The Potemkin Economy Just Fell Over

Let there be no mistake, no further debate. With two months of back to back Jobs Report declines the discussion on the US economy must shift from "full recession or mild slowdown" to "how long a recession and how bad."

The internals of the numbers were actually worse than we expected, and worse than the headline number.

We often thought that this would be an interesting economic experiment, with the Fed chairmen, first Greenspan and then Bernanke, getting the chance to replay the onset of the Kondratieff Winter and an economic depression. This time they were allowed to pour the money on in significant amounts, in the absence of that barbaric Gold Standard and honest mainstream economic scrutiny, to try and turn the winter into spring.

Well now we know. It's not working. It raised up a Potemkin economy that looked pretty on the surface from 2003 to 2006, but in reality was as thin as ..... paper.

We're chuckling to ourselves this morning as stocks rally from their lows, ignoring the economic news presumably, perhaps using the increased largesse of the Fed and their Treasury Auction Facility (aka Selective Helicopter Money). But we like to think of it as a fresh coat of paint on the Potemkin facade, to make people doubt their own eyes, and ears, and reason. The first principle of the Big Lie is to never tell the truth, never admit a mistake, while you can shield the people from the consequences of your deceptions.

But the charade can only continue for so long. As von Mises observed:

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved... The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment."

February 2008 Non-Farm Payrolls Report

We are not going to try to forecast tomorrow's Non-Farm Payrolls Report. The work we have done so far with this report has made us believe that it is written in sand, and equally subject to change, and more adjusted in opaque ways than most numbers from official sources.

The consensus of economists is a net addition of 25,000 jobs, against a prior decline of 17,000 jobs in January. We fully expect January to be revised, and probably December as well. It will not surprise us to see this number come in revised to positive, with a potentially lowball number for February. Why? Because that is how the Bureau of Labor Statistics has been rolling their adjustments lately. They give us the 'bad news' but then show its unreliable, and probably not so bad.

We would like to show three graphs in anticipation of this report.

The first compares the seasonal adjustment with the actual numbers. As you can see February is a quite large downward adjustment, although not quite as large as the upward adjustment in January. There is obviously substantial room to play with adjustment in both months, especially when the adjustment method keeps changing and is 'proprietary.' The swings in the non-adjusted number are enormous this time of year, making the 25,000 net adds in the seasonally adjusted headline number almost a statistical rounding error. But Wall Street will react.

The second graph shows what we have been calling the Imaginary Jobs Component, more familiarly known as the BLS Birth-Death Model of small companies that are incognito. The net add in February should be about 100,000 jobs based just on prior history as we have shown here. We have heard that BLS will be issuing some major revisions in their methods, but cannot recall if its in this month or some coming month. This number is added PRE-adjustment, so its tossed in the wash in many months, and is not so big a deal as many have come to believe.

No matter how the number comes out tomorrow, highball or lowball, with a prior month twist, or a total restatement of everything back a couple of years (yes they do that too often we might add), we would like to emphasize that no matter what the stock market does in reaction to the headline numbers, there really is only one type of chart worth looking at for these types of volatile numbers: the moving average trend chart.

We have included the chart below to show how clear the the trend has been. The peak of Jobs Growth occurred in early 2006, and has been in a slow but steady decline since then. During the entire 'recovery' that the stock market was discounting we kept asking, "But where are the Jobs?" Well, they really were not there after the first few bubble years after 9/11 during what we like to call "The Great Reflation." Mask the unemployment as they might by dropping people from the counts as their unemployment runs out, the fact is that we entered a recession at the end of 2007 at the latest, and probably earlier than that if we could obtain a realistic Inflation number with which to deflate our bloated nominal GDP.

Don't be shocked if we do get a positive number tomorrow. Its well within probability given the revisions, and the history of Administrations messing with the numbers going back to LBJ at least. And don't be shocked if the Financial Talking Heads say "What Recession?!!".... or not. The number is capable of coming out any which way, and will be revised next month regardless. We're in the silliest of seasons here, as the proverbial piper comes to be paid, and the entire financial and political structure in the United States seems badly in need of adult supervision.

IRX index, Interest Rates, the Yield Curve and US Equities

Someone asked us to comment on the IRX index, and its relationship to the SP 500.

The IRX index is the discount rate of the 13 week Treasury bill. It is called the discount rate because it has no coupon, but matures to its full face value. But it does have an effective interest rate, and this is what the IRX index is.

So to understand the IRX we need a little understanding of Treasury Bills.

U.S. Treasury bills (T-bills) are among the safest short-term financial instruments denominated in dollars because these debt obligations are perceived to have virtually no default risk. Moreover, because T-bills mature in less than one year, with most maturing in a matter of months, they do not have a significant interest rate risk component, either. This is a major difference between T bills and T bonds and notes which are of longer durations.

There are four major influences on the price and yield (discount rate) of Treasury bills:

• Demand for risk-free fixed-income securities in general as opposed to other short term investment choices. For example, a "flight to safety" caused by concerns about default or liquidity risk in other financial markets may cause investors to shift to T-bills to avoid risk.
  
• Supply of T-bills by the U.S. government--for example, federal budget surpluses in 1998-2000 temporarily reduced the supply of some Treasury securities issues.
  
• Economic conditions may influence rates-- T-bill rates typically rise during periods of business expansion and fall during recessions.
  
• Monetary policy actions by the Federal Reserve--Fed actions that affect the Federal funds rate likely will influence interest rates for short-term instruments like T-bills.
  
• Inflation and inflation expectations also are factors in determining interest rates--for example, periods of relatively high (low) rates of inflation usually are associated with relatively high (low) interest rates on T-bills.

Here is a graph showing the 3 month discount rate going back to 1934. The primary value of this is to show what a truly dramatic event the inflation of the 1970's had been, and how remarkable and historic the steps taken by Fed Chairman Paul Volker had been to bring it back under control and prevent it from growing and evolving into something more dangerous.

Here is a graph showing the profound effect that the Fed Fund Target Rate, with changes anticipated by the Effective Funds Rate, has on the 13 week T Bill rate in the secondary markets. The 13 week T Bill discount rate is called by the Fed the 3 month Treasury Bill secondary market rate. There is an index that tracks this yield that is called the IRX. The short term rates move lower with recession and higher with business expansions. This is not only the result of Fed actions, but also the demands of business as stated in the four influences above.

If we include the Ten Year Treasury Note Yield to the Chart, we can see the long end of the yield reacting to the perceptions of inflation. But perhaps more importantly we can see Yield Curve Inversions on the chart. These are times when the long end of the curve, represented by the Ten Year note, has a yield less than the effective interest rate of the short end of the curve, as represented either by Effective Fed Funds or the 3 Month T Bill Discount Rate.













If we add the SP 500 to this chart, we can now see the interaction of a relatively broad stock market index with the short end and the long ends of a the yield curve. Of special interest is the clear presaging that a yield curve inversion provides for an economic recession and a stock market bear market. Note the timing of the inversion, the recession, and the approximate stock market market bottom.













We find the example above just a little 'short' because it does not reflect the real SP 500 adjusted for inflation, but merely the nominal number. Of course the interest rates shown are not real rates, but the nominal rates. With inflation, the real interest rate has probably gone negative. The problem we have in most of these instances is that the CPI in our opinion is no longer a valid measure of inflation, having been corrupted by the Clinton and Bush administrations. So we will deflate the SP 500 by gold.













The chart above helps to illustrate the sad truth that the economic recovery after the bursting of the tech bubble was just a mirage caused by what we call The Great Reflation. The clever boys at the Fed, thinking they had learned their lesson from the Great Depression, were determined to pile on the monetary stimulus early and heavily. Alas, although it triggered a housing bubble and a reflating of the stock bubble, it was coopted and misspent by a corrupt financial sector. There is also a strong case to be made that one cannot reflate their way out of a bust following a boom, by attempting to recreate the boom. The recovery must come from reform, hard work, and savings.

It becomes difficult if not impossible for most people to pick out relationships on charts like these, unless they have a mathematical background or many years studying complex graphs. And personally we like to use the math anyway, because we find the eye deceives where the numbers tell the truth.

Let's just say that we're in for a rough time of it in equities in the US, and we are in a recession now. Why couldn't the Fed have kept rates low? Why did they have to raise the Fed funds rate and trigger the yield curve inversion? Why not just keep things as they were. The answer is clearly contained in the first chart. There are too few instances wherein you can unleash the inflation genie from the bottle, and hope to get it back in again gracefully. Volker did a remarkable job AND was exceptionally fortunate. It may not be so easy the next time, and the alternative is, for bankers at least, hyperinflation and the abyss.

As a final note, we wanted to mention that some years ago a few clever economists found out that its not so much what the inflation rate is that triggers the inflationary spiral, but rather what people think it is. This is not some arcane Clintonian parsing of logic, but a clear connection between perception and behaviour. It is the behaviours that people take in anticipation of inflation that reinforce it like a feedback loop and make it particularly nasty. So if you can control their perception of inflation, the Fed will have a much greater degree of latitude in engineering the economy and money supply since inflation is a major pitfall. What might they do to manage that perception? They aren't being subtle about it, we'll say that much for now. (Hint: three major indicators of inflation are the CPI, broad money measures like M3, and Gold.)

To summarize, the economy is in a recession, and the SP 500 has more correcting to do by historical standards. Short term rates are moving lower ahead of the recession. The Fed will not be able to raise short term rates until the recession is behind us, which means that the US Dollar has further downside potential unless the G8 countries take some extraordinary actions to help the dollar, most likely by inflating their own currencies. The Fed has a tradeoff between the stock market and the economy on one hand, and the dollar and the Treasuries on the other.

The Big Lie

"ONE great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming. Alan Greenspan, a very serious student of the markets, didn’t see it, and, moreover, he didn’t see the stock market bubble of the 1990s, either." Robert Shiller, How a Bubble Stayed Under the Radar, NY Times, March 2, 2008

“I recognise that there is a stock market bubble problem at this point, and I agree with Governor Lindsey that this is a problem that we should keep an eye on....We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.” Alan Greenspan, September 24, 1996 FOMC Minutes

"While everyone enjoys an economic party the long-term costs of a bubble to the economy and society are potentially great. They include a reduction in the long-term saving rate, a seemingly random distribution of wealth, and the diversion of financial human capital into the acquisition of wealth. As in the United States in the late 1920s and Japan in the late 1980s, the case for a central bank ultimately to burst that bubble becomes overwhelming. I think it is far better that we do so while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric heights. Whenever we do it, it is going to be painful, however.” Larry Lindsey, Federal Reserve Governor, September 24, 1996 FOMC Minutes (the same Larry Lindsey who was later fired by G. W. Bush for stating that the Iraq War could cost as much as 200 Billion dollars when Rumsfeld estimated less than 50 billion).

"As societies grow decadent, the language grows decadent, too. Words are used to disguise, not to illuminate, action...Words are used to confuse, so that at election time people will solemnly vote against their own interests." Gore Vidal, Imperial America, 2004

His primary rules were: never allow the public to cool off; never admit a fault or wrong; never concede that there may be some good in your enemy; never leave room for alternatives; never accept blame; concentrate on one enemy at a time and blame him for everything that goes wrong; people will believe a big lie sooner than a little one; and if you repeat it frequently enough people will sooner or later believe it." United States Office of Strategic Services, Adolf Hitler, p.51

"...when one lies, one should lie big, and stick to it. They keep up their lies, even at the risk of looking ridiculous...If you tell a lie big enough and keep repeating it, people will eventually come to believe it. The lie can be maintained only for such time as the State can shield the people from the political, economic and/or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State.”

" Joseph Goebbels

"All this was inspired by the principle...that in the big lie there is always a certain force of credibility, because the broad masses of a nation...often tell small lies in little matters but would be ashamed to resort to large-scale falsehoods. It would never come into their heads to fabricate colossal untruths, and they would not believe that others could have the impudence to distort the truth so infamously. Even though the facts which prove this may be brought clearly to their minds, they will still doubt and waver and will continue to think that there may be some other explanation." Adolph Hitler, Mein Kampf

"Through clever and constant application of propaganda, people can be made to see paradise as hell, and also the other way round, to consider the most wretched sort of life as paradise." Adolf Hitler

"...we're going to redesign the current system...you don't have anything to worry about -- third time I've said that. (Laughter.) I'll probably say it three more times. See, in my line of work you got to keep repeating things over and over and over again for the truth to sink in, to kind of catapult the propaganda. (Applause.)" George W. Bush, May 24, 2005

"...the problem at its root is a flawed business model, and that business model is the product of a government regulatory decision to repeal Glass-Steagall administratively and legislatively, and to seek this tremendous concentration of power; and then the abuse of that power by the investment houses...What we want to do is clean up the system and hold the individuals accountable, and that is what we have tried to do...But there was an understanding that if we were to seek criminal sanctions against either the institution or the most senior people of the institution, the practical impact in our regulatory environment would have been to destroy those institutions, and then structural reform would be meaningless...because the harm to our economy that would result from eliminating a Citigroup or a Merrill Lynch is enormous, and it's disproportionate to the remedy that we want.....It was incredible. It was distressing to me how simple and outrageous it was. It wasn't so complicated that you said, "Wow, at least they're smart in the way they're doing it." It was simple. It was brazen. The evidence of it was overwhelming. It's just that it hadn't been revealed to the public, and that's why could get away with it...Right, we have seen a failure of accountability -- what I call a crisis of accountability -- over the past decade, in many institutions...Over the past decade we've wanted to deregulate, and we've said, "Let's get government out of the business of looking at these issues, and permit industry to control itself, because we can trust them." Maybe that's been a very good thing in some ways. One of the things that is eminently clear from our investigation is that all the compliance departments, all the self-regulation is nothing. They watched it, but they did nothing. So we've got to think this through, and it's not only the financial community. There are a lot of sectors where we have said self-regulation is the answer. We've got to think about it." Eliot Spitzer, The Wall Street Fix, March 16, 2003