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Are We There Yet?

Driving with No Spare

A Muddle Through Economy

Absent a Policy Mistake

Maine and Turks, Etc.

By John Mauldin

[this economic condition] has been brought about by policies whichthe majority of economists recommended and even urged governments to pursue.

We have indeed at the moment little cause for pride: as a profession we have

made a mess of things.

Friedrich August von Hayek, Nobel Speech 2010 1974

Those of us who have taken young children on long road trips to somewhere they

wanted to go are familiar with the plaintive question Are We There Yet? As a nation

and indeed the developed world, it is not unreasonable to be asking Are We There Yet?about the road to recovery. The NBER, those self-appointed economists who are the

official keepers of the score sheet of recessions and recoveries, have yet to tell us we areout of recession. Yet the economy is growing. Kind of. Today we look at the most recent

data on second-quarter US GDP (which came out this morning), and even though it isbackward-looking data, well see what we can discern that might help us chart the

direction of the future. And then, if there is time, Ill highlight what is a very serious andgrowing problem for our state and local governments. There is a lot to cover and so, with

no but firsts, lets dive in.

Are We There Yet?

The economy of the US grew at a weaker than expected 2.4% in the secondquarter, but the first quarter was revised back up to 3.7% on the strength of stronger-than-

projected inventory rebuilding. But the recession years were revised downward rathersignificantly for this late in the cycle. We find now that the recession was worse than we

thought, taking the economy down a total of 4.1% during the recession. As of today, weare not quite back to where we started, still down 1%. That means it is quite possible that

we could finish the year and still not be there yet. (To see a 1% rise in GDP we wouldneed to see a 2% annualized rise for the rest of the year. Well look at that possibility in a

few paragraphs.)

Lets look at a few charts courtesy of the Dismal Scientist, atwww.economy.com.First, recent GDP numbers:

http://www.economy.com/http://www.economy.com/http://www.economy.com/http://www.economy.com/

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If this were an average recovery, the economy would be growing at a 6% rate at

this point, which pretty much says it all about our current 2.4% number. Further, 2.5

years after the beginning of a recession, we are typically already 8% higher than the priorhigh. This is a very tepid recovery, indeed.

Now, lets look at the actual numbers.

There is a category called Final Real Sales you can create by subtracting the

inventories number from the real GDP number. That reveals that final real sales grew by1.3% last quarter. This is against what is normally a 4% number this far into a recovery.

Is it any wonder that small businesses are asking When will we get there?

Next, look at the contribution from fixed residential investment. It has beennegative or flat for six of the previous seven quarters. This time it added 0.6% to last

quarters GDP. But the housing market is lousy. What gives?

It seems that the housing tax credits induced home builders to increaseconstruction by an annualized 28% last quarter. That was in spite of there being 18.9

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million homes vacant in the US (an all-time high), and the number of foreclosures risingby as much as 100% in some cities. (Hat tip: David Rosenberg)

Lenders are accelerating foreclosures as borrowers fall behind in mortgage

payments after the worst housing crash since the Great Depression. A record 269,962 US

homes were seized in the second quarter, according to RealtyTrac Inc. Foreclosuresprobably will top 1 million this year, the Irvine, California- based data company said in a

July 15 report. (Daily Reckoning)

Ownership rates are falling and heading back to more traditional levels. Mortgage

delinquencies are rising as the unemployment level stays persistently high. It is my guessthat residential real estate will not contribute much if anything to GDP this quarter.

What about inventories? That has been a strength the last few years, adding a lot

to our national growth. But inventory-to-sales ratios are at an 8-month high, whichsuggests that businesses may back off from increasing inventories at the recent pace.

Government spending? The bulk of the stimulus programs are going away in the

latter half of the year, especially those that benefited state and local governments.Governments are slated to cut back spending or raise taxes by almost 1% of GDP. As

many as 500,000 government employees may lose their jobs.

On a positive note, fixed nonresidential investments were the best they have beenin several years. Lets hope that businesses keep it up!

A Muddle Through Economy

All that being said, if we take away housing and project slower inventory growth

and less government spending, we could see the GDP number for this quarter fall to the1% range and stay there for the rest of the year. Even the normally bullish Economy.com

suggests that growth will be sluggish in the last half of the year. All in all, the verydefinition of a Muddle Through Economy.

Until we start to see a real rise in employment, it is hard to get too enthusiastic.

Everyone seems to be happy that initial claims have come down from their highs. Butthey have gone sideways for almost a year. Lets look at two charts. First, the last five

years of initial claims.

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Then a chart (courtesy of Bill King) which shows that continuing claims are at

levels typically associated with recessions. This is not the stuff that V-shapedrecoveries are made of.

Driving with No Spare

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I was on CNBC and Fox this last Thursday to talk about deflation. On CNBC Iwas side by side with my good friend Paul McCulley. It is no secret that Paul is a rather

liberal Democrat. He is all for increasing taxes on the rich. This spring he told me at myconference that tax increases on the rich do not have the same multiplier as those for

everyone else, and so therefore taking the Bush tax cuts away will not threaten the

economy. I, of course, think it will.

I called Paul up to chat before we went on together. I was quite surprised to learn

that he now thinks the Bush tax cuts should be extended for maybe another two years.

Why? We are both concerned about an unwelcome bout of deflation stemmingfrom lack of final demand (as opposed to falling prices from increased productivity).

Look at the graph below. Notice that prior to the beginning of the last recession inflationwas running at a 4% clip and actually rose to above 5% before falling to a minus 2% and

then rising to almost 3%. Since the beginning of the year, as the economy has softened,inflation has been steadily falling and is now at 1%. If the economy continues to falter,

one would suspect that inflation could fall even lower.

Ifthe economy were to tip into a recession with inflation so very low (or even

near zero at the end of the year), the results could be very toxic. As Pauls colleague andmy friend Mohamed El-Erian writes, we are driving our economic car without a spare

tire. If we were to go into a deflationary recession, there is not much that governmentcould do. Our deficits are already at dangerous levels, and a recession would mean that

tax collections would fall further. The Fed has some policy room, but it is of a varietythat has not been tried for a very long time. Frankly, we cannot be sure of the unintended

consequences.

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One of the guest hosts on Fox informed me that double-dip recessions are veryrare things. And I agree. Absent a policy mistake it should not happen. But increasing

taxes to the level that is now contemplated, along with spending cuts and tax increases atthe state and local levels, is a very dangerous experiment with the economy being as soft

as it is.

Absent a Policy Mistake

The key words are absent a policy mistake. If the economy is growing at 3%and inflation is over 2%, if a majority thinks that taxes should be raised, then so be it. We

would survive. But raising taxes in January is an experiment on our economic bodywithout benefit of anesthesia.

Mark Haines (host at CNBC) rightly pointed out that there is a lot of sentiment for

reducing the deficit, and was I against reducing the deficit? The answer is no. But Iwant to do it with spending cuts and spending freezes until the economy is more vigorous

and inflation is above target levels. And then lets see what Obamas tax commissioncomes up with in December.

This is a variant onPascals Wager. The losses are very large if we fall back into

recession: Increased unemployment on top of already high levels. Reduced tax receipts.A very sick stock market. The world will suffer from our reduced demand. The cost to

prevent that outcome? We forego a few hundred billion in the next year against thedeficit.

One last thought. The correlation between CPI and M2 has risen to -.85 in the last

15 or so years. M2 is continuing to fall, as is the velocity of money. Just one more reasonto wait until there is clear evidence of a real recovery.

http://en.wikipedia.org/wiki/Pascal%27s_Wagerhttp://en.wikipedia.org/wiki/Pascal%27s_Wagerhttp://en.wikipedia.org/wiki/Pascal%27s_Wagerhttp://en.wikipedia.org/wiki/Pascal%27s_Wager

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Ok, one more last thought. One of the guys on Fox (you cant see who, in a

remote studio) said we shouldnt worry about inflation because corporate profits aredoing well. Really? That seems to be the bull argument everywhere for everything. Look

at the above chart. Corporate profits have been rising as inflation and M2 have been

falling, as bank lending is imploding, as capacity utilization is at recession-era levels,unemployment is outrageously high, savings rates are back up to 6% (see below), andconsumer spending is abnormally weak compared to what it should be after a recession.

When those corporate profits start turning into jobs, when we can see pricing

power in the markets, then we can possibly say that there is a correlation between profitsand inflation.

Maine and Turks, Etc.

I fly to Minneapolis on Sunday for a speech on Monday morning, then back to

Dallas that afternoon. On Wednesday I fly with my youngest son, Trey (16), to NewYork. Larry Kudlow is planning on working me into the show on Wednesday, so watch

or hit your record button. Then Trey and I are off to Maine for the annual Shadow Fedfishing trip hosted by David Kotok. This year Bloomberg will be covering it on Friday.

Then its back to NYC on Sunday for some meetings, on to Washington DC for aTuesday consulting gig for the Defense Department, and then down to Miami and off for

five days to the Turks and Caicos with Barry Habib and his family.

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I am still working on the book, and we will have a full rough draft in the next fewdays. I am very happy with the way it is coming together.

Some of my readers know that every year for the last four years Trey has caught

more fish than I have. That is a little frustrating. This year, one of my readers has sent me

some special hi-tech lures. If they work, I will give you a link. Maybe Dad can finallycome into camp without Trey bragging about how much better a fisherman he is (whichis unfortunately true).

It is time to hit the send button. Have a great week.

Your hoping for lots of tight lines analyst,

John Mauldin