Okay, we made up the word. But in medicine, as any physician knows, a blastoma is a malignancy of so-called precursor cells called blasts. Should such an anomaly go untreated…well, let’s not go there. Anyway, we decided to refer to any chronic economic conditions that threaten the health of our economy as econoblatomas, because of the real risk that they are precursors to a potential economic crisis; that is, they can spread. What follows are what we call the Seven (there are, of course, others) Warning Signs of Econoblastoma.
1. The Euro – A default by any other name:
Greece will default on its debt, probably within the next 60 days. They’re working on a plan that will allow the EU leaders to call it something else, but whenever lenders get taken to the cleaners by a borrower there has generally been a default. Greece’s lenders (bond holders) are soon to be taken to the cleaners (again) so we’re about to see the first default in a Euro Zone country. Now this Econoblastoma has been under treatment for a long time with, we’re sorry to say, poor results. The prognosis is dire.
The reader will recall that over a year ago, the private bondholders who loaned money to Greece (based on fabricated economic assurances by the Greek government) were informed they would have to take a 20% haircut in order for Greece to meet its obligations. Then last July the bondholders were told that 20% just wouldn’t do it, and that a 50% haircut would be required. Now the bondholders are being told, “fifty percent?” well, “that was okay for starters,” but it’s not nearly enough to treat this particular Econoblastoma.
No, it seems the cure for years of Greek profligacy will require that the holders of about $206 billion in Greek bonds will have to swap them for bonds that will pay, upon maturity, 60% less.
And, oh yes, that maturity date will have to be strung out somewhat longer too. And, did we mention, Greece wants the interest rate they will have to pay to be reduced to something under 4%, like maybe 3.5%. Now, that’s within 375 basis points of what the United States of America pays for its long bonds. And, to complicate matters more, the private creditors are insisting that if they have to take a 60% haircut (or more) than it is only fair that the public bondholders (think European Central Bank) take the same haircut. “It would be outrageous if the ECB doesn’t take part as keeping their Greek bonds to maturity would allow them to make a profit, while everybody else is taking 70 percent (losses) or even more,” one source close to the talks said. To complicate matters even more the ECB is demanding greater austerity commitments by Greece, many of whose elected officials are facing elections in the spring.
Now, the real concern isn’t about the fate of Greece. After all, Greece’s entire GDP is about the size of one major American city. The reason Greece is creating such heartburn throughout Europe and, yes, here in the United States, is that if the coming default get’s sloppy, as we believe is likely, an entire gaggle of EU countries could see their cost of borrowing go through the roof as Portugal is experiencing as we write this essay. That’s why the EU is cobbling together the biggest “firewall” it can. What does all of this mean? It means that the recession into which Europe has really already descended could rapidly deteriorate into an economic depression and that would have severe implications for America given the importance of Europe as the leading destination for American exports.
2. Declining Job Creation
This is the symptom we most want to avoid. Job creation ticked up nicely at year’s end and that’s good. Net job creation is a far more important indicator of economic recovery, or lack thereof, than the monthly unemployment claim data on which the media tends to focus. People taking poor jobs or multiple jobs just to make ends meet, or people who just throw in the towel and stop looking may lower the claims for unemployment compensation in a given month, but it doesn’t tell us much about the health of the economy. Job creation data, however, do. According to the Bureau of Labor statistics, 2011 ended with 200,000 new jobs created in the month of December. That was encouraging, but whether it can be sustained month after month is questionable.
According to economist Nouriel Roubini of New York University’s Stern School of Business and Chairman of Roubini Global Economics, US job growth is still too mediocre to make a dent in the overall unemployment rate and on labor income. The US needs to create at least 150,000 jobs per month on a consistent basis just to stabilize the unemployment rate. More than 40 percent of the unemployed are now long-term unemployed, which reduces their chances of ever regaining a decent job. Roubini also notes that firms are still trying to find ways to slash labor costs in order to stay competitive and grow their companies.
While the trend has been in the right direction, the average seasonally adjusted number of jobs created per month last year was below Roubini’s estimate of what it takes just to break even. Monthly Job creation is, perhaps, the most critical measure of the economic health of the country. We’ll closely watch this indicator.
3. A Decline In US Exports
Our exporting industries are vital to the American economy, accounting for somewhere around 11% to 12% of our entire GDP. We are the world’s leading trading nation although we import considerably more than we export. Our goal, of course, is to sell more (abroad) than we buy. While that is a goal we rarely achieve, a sustained net decline in exports will most certainly have a negative impact on the American economy. As 2011 came to a close the United States was experiencing a decline in new orders for durable goods and that was probably a pretty reliable sign that Europe’s slowdown has begun to affect the U.S. economy. While, overall, exports dropped 0.9%, exports to Europe fell more sharply — nearly six per cent. We believe Europe is in major trouble and the odds are that things will only get worse in the short to medium term, which will cut demand for American-made goods. Europe accounts for about 20% of all U.S. exports, so the mess in Europe (Euroblastoma #1 above) is also a mess for us. A decline in exports translates to a decline in US economic growth. Less production at factories and weaker revenue for U.S. companies obviously means a weaker US economy.
4. More Quantitative Easing
Quantitative Easing is a euphemism for printing money in order to buy US debt, which, in turn, keeps the nation’s cost of borrowing down…at least temporarily. When the Federal Reserve steps in and buys US debt at auction it creates what we think is pseudo demand for our debt. Given the uncertainly about future demand for European sovereign debt, there may be no other place for bond holders to go, assuming they place a high priority on preservation of principle, so there may be no need for further Quantitative Easing. There are three reasons to keep interest rates unrealistically low. First, easy money generally stimulates an economy and our economy still needs plenty of stimulating (although not way the government chooses to stimulate the economy). Second, the government really can’t afford to pay higher interest rates on its debt and, finally, and somewhat cruelly, it forces almost everyone to take greater risks. This causes generally conservative fixed income investors to turn to riskier equity investments, driving up the price of equities thereby generating an aura of wealth creation. Unfortunately, our past experience with Quantitative Easing suggests that the price of commodities will also rise driving up the cost of many essentials. Talk about Voodoo Economics.
5. Bond Vigilantes Turning the Tables On The Fed
The Fed doesn’t quite have the free hand many politicians think it has. It is true that, so far, Quantitative Easing has created enough demand for our debt to keep down the government’s borrowing costs. The ECB has been practicing it’s own version of Quantitative Easing in Europe and we’ve still seen great volatility in borrowing costs among troubled Euro Zone countries. In other words, when bond purchasers dig in their collective heels and stay home when sovereign bond auctions take place, they send a sudden and drastic message. They become bond vigilantes and they can and have forced up interest rates.
The United States has already had its debt downgraded by Standard & Poor’s, and should the bond vigilantes decide they deserve a greater return for the risk they take when lending to the United States the results could be catastrophic given the fragility of our economy.
For the time being, US Treasuries are a hot item with a $15 billion auction of Treasury Inflation-Protected Securities (TIPS) this month drawing the strongest demand in nearly a year even though yields on the notes average less than zero percent for the first time. Yields on all types of Treasuries are at or near record lows and, except for the 30-year bond, provide negative real returns net of the Consumer Price Index. Given the paucity of fixed income alternatives, we do not see Bond Vigilantes lurking in the shadows, but it would be a very serious precursor of serious trouble ahead should they awaken from a long slumber.
6. A Decline in Consumer Spending
When all is said and done, if the American consumer won’t buy, the American economy won’t grow. The fourth quarter, which started out with a bang ended with a whimper, with December sales much weaker than expected. The Wall Street Journal reported that sales all but stalled in December increasing only 0.1% from November. December sales were driven by deep retailer discounts and the strong sales for the fourth quarter overall were a significant draw on consumer savings. Spending at retailers sagged each month as the quarter progressed. It is expected that much of the first half of 2012 will see reduced spending as consumers replenish their savings. A steep decline in consumer spending will be a severe blow to our recovery hopes, and the current politics of envy, whereby the Administration targets for tax increases the so-called 1.0% who happen to pay nearly 40% of all federal income taxes is, in our judgment, very ill-conceived.
Conventional wisdom and generations of experience teaches that a surplus of money in the economy will, sooner or later, result in inflationary price increases. Inflation, would, of course, torpedo any hope of economic recovery. Those on the left who advocate robust and muscular spending initiatives argue that we needn’t constrain government spending because the beast of inflation hasn’t raised its head. That seems akin to a physician counseling a patient that there is no reason for him or her to stop smoking because there seems to be no evidence yet of lung cancer. We would counsel such a patient to change doctors.
By Hal Gershowitz and Stephen Porter