The productivity watch: The nirvana of high growth and low inflation may be over

[EJ]

The productivity watch: The nirvana of high growth and low inflation may be over
August 22 2006 (Fortune)

At 2 p.m. on Aug. 8, the Federal Reserve declared a cease-fire in its long-running rate-hike campaign. A week later the government reported benign inflation figures for July: The producer price index rose a meager 0.1 percent, while the core consumer price index was up just 0.2 percent.

Investors and Fed watchers concluded that inflation is under control. And newly confident in the sound judgment of Federal Reserve chairman Ben Bernanke, they began spinning happy scenarios of a soft landing.

But less noticed on Aug. 8 was the first dissent of the Bernanke era: Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, voted for a 25-basis-point increase.

He may have been reacting to a bit of news released just days before - one that may indicate we're in for a bumpy macroeconomic ride. The Bureau of Labor Statistics reported that in the second quarter productivity growth came to a screeching halt, falling to 1.1 percent from 4.3 percent in the first quarter.

If lower productivity and higher inflation amplify each other - as higher productivity and lower inflation did in the 1990s - we face the risk of a bizarro virtuous circle, says Achuthan: a vicious reinforcement, in which lower productivity drives inflation higher, which in turn drives productivity lower.

The most recent productivity release showed unit labor costs rose 4.2 percent in the second quarter of 2006, up from 2.5 percent in the first quarter.

"These are traditional markers of a cyclical inflation upswing," says Allen Sinai, chief global economist at Decision Economics.

AntiSpin: Takes the mystery out of comments today from Chicago Federal Reserve President Michael Moskow who's joining the Lacker choir saying that higher inflation risks outweigh concerns about slower economic growth. This begs the question, does the Fed really have a choice between the two? Not really, but Wall Street hasn't figured this out yet, and the suggestion that the Fed might have to tighten some more someday caused the usual knee-jerk reaction in the markets, it sent stocks into the red from a minor rally earlier in the day. Some day stocks will decline for the right reason, with a full comprehension of structural inflation and all that entails... but not yet.

Meanwhile, Merrill Lynch's bearish chief economist David Rosenberg, hired in the fall of 2003 after the bullish Bruce Steinberg was fired just as the economy and markets were starting to recover, continued to wax bear-colic, stating: "Practically every indicator at our disposal tells us that we are very late cycle, and the historical record also suggests that the next wave after the Fed has inverted the entire yield curve is either a hard landing or a very bumpy soft landing. Either way, the economy is going to have some sort of a ‘landing,' which is far different than a ‘takeoff.'"

In other words, a recession.

Last time I called a recession was January 29, 2001. Let's compare my Short Term Predictions from then to what actually happened:

"The U.S. economy will experience negative GDP growth for Q1 and Q2 with possibly some moderation in Q3 but no return to positive GDP growth until 2002 at the earliest."

Good call. The US experienced an eight month recession that lasted from March until November 2001.

"Unemployment doubles from 4% to 8% by the end of 2001."

Not according to the Bureau of Labored Statistics, but who listens to them anymore? U9 unemployment was easily 8% by the end of 2001. ShadowStats explains:

"The popularly followed unemployment rate was 5.5% in July 2004, seasonally adjusted. That is known as U-3, one of six unemployment rates published by the BLS. The broadest U-6 measure was 9.5%, including discouraged and marginally attached workers.

"Up until the Clinton administration, a discouraged worker was one who was willing, able and ready to work but had given up looking because there were no jobs to be had. The Clinton administration dismissed to the non-reporting netherworld about five million discouraged workers who had been so categorized for more than a year. As of July 2004, the less-than-a-year discouraged workers total 504,000. Adding in the netherworld takes the unemployment rate up to about 12.5%."

Moving on to the next part of my 2001 recession prediction:

"The discount rate will be reduced to under 4% by December 2001."

There I go with my eternal optimism, again. The discount rate was 4% by April 2001 and by December stood at 1.5%.

"Evidence of a deepening recession by mid-2001 even as rates are cut will cause foreign investors to start to doubt the ability of the Fed to halt the economic contraction. At first foreign capital leaves the U.S. in search of better returns elsewhere. Later, as perception of default and currency devaluation risks rises, capital flows out of the U.S. in earnest."

Half right. Net acquisition of financial assets indeed declined, from just under $1 trillion in 2000 to about $640 billion in 2001. But the percentage of foreign acquisition of assets rose from 45% to 65% of issuance, thanks to foreign central banks that stepped into the breech to keep the US economy afloat. This same pattern repeated from 2004 to 2005, with net acquisition of financial assets declining but the percentage of foreign acquisition rising.

"The fiscal 'surplus' of the past few years will turn out to be due primarily to capital gains tax receipts. As tax payers take capital gains losses against gains in 2001, tax receipts will fall by a greater extent than expected. Tax cuts, blessed by Greenspan last week and enacted to help the economy, will create an enormous fiscal deficit for 2001. The bond market will price this in before the event, driving up interest rates in late 2001 and further stifling capital formation."

Again, half right. The fiscal "surplus" did turn out to be due to stock bubble capital gains tax receipts, and tax cuts did start the run-up of the biggest, baddest fiscal deficit in US history. But long term rates did not rise, as The Three Desperados stepped in to keep long rates down and the dollar up, and kicked off the Housing Bubble in the bargain.

"The first stage of the depression is deflationary, the second inflationary."

This is, as long time readers are no doubt tired of hearing, a reference to the Ka-Poom Theory cycle. The theory states that sooner or later, the US needs to do its own saving, and the rest of the world figures out how to grow without such heavy reliance on US consumption, US financial markets, and US dollars. We had a dress rehearsal, 2000 to 2006, but not the real deal.

From here it looks like the current inflation cycle that Allen Sinai correctly identifies extends out past the elections to the end of 2008, with the recession that the economy is trying to give us, and that Steinberg and others are predicting, put off another couple of years via a period of Mauldin-style muddle through stagflation lite. Then we get the Big Recession that global central banks have been forestalling for decades, with "Ka" disinflation from 2009 to 2011 or so, followed -- finally -- by the Event that Can Never Happen: the dollar repatriation-driven, inflationary "Poom" lasting into 2014 or so.

Keep in mind that much like my January 1999 87% tech stock bubble decline prediction and my January 2005 ten to 15 year housing correction prediction, this prediction may also be optimistic. The bid to put off the long overdue recession via mild stagflation may not last until after the elections, start in 2007 or even sooner, and the whole Ka-Poom cycle might then last only five or six years versus eight.

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[jk]

Re: muddling through

when mauldin discusses muddle through he says he expects 2 recessions or so over the next 10 years, and these recessions are part of his muddling through scenario. it is not clear to me whether his description is really any different than the scenarios discussed here, but with less apocalyptic language. more specifically, he has written things along the lines of "we'll survive", i.e. it won't be the end of the world. on the other hand, when you, e.j., write that the "depression" will first be deflationary and then inflationary the 2 images that come to mind are bread lines in the 30's in the u.s. [for the deflationary part] and money in wheelbarrows in weimar germany [for the inflationary part]. i.e. frightening, near-apocalyptic images.

[EJ]

Re: muddling through

when mauldin discusses muddle through he says he expects 2 recessions or so over the next 10 years, and these recessions are part of his muddling through scenario. it is not clear to me whether his description is really any different than the scenarios discussed here, but with less apocalyptic language. more specifically, he has written things along the lines of "we'll survive", i.e. it won't be the end of the world. on the other hand, when you, e.j., write that the "depression" will first be deflationary and then inflationary the 2 images that come to mind are bread lines in the 30's in the u.s. [for the deflationary part] and money in wheelbarrows in weimar germany [for the inflationary part]. i.e. frightening, near-apocalyptic images.

Coming from you, jk, this deserves a detailed response.

First of all, I know John, had dinner with him a few weeks ago, and we talk from time to time. I have great respect for the man, a very smart, creative, and original thinker.

While we agree on a lot, the differences between our visions are shaped, naturally, by differences in our backgrounds and experience, our methods and objectives, and the starting points and evolution of our thinking as reflected in the history of our respective web sites, and what we've been up to since we started on our respective journeys.

Starting at the beginning, if you go to archive.org, one of my favorite sites on the Web, and type in itulip.com, the first reference you get is this from January 2000:

"Saw an ad on TV today says I can buy a new Pontiac for $20 down, 2.9% monthly rate on the balance. A liquidity-driven boom? Top of a credit bubble? Nah. It's the new internet technology. We're in a 'New Era.' Ha-ha ha ha!"

Pretty goofy. The site started as a parody of a dimwit Internet company. There were thousands around then, so many eager entrepreneur wannabes with dreams of dipping a bucket into the Fed's river of money for their share. I have a hundred business plans in my office closet from the time as I was Managing Director of Osborn Capital. But, at the same time, the site was also issuing serious warnings about what was to come, that the stock market had become a bubble and that the credit machine was starting to run out of control. My thought was, don't hit people over the head with the news, ease them into it with parody. Plus it's more fun.

Do the same archive.org search on John's site and the first thing that comes up is this also from January 1999:

"The Y2K computer bug will affect your investments and the economy. Year 2000 Alert editor John Mauldin outlines how to profit from the Y2K recession."

So, while I was warning folks to get any money out of the stock market they could not afford to lose and to avoid taking on debts that they may not be able to repay, 2000wave.com was warning about Y2K. I took a different view of Y2K. As documented, again on archive.org, in August 1999 I had this to say about it on itulip.com:

"What the heck's gonna go down after Dec. 31, 1999? Do we at iTulip.com envision a world in chaos ruled by tribal warlords marauding the strife torn land in ox drawn Rolls Royces, plundering suburban America for precious caches of bottled water and canned tuna fish? Time to invest in a bomb silo apartment? Nah. After the clocks roll over into 2000, a lot of crappy software that doesn't work very well and breaks all the time will continue to be crappy and not work very well and break all the time."

Which is pretty much what happened.

After that first entry, it's hard to compare the2000wave.com record to what later happened using archive.org because the2000wave.com has set up redirects so you can't see the results. That's not the case with iTulip.com. The whole history is there... the good, the bad and the ugly. Can't preach transparency without practicing it.

So one key difference isn't that I tend to be more apocalyptic, it's that I'm not interested in popular belief. I'm interested in the truth, and this often runs counter to popular belief, especially where there are pots of free money, whether in inflated stocks or cash-out refis, sitting out there apparently free for the taking. I don't think these pots of money are free. We will have to pay for them, one way or another, sooner or later, individually via defaults and collectively via inflation, higher interest rates and taxes. My approach is to develop hypotheses -- the tech stock bubble in 1998, Ka-Poom Theory in 2000, the rise of gold in 2001, the housing bubble in 2002, the "seize up" theory of the housing bubble end in 2004, the 15 year housing correction in 2005, and so on -- and beat the stuffing out of a hypothesis over time until I reach the point that I'm sure it's is correct, at which time I'm prepared to say: "This is what is going to happen."

This process is not what most people want to experience. They want to be told what they want to hear, to have their hopes and fears played back to them, such as that the gold they bought will protect them from a Y2K recession. The concept of a "Muddle Through Economy" is a very thoughtful and reasonable hypothesis of our economic future. Economic and political muddling is what usually what happens. Japan has been doing it for nearly 15 years. We did it in the 1970s until Volcker took us down a distinctly non-muddling path. But the Muddle Through Economy is also a brilliant marketing message because it appeals to a very broad range of viewpoints and personalities (read: big market of newsletter readers).

I don't think we're going to get to muddle through this time. I don't think we'll be able to. Not this time. Not through this crisis. The most unique feature of the coming crisis is that it will be, well, surprising and unique. The job of trying to characterize it, never mind time it, is therefore very challenging, and the process of shaping the Ka-Poom hypothesis to be as predictive as others of my hypotheses will no doubt bore many people to tears. That, together with the message that we are going to experience a severe event is a turn-off to all but the most intellectually patient with strong stomachs. That means iTulip.com will likely never be as commercially successful as John's or many other sites.

I don't need to make much money at this, so I don't really care about its marketability. I sold all my Cisco and other tech stocks in 2000, sat in cash for a year then bought a pile of PMs in 2001, as anyone reading the site knows. I didn't continue to run iTulip.com after the crash and during the recovery but instead raised $30M and ran two VC backed companies. I restarted iTulip.com in March 2006 at what I perceived to be a new peak of complacency and risk in the markets. I want to understand what's going on and what's going to happen, and we don't have a lot of time.

To me, and for those of you who stick with me through the next while, the payoff comes not from selling messages along the way but from getting to the truth. That's the key difference between itulip.com and other sites. If that truth evokes images of future potential severe hardship by US standards, we should not turn away from these images because they appear unseemly, but neither should we fixate on them because they are compelling. They may in fact be innacurate. But we need not look too far in time or distance to see far worse circumstances than we are likely to find ourselves in here in the West, worst case, compared to the fate of so many people on this troubled planet. Just open the newspaper. How often do you do so any given day and ask, There but for the grace of God...?

And what if we should fall from grace, through neglect, greed, ignorance, arrogance, entitlement, laziness, corruption, lack of sound leadership, lack of accountability? Let's face it. For so many years we've been more or less on our hands and knees begging for a fall from grace for these reasons. So "muddle" is not the operative word for our economic and political future, in my mind. The operative word is "fight." We need to fight our way back to justice, honesty, compassion, thrift, hard work, fairness, security, and I have no reason to believe that this will be easy.

[Jim Nickerson]

Re: muddling through

And what if we should fall from grace, through neglect, greed, ignorance, arrogance, entitlement, laziness, corruption, lack of sound leadership, lack of accountability? Let's face it. For so many years we've been more or less on our hands and knees begging for a fall from grace for these reasons. So "muddle" is not the operative word for our economic and political future, in my mind. The operative word is "fight." We need to fight our way back to justice, honesty, compassion, thrift, hard work, fairness, security, and I have no reason to believe that this will be easy.

Excellent, EJ.

To paraphrase you, my opinion is: America needs to fall from grace because as a nation we epitomize neglect, greed, ignorance, arrogance, entitlement, laziness, corruption, lack of sound leadership, and lack of accountabilitily. The operative words are "need," "force," and "fight." If this country is ultimately to survive, we need events dire enough to unequivocally force us to fight out way back to fully embrace the values of justice, honesty, compassion, thrift, hard work, fairness, security, and a sound political system.

Without something relatively terrible occurring to reset the value system of a majority of Americans, I see no hope for us as a nation that can continue in any manner on a path similar to the one on which we now are.

[BK]

Re: Fall from Grace - what was the least corrupt period for the US?

So, the idea that the US (or any county) becomes a more honest society after a fall from grace begs the question "when was there a period of time in US history that was more noble and less corrupt?"
I think the idea that a fall from Grace leads to a less corrupt society is a bit too Utopian for me.

I love history and corruption has been with the US for a long-long time. Ben Franklin frabricated news interesting stories to sell newspapers. The Kennedy Camelot story is built on a foundation of boot legging and stock market manipulation.

So, what period of US history do Itulip readers believe was the least corrupt in the US History.

I firmly believe the US has done more good than bad in the totality of our history (just an old fashioned patriotic guy). But, even the best society will routinely vote bums into office.

[lobodelmar]

Re: The productivity watch: The nirvana of high growth and low inflation may be over

EJ, Thanks for writing such thoughtful pieces about so many issues, and even just explaining like you just did about why you brought iTulip back. I for one am glad that there is someone out there who isn't solely interested in profit by himself, but is also interested in helping others learn how and why things are happening in the financial world. As a VC, I am sure you had plenty to focus on, rather than starting this forum up again.

You'd think that business school professors might take a lesson or two from this type of discussion...but it is still all "efficient market theory", all the time.

[jk]

Re: The productivity watch: The nirvana of high growth and low inflation may be over

To me, and for those of you who stick with me through the next while, the payoff comes not from selling messages along the way but from getting to the truth. That's the key difference between itulip.com and other sites. If that truth evokes images of future potential severe hardship by US standards, we should not turn away from these images because they appear unseemly, but neither should we fixate on them because they are compelling. They may in fact be innacurate.

thank you for your response.

i am trying to separate data [in this case, predicted data] from language. i think people who are thoughtful about various issues will often use different language to describe [aspects of] the same phenomena. so it is important, for me at least, to ask whether people are really saying different things or just using different language to describe the same things.

i personally find apocalyptic images all too compelling - whether from congenital bearishness or from listening to my parents stories about the depression. i've been waiting for a severe event in the economy since about 1981. seriously. that didn't prevent me from being leveraged long from mid1982 [after the breakout] to mid 1987, but it kept me out of equities for some time after '87 as i waited for the other shoe to drop. [it never did.] so i have to be careful of my own attraction toward drastic scenarios.

what kind of scenario do you imagine that mauldin won't call muddling through? i figure it has to be worse than the double recession of 1980-82 in order not to be just muddling. it has to be worse than japan for the last 15 years - but that shouldn't be hard with our levels of debt.

as i understand it, your model, e.j., is a stagflationary muddle, followed by a feint toward deflation followed by severe inflation. bill fleckenstein thinks that inflation is in the immediate future and will preceed any possible deflation. richard russell says the fed must "INFLATE OR DIE!", but this is because of a deflationary undertow implicit in all the debt.

i think we can't predict. hypothesis generation is important, however, in generating scenarios that allow us to think about alternative futures. and then we place our bets based on the probabilities we assign to the alternatives. and we must constantly reassess our models, and re-evaluate the probabilities, as new data comes in.

And what if we should fall from grace, through neglect, greed, ignorance, arrogance, entitlement, laziness, corruption, lack of sound leadership, lack of accountability? Let's face it. For so many years we've been more or less on our hands and knees begging for a fall from grace for these reasons. So "muddle" is not the operative word for our economic and political future, in my mind. The operative word is "fight." We need to fight our way back to justice, honesty, compassion, thrift, hard work, fairness, security, and I have no reason to believe that this will be easy.

amen

perhaps the saving grace of such a process is that it opens up the possiblity and the hope of cutting through the neglect, greed, ignorance, etc. i strongly agree with your assertion that only a financial crisis will force us to address these problems. i hope we don't blow it.

[Finster]

Re: The productivity watch: The nirvana of high growth and low inflation may be over

AntiSpin: Takes the mystery out of comments today from Chicago Federal Reserve President Michael Moskow who's joining the Lacker choir saying that higher inflation risks outweigh concerns about slower economic growth. This begs the question, does the Fed really have a choice between the two? Not really, but Wall Street hasn't figured this out yet, and the suggestion that the Fed might have to tighten some more someday caused the usual knee-jerk reaction in the markets, it sent stocks into the red from a minor rally earlier in the day. Some day stocks will decline for the right reason, with a full comprehension of structural inflation and all that entails... but not yet.

Same old flawed Philips Curve mentality. Despite the fact that the past three decades have empirically demonstrated beyond all reasonable doubt that inflation and economic growth are not choices that the Fed must face, the Fed (and Wall Street) continues to pretend they are. When it comes to expanding money and credit, the only differences between inflation and growth are the phase of the economic cycle and the statistics you focus on.

Creating money never has and never will create wealth. All the Fed can do to support the latter is try and keep the value of the dollar stable and inflation low, and rest will do what it will do regardless.