consumer Rising retail sales are often cited as evidence of the US recovery. However, outstanding consumer credit in the US contracted another $11.5 billion in February, marking the twelfth decline in 13 months and demonstrating that the household sector is still undertaking balance sheet adjustments. A robust recovery in consumer spending is unlikely as long as credit continues to shrink. Retail leader Wal-Mart announced on 9 April that it would lower the prices on 10,000 of its products in response to a Q1 decline in US store sales, calling into question the oft-heard argument that retail sales are strong. The chain also said it plans to cut more prices in the future. There are two possible causes for the drop in sales at Wal-Mart. One is that incomes have risen, causing consumption to shift from the chain’s inexpensive offerings to higher-end products. The other is that the weak economy has caused a further reduction in consumers’ purchasing power.
That Wal-Mart is addressing the drop in sales with further price cuts suggests that the company’s executives believe the latter scenario is the more likely. If they attributed the drop in sales to rising incomes, they would instead have announced a shift in their product mix to higher-quality, higher-priced items.”
What does it all mean? It means the government must continue to spend or the private sector will fall back into a debt-laden slump. As we previously mentioned, the private sector is not yet ready to run with the baton and likely won’t be ready to run with it for several years. If the government cuts back on spending and stops effectively crediting private sector bank accounts the likelihood for a double dip or an all-out new recession increases substantially in 2011 and 2012:
“Discontinuation of fiscal stimulus could trigger another slump. The impact of the Obama administration’s $787 billion fiscal stimulus, unveiled last February, is now peaking. That reported improvements in economic conditions are still so modest naturally leads to concerns about what will happen when the stimulus winds down. The stimulus is scheduled to have its greatest impact in Q2 and Q3 this year, so I do not expect the economy to lurch backwards in the near future. Nevertheless, the economy could stall again once the stimulus ends unless private demand picks up in the next few months. The economy may rapidly improve in the coming months. However, the fact that the Fed is retraining bank inspectors in an effort to address the credit crunch suggests that central bank officials do not see the recovery as having firm underpinnings.”
“Economies’ fate depends on whether governments try to reduce deficits. The recent problems in Greece have helped focus attention in the eurozone on the supposed need for deficit-reduction efforts. This comes at a time when the region’s fiscal stimulus already consists mostly of automatic stabilizers rather than pro-active spending. To cut government spending at this juncture would further reduce the pro-active portion of fiscal outlays and postpone the recovery.”
In the UK, both the Labour Party and the Conservative Party have laid out deficit-reduction plans ahead of the 6 May elections while the private sector continues to deleverage by paying down debt. The implication in my view is that even if the economies of the US, UK, and the eurozone survive fiscal cutbacks, the eventual recoveries will be modest at best. And if the spending cuts are too severe, the economies are likely to stall once again. Japan and other Asian countries that remain heavily reliant on exports to the US and Europe therefore need to closely monitor political debate on fiscal consolidation in these countries. US consumer credit continues to contract, and British households and businesses are paying down debt. Those of us in Japan, which unsuccessfully attempted to reduce its budget deficit under similar conditions in 1997 and 2001, are perhaps best positioned to warn people in the US and UK what will happen if the governments of these countries embark on fiscal consolidation efforts.”
In March of 2009 we began referring to the rally as “the government run rally“. The rally started on government interventions and continues to this day with a massive and continuing stimulus plan that props up the economy.
In summary, enjoy the continuing appearance of an economic recovery into the back half of this year (and what will likely be higher equity prices), but don’t get your hopes up for a sustained recovery. The likelihood of spending cuts and higher taxes will put a damper on the recovery in 2011 just when things are starting to look so good. And that’s assuming that Ben Bernanke’s cattle prodding of prudent savers into risk assets doesn’t result in extreme malinvestment and destructive asset bubbles before that.
After 4 seemingly wonderful years wouldn’t it be ironic if President Obama is running for re-election in 2012 and falls on the same Keynesian sword that President Bush and the Republicans fell on in 2008? All thanks to the creativity of Ben Bernanke and his continuation of the failed Greenspan doctrine.