Sunday, April 11, 2010

James Galbraith Response

Yesterday I posted a video of economist James Galbraith where I had issue with his response to a question about ruling out a double dip recession. He commented on the blog post clarifying his position. Since most of my followers do not follow the comment section (never a tool I have put much emphasis on), out of fairness I wanted to give his response its due. I appreciate intellectual thought and him taking the time to clarify his views. His full response is as follows:

My meaning may not have been as clear as it should have been.

To rephrase: "a double-dip recession seems unlikely to me, because housing and other construction have already collapsed, and it would be hard for them to collapse much farther than they already have. Other forms of spending (such as household consumption) are supported by income flows that come from wages and from government transfers, and these are much more stable. What I fear more, is an inexcusably slow expansion."

By the same token, avoiding a second-dip of the recession should not be considered much of an accomplishment.

Finally, I interpreted the question as referring to the situation in the US. The situation in Europe is very dangerous.


In some ways I agree with his response, though probably not in the way he would guess. My thesis has been that we have started the third and final bubble. A bubble that will end all bubbles for decades. We had the equity market bubble that never fully corrected but was stopped short by the Fed morphing it into primarily a private debt bubble. This private debt bubble kept the equity bubble propped up. With the collapse that started in 2007, the market forces once again were not allowed to work their magic with massive intervention by the government to create the third bubble, the government bubble. This government bubble is propping up the equity market and the private debt market. We should have had a small recession in 1998 with the failure of LTCM, without that small recession we should should have had a severe recession in 2001 and 2002, without that severe recession we should have a depression that would be ongoing currently. Every step of the way, the government has stepped in ratcheting the pressure ever higher, refusing to let the market work, and in the last iteration taking the risk of the private sector onto the government balance sheet. In finance theory terms, the bubbles have simply moved down the CAPM line never fully correcting and now the risk free rate is mispriced as systemic risk weighs more heavily than unsystematic risk. In my mind it is unconscionable what has occurred and puts the entire system at risk.

So when James makes the comment that a second double dip is unlikely because housing and construction will not cause the double dip and steady income flows from government transfers will continue to support the consumer, I would be inclined to agree with him. In the same breadth I would also counter that is not what is important.

At this point, the private sector has been backstopped by the government. The private sector won't fail (or reach a natural equilibrium point) unless we have system failure. In my opinion this is unamerican and is what I have coined Sociapitalism. It is a new financial order that has slowly socialized risk. From a stock picker standpoint, someone like Regions Financial which is an insolvent institution has become less risky as its risk has been diluted. In contrast, Wal Mart has become more risky as it has taken a slice of Regions Financial risk.

So to housing. Housing left to itself is in a world of hurt. According to Fannie Mae there are over 5 million mortgages that are seriously delinquent. 5 million!!! Think about that number compared to existing home sales and new home sales. Amherst Securities estimates the number is closer to 7 million. Bank of America has indicated that they expect their foreclosure to increase 600% this year. By the end of the year, Bank of America alone is expected to foreclose on 300,000 homes. To put that in perspective, the new home sales rate in the entire United States is currently running at 308,000. That isn't what is scary though. The area of the financial system that brought our system crashing down was the resets/recasts of the subprime loans that started in the fall of 2007. This wave essentially ended in late 2008 and total loan resets bottomed in September of 2009. The next wave has just started. The subprime wave is over with. The next big wave is Option ARM and Alt A resets/recasts. This wave is just as big as the first wave. The first peak occurs around October of 2010 and than a much bigger peak in October of 2011.

Even from its current level left to market forces, I believe housing would not only cause a double dip but lead to a depression. I agree however that the government will not allow this to happen, until the government can't stop it from happening.

At some point, a month from now, three months from now, a year from, three years from now, there will be an event that calls into question the ability of the federal government to be able to backstop the entire private market. This could come from problems in Europe, Japan, or something closer to home. This is when the end game will occur. This will cause the popping of the final bubble, the government bubble and cause systemic risk to be repriced. Because of the stealth Sociapitalism that has sneaked into our system, the risk that is shared by all will be revealed for what it is.

I am sure James would disagree with me but this is one the core problem of Keynesian economics. It simply acts as a pimp to various politicians to give them cover to buy votes. What politician wants to hear that a market equilibrium (something very basic to economics 101) needs to be pursued and for that to occur you need a recession/depression to clear the system? No one and so it is occupational hazard to think of such views. Instead the answer is to spend which the politicians love to hear because it makes them popular as well. It is a system that feeds on itself until there is nothing left to consume and the system collapses. The great Japanese miracle is they have lasted as long as they have without a market cleansing continuing to string out their problems pushing them off until tomorrow. The great Japanese tragedy is they have lasted as long as they have without a market cleansing preventing them from participating in one of the greatest growth stories just a few hundred miles from its border, in China. Think what could have been if Japan would have allowed financial collapse and reorganized in the early 90s. Sure the early 90s would have been much worse than what they ended up being but the rewards today would have far outweighed any costs of yesterday as they would have had a clean system to feed China's growth appetite.

So to summarize, my view is essentially that we will not double dip until the market reprices the systemic risk because the government has created a government bubble. The government is the private market at this point. The government is propping up equity prices, consumption through wealth transfers, the housing market through tax credits, the debt market through all sorts of programs etc etc. The government is the market. If housing starts going down hard again a new government program will come along. The entire private market is being held up by various scaffolding of the government. Until a storm comes that destroys the scaffolding the private market will most likely muddle, which is James baseline view. Like I said originally, I basically agree with his response but for probably much different reasons than he believes his response.

There is one caveat. There is a growing American anger at this whole con game and the Keynesian's thought process. A new political order could sweep into office this fall through a movement like the Tea Party that puts huge pressure at removing the scaffolding. If that occurs, the whole system will come collapsing down faster than you can say capitalism. While this is what was needed in 1998 or 2002, my fear is at this point the system is beyond saving. It is a catch 22. At this point, I believe there is no way to rebuild without tearing down. But if you tear down will there be anything left to rebuild?


Jeff said...
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Justin said...

Kaspar, you mention the Option ARM and Alt A resets - my understanding was that these mortgages would reset at current rates; e.g. very low.

Thinking aloud here, but will there be the same level of defaults on these mortgages as we saw with subprime, given that they reset to possibly a lower level than the current rate? Or do they reset to a higher rate?