Part I: Is This Recovery? Where Are We Going and Why?

Jeff Harding:  There is a lot of good news to buoy the markets and give cheer to the public. We hear that new jobless claims are down another 15,000 to 358,000, the ninth week of declines out of the last ten, finally breaking below the 400,000 mark. A reduction in unemployment is a very positive sign and is politically significant. Also Gallup released its latest economic confidence poll and it is up to -20, the highest in 12 months, a very solid gain from the -54 score in August and September.  We heard as well that Greece may qualify for another round of funding to stay default (we are very skeptical of that). And, the S&P is very close to its 52-week high.

There is more. The official CPI was up 2.4% last year, a very modest and tolerable amount according to the Fed. Markit reports that the combined U.S. ISM manufacturing and non-manufacturing indices were up from 56.4 in December to 58.9 in January, hitting its highest level since March of last year. New orders in both surveys were up significantly. These data were backed up by reports of durable goods orders and factory orders. Data from many of the regional Feds confirm this.

Personal income increased 4.7% in 2011 versus an increase of 3.7% in 2010. Real disposable personal income (DPI) increased 0.9% compared with an increase of 1.8% in 2010. Real personal consumption expenditures (PCE) increased 2.2%, compared with an increase of 2.0% in 2010. State tax revenues increased 6.1% YoY according to the latest report.

What possible could go wrong?

Are we in a recovery or not? This article will deal with this issue. I will briefly recap how we got here and the problems we need to overcome before we can call it a recovery. I will look at the reasons behind our current positive data. And then I will compare the current data to see where we are.

What is holding back recovery?

Economic recovery is quite simple when you think about it: bad investments and their supporting debt need to be liquidated. These bad deals are called “malinvestment” and our recent housing boom left huge piles of them for us to clean up. Think of it as the detritus of bad economic policies that led to bad business decisions. Massive amounts of capital (consisting of real and fiat “paper” capital) were lost during the resulting bust and there is nothing anyone can do about it. Keeping bad deals alive only serves to trap valuable capital into unproductive assets and delays recovery. New capital must be created through real “organic” production to get the economy going again.

The biggest piles of detritus to clean up before the U.S. economy can recover are:

  • The asset and capital structure of our local and regional banks, mostly as related to real estate loans;
  • The debt of small business owners, especially in relation to commercial real estate holdings;
  • The debt of households in relation to home mortgages, student loans, and consumption-related debt.

All of the above have been important contributors to the stagnation of our economy. And all of the above, except student loans, have to do with real estate.

There certainly are other major issues this country needs to deal with that will also affect economic recovery. Those issues are political in nature and will depend in large part on the outcome of the 2012 elections. They are our budget deficit and huge national debt, tax policies, social welfare entitlement programs, and regulations which negatively impact capital formation and business expansion. These issues are not within the scope of this article but we have discussed them frequently here at The Daily Capitalist.

There is one further policy matter that is political in nature and that will impact the economy, and that is Fed policy which I will discuss.

Will consumer spending drive the economy?

Most economists and analysts point to the lack of consumer demand as being the economy’s greatest hurdle, but that is a symptom of a serious underlying problem rather than the cause. The cause is what Austrian theory economists call a lack of “real savings” (real capital). That lack occurs because, as noted above, the boom-bust business cycle, which we are still in the midst of, destroyed huge amounts of real capital/savings. (Household wealth declined by $10 trillion, for example.) We need real capital in order to have new production; without it, the economy stagnates.

To get production going manufacturers need to buy capital goods and commodities in order to make things. If they haven’t been produced and you have a fistful of fiat dollars, then there is nothing to buy and nothing to produce. If we could print real savings we would already be in recovery which tells us that fiat money, the stuff that the Fed creates out of thin air, is not real wealth. Real savings can only come from the production of things that consumers, or the manufacturers of consumer goods, want. Profits saved from such production or from saved wages of workers employed to make such goods, is real capital/savings.

The bottom line is that if we had enough real capital/savings, we would have already recovered. The fact that we haven’t recovered means that we don’t have enough real capital/savings. Flogging the consumer to spend will only impoverish the consumer and destroy more capital. Consumers need to save, not spend.

Will manufacturing drive the economy?

Manufacturing is an important part of our economy, but not as important as it was. The production of goods represents only 24% of the economy (services are 47%). There is no question that recently manufacturing has been improving. It is being driven mainly by manufacturing exports and auto sales.

What is causing this?

There are two parallel functions occurring that are giving rise to the current good economic news. One is the natural forces that cause an economy to recover. The other is the Fed’s policies to devalue the dollar and keep interest rates artificially low.

When I refer to “natural forces” causing a recovery, I am talking about market forces such as the liquidation of debt related to malinvestments, the devaluation of those malinvestments, and the formation of new real capital/savings. It is occurring naturally, often despite government policies, and is clearing the way for new production. But I believe it has been a very slow process and has not been sufficient to cause most of the positive economic news. I will discuss this in some detail in another article coming soon.

Much of the recent good economic news comes as a result of the Fed’s cheap dollar policy. It does two things to stimulate manufacturing:

First, fiat money devalues a currency. This is obvious to us as we look at a constant positive inflation rate and the decline of the dollar in relation to most other currencies. That devaluation makes U.S. goods appear to be relatively cheaper on foreign markets and stimulates demand for them.  Thus a cheap dollar policy stimulates exports.

Second, the Fed’s zero interest rate policy (ZIRP) which has driven down interest rates, stimulates demand for certain big ticket goods such as autos.


Exports represent about 14% of GDP and of that manufacturing exports is about 5% of GDP: a substantial factor. So when the dollar declines it stimulates exports and this is going a long way to revive manufacturing in the U.S.

The following chart shows the decline of the dollar (blue), the level of exports (red). I have inserted the two incidents of quantitative easing as shown in the salmon and light green bars. It is easy to see the mirror image inverse relationship of rising exports and a declining dollar.

  The recent strengthening of the dollar, a result of the eurozone crisis driving the dollar up, and declining world economies do not point to continued strong export growth. This is already starting to show up in the numbers as this chart shows more clearly (gray bars):

The below chart of leading indicators, just out from the OECD, shows that the world is not cooperating with exporters—these are their major markets:


Auto production is about 2.5% of GDP, a substantial part of manufacturing. Recent sales improvement is being driven by cheap credit (ZIRP). This chart shows new car sales (blue), expanding nonrevolving credit (red), and auto loan interest rates (black):

The first thing you should notice is the high level of sales pre-Crash and its rapid decline in 2008 (blue). Note the spike in 2009 which was the ill-conceived Cash for Clunkers program. Nonrevolving credit is used mainly for financing autos and this chart shows the post-Crash rise of such credit growing in lock-step with auto sales. It also shows a significant spike in sales beginning in 2010 as auto loan interest rates decline (black) to historic lows. While recent sales growth is also a function of pent-up demand as consumers replace worn out vehicles, in an economy where consumer debt is still very high and where consumer income has been flat, most of these auto sales are being spurred on by low ZIRP-driven financing costs, not just organic demand.

Industrial production

The other thing is that industrial production is not growing strongly as the headlines would have you believe. If it was strong, it would be a good indicator of positive growth and the presence of real capital/saving driving growth. While factory orders and industrial production have improved, they have been essentially flat-to-declining for the past 12 months:

Improvements in manufacturing and industrial output are largely being driven by Fed policy, QE and ZIRP. I don’t believe it will last because it appears that monetary growth and the rate of change of such growth, are declining as the effects of QE wear off.

Tomorrow, Part II, the conclusion and outlook.

Thanks to DoctoRx and Michael Pollaro for their help with this article.

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Written By Jeff Harding From The Daily Capitalist

The Daily Capitalist comments on economics, politics, and finance from a free market perspective. We try to present fresh ideas the reader would not find in contemporary media. We like to call it “unconventional wisdom.” Our main influences are from the Austrian School of economics. Among its leading thinkers are Carl Menger, Ludwig   von Mises, Friedrich von Hayek, and Murray Rothbard. There are many practitioners of this school today and some of their blogs are shown on the blogroll. We trace our political philosophy back to Edmund Burke, David Hume, John Locke, and Thomas Jefferson, to name a few.

Our goal is to challenge contemporary economic thinking, mainly from those who promote Keynesian economics (almost everyone) and those who rely on statist solutions to problems. We apply Austrian theory economics to investments, finance, investment risk, and the business cycle. We have found that our view has been superior in analyzing and understanding economic and market forces. We don’t consider ourselves Democrats or Republicans, right wing or left wing. But rather we seek to promote free markets and political freedom.

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