Boom, Gloom and the New Normal

US subprime lending was the starting point for the economic crisis now spreading around the world. The blog believes a key cause was policymakers refusal to accept that the ageing of the BabyBoomers (those born between 1946-70) would cause a major change in demand patterns.

Instead, they have continued to believe that underlying levels of housing demand are the same today as in 1970-2000, when the Boomers were settling down and having children. Their idea is that ‘housing demand is a constant’. They will not accept that ageing Boomers no longer need to buy new homes to house growing families.

Thus Fed Governor Sarah Bloom Raskin set out their thinking this week:

“The conventional tool of monetary policy is to modify the near-term path of interest rates…. This policy accommodation also tends to raise household wealth by boosting the stock market and prices of other financial assets. With greater household wealth and cheaper borrowing rates, consumers tend to increase their purchases of houses, cars, and various other goods and services.”

Yet the chart above, based on US Census data, clearly shows that the policy has failed:

• Housing starts (purple) and building permits (red) remain well below anything seen since statistics began in 1959.
• Starts were just 571k in August, and permits only 620k.

This surely represents a generational shift in demand patterns.

Any scientist or engineer, faced with this situation, would re-examine their assumptions. They might well, like the blog, notice that a record 25% of the US population is now over 55 years old. Just 17% were in this cohort back in 1950. And the percentage is rising by 1% every 5 years.

Equally, this refusal to consider other factors is creating great pain for more and more Americans. Their equity in their homes has declined 54% since 2006 from $13.5trn to $6.3trn. 1 in every 5 Americans owes more on the mortgage than the home is worth.

We are now moving into Budget period for most companies. The blog believes it is vitally important that they include their own assessments of the outlook. It fears that the global economy is increasingly threatened by these failed policies.

• On Tuesday, it will outline a 4-point Action Plan for companies to review
• On Wednesday, it will propose 4 key Scenarios for discussion
• On Thursday, it will highlight 5 Critical Success Factors, to help guide implementation plans.

Sadly, it is becoming clear that we cannot rely on wise and far-seeing policymakers to guide the global economy in the right directions. In turn, this may mean that we all need to prepare for increasingly turbulent times ahead.

The blog’s Boom, Gloom and the New Normal eBook highlights the impact of the ageing Western babyboomers on future demand patterns.

Yet central banks such as the US Federal Reserve and the European Central Bank believe demographics have nothing to do with demand. For them, as one former central banker told the blog “demand is a constant”.

They have invested years of effort, and $millions, in developing complex mathematical models of demand. The algebra behind these is the equivalent of the alchemists’ search for the philosophers’ stone, as shown in the example above from a May 2006 Fed paper .

But a mathematical model based on algebra cannot replicate human behaviour. Therefore the modeller needs to believe that human nature can safely be ignored as a input into the model.

Any reader who doubts this argument might like to read the latest speech by US Fed chief Ben Bernanke. It analyses the background to today’s economic weakness. And it then goes on to ask the critical question, “Why has this recovery been so slow and erratic?”

It answers this question by referring to the idea of ‘pent-up demand’.

This concept is a cornerstone of economic models, and was developed during the babyboomer-led supercycle, when interest rate changes really did lead to temporary ebbs and flows in demand for housing, autos etc:

• Higher mortgage rates led boomers to postpone major purchases
• Their demand quickly revived when interest rates were reduced
• Meantime, more boomers had also entered the 25-54 age group
• So the release of pent-up demand was even greater

The Federal Reserve and the European Central Bank have not changed their models since the end of the supercycle, to reflect changing demographics. So they believe that the same level of demand for housing, autos etc, still exists today.

On this basis, they have assumed that more buying of near-worthless Greek bonds, or more liquidity via a QE2 programme to boost financial markets, will ensure economic recovery in the end. They are sincere people, but the blog believes they are terribly wrong in this assumption.

As John Richardson, the co-author of Boom, Gloom and the New Normal has commented:

“If you’ve spent your whole career – and built your whole reputation – on pushing a particular model it must be really hard to stand back and say, ‘Wow, I’ve been wrong for the last few years and everything has changed’.

“We also need to get past our own self-doubts, as it is really difficult for anyone less academically qualified than them (which is 99.9999% of us) to imagine that they could be wrong”.The need to challenge the power of the models is urgent. Until this happens, the global economy will get worse, not better.

Alchemists have always claimed to be able to perform the impossible. The most common claim was that they could turn lead into gold.

In Europe, the European Central Bank has been trying the same trick. It claimed to turn near-worthless Greek bonds into German-quality euros.

Now its German board member Jürgen Stark has followed German Bundesbank president Axel Weber in resigning over the issue. The reason is obvious:

• The ECB action can only work for a short period. Greece, as the blog has argued since May 2010, will never be able to pay its bills
• Germany will then end up paying the bill, when it is finally agreed that lead is not gold.

The ECB has made a major mistake by becoming an alchemist. It has lost support within N Europe, which adds to the political issues now surrounding the fate of the Eurozone itself.

Across the Atlantic, the US Federal Reserve also became an alchemist when it launched its $600bn QE2 programme. As the blog has noted over the past year, this aimed to prove that liquidity was the same as capital.

Printing money can provide liquidity to financial markets. But it cannot repair the balance sheet in the housing market. As with Greece, banks that lent capital unwisely will not be repaid.

And just as in Europe, two Fed Governors, Charles Plosser and Richard Fisher, have rebelled against Fed policy. They argue that the Fed’s focus on supporting the stock market has done nothing for the real economy.

Tomorrow, the blog will look at the key issue of why the two most important central banks in the world have made such similar errors of judgement.

A recession is often defined as being when your neighbour loses their job. A depression is when you lose your job.

Latest industrial production data shows output is falling around the world. And US unemployment is rising again, with the wider measure at 16.2% as long-term joblessness becomes a major problem.

Last month’s IeC Boom/Gloom Index suggested that financial markets were “on the edge” of a renewed recession, or worse. The Index had fallen to its lowest level since the US Federal Reserve ‘rescued’ financial markets last year with its QE2 liquidity programme.

This did more harm than good in the real world, by boosting oil and commodity prices, and thus destroying end-user demand. Now all of us, just as the blog feared back in October (when QE2 began), are having to live with the consequences of the Fed’s mistake.

Even stock markets are becoming worried, as this month’s Index (blue column) shows. It reflects the sharp change in sentiment since May, and is now back to the recession levels of 2008-9. Similarly, the S&P 500 (red line) has lost momentum, and is clearly slipping.

The fundamentals are also looking worse, as the politicians posture over Eurozone bailouts and the US debt position, and avoid the hard decisions. Whilst China’s stimulus-induced inflation remains far too high for comfort.

The odds on a new recession are therefore clearly shortening day by day. As Deutsche Bank head Josef Ackerman warned yesterday, “‘The new normal’ is characterized by volatility and uncertainty. All this reminds one of the fall of 2008.”

The failure of GDP in most Western economies to recover 2007 levels means this could quickly become a depression, despite (or perhaps because of) the $trns spent on global stimulus programmes.