Down Time. Yesterday's
bit of bad economic news was the first quarter GDP report, which showed
the weakness in retail spending and durable goods orders is evolving
into a classic inventory-led slowdown -- even if it hasn't yet
curtailed the energy-led upturn in consumer inflation.
A whiff of stagflation, in other words -- just as Paul Krugman predicted.
While growth slowed to an annualized 3.1% (and will probably be pushed
even lower in subsequent revisions) the so-called core personal
consumption expenditure (PCE) price index rose at a 2.2% rate, the
highest level since the last quarter of 2001.
However, just as I predicted,
the odor of the "stag" was much stronger than the smell of the
"flation." A 2.2% core inflation rate (i.e. excluding food and energy)
is still relatively benign. And there's not a trace of evidence that
wage gains are accelerating, which would be the sine qua non for an authentic inflationary spiral.
On the other hand, the details of GDP growth were considerably
weaker than the overall number. Durable gods consumption went from a
3.9% growth rate in the fourth quarter to a complete standstill in the
first. Private nonresidential fixed investment (capital spending)
slowed from a sizzling 14.5% rate to just 4.7%. The pace of business IT
spending decelerated even more dramatically. Net exports (i.e. the
trade deficit) were, as usual, a giant sucking chest wound.
In the end, the two things holding the expansion together were
consumer spending on services, which contributed almost half of last
quarter's rise in GDP, and inventories, which accounted for most of the
rest. Home building was also strong (the housing bubble lives!) but
since residential construction is just 5% of GDP, the contribution to
growth was relatively trivial.
What's more, the sudden slowdown in final demand makes last
quarter's big inventory build look clearly unintentional -- which means
firms will be looking to clear the shelves in the current quarter. But
that will mean less production, which means lower demand, which makes
it harder to cut inventories.
This is one way recessions get started. Alan Blinder, the Princeton
economist and former Fed vice chairman, has even argued that at the end
of the day all recessions start out as inventory cycles.
But that doesn't mean we're necessarily heading into a recession
now. I'm not certain the slowdown in capital spending will last -- the
data show a similar slump in the first quarter of each of the past
three years. This could be related to the expiration of tax incentives,
or it might be a new pattern the seasonal adjustments haven't caught up
with yet. Either way, investment could bounce back in the current
quarter, which would probably be enough to break the downward momentum.
A Really Soft Patch
On the other hand, this looks like a much more substantial
break in momentum than last year's "soft patch." Given the underlying
trend in personal income and the rock-bottom household savings rate, it
was always inevitable that consumption would slow at some point. If
(when?) the housing bubble finally pops, it almost certainly will slow
enough to pitch us into recession. Right now, though, we don't seem to
be at that point.
However, even if home prices and personal consumption hang in there,
a prolonged slump in business investment (i.e. one that lasted beyond a
single quarter) could also tip the recessionary bucket -- assuming, of
course, the Bushies don't dial up another war.
A major slowdown in capital spending would be profoundly
demoralizing, since there would be no obvious scapegoat, other than the
high price of oil. And while $50 a barrel oil is definitely a drag on
profitability, it's hard to construct a scenario in which energy prices
single-handedly drag capital spending (and economic growth) into the
toilet and beat the crap out of them.
With the federal fund rates still south of 3% and the 10-year
Treasury yield sinking back towards 4%, it's also hard to come up with
a conventional story that blames the Fed for taking the monetary punch
bowl away too fast.
That being the case, a U.S. investment slump could force investors
and analysts to look up and see the deflationary imbalances hanging
over their heads. (Based on today's stock market action, this may
already be happening.) This could pull one of the other effective
triggers for recession -- collapsing equity valuations.
It's intriguing (if masochistic) to speculate about what might
happen next. Brad Setser, the NYU economist last seen on this blog
keeping Mr. Creosote company, has suggested a scenario in which slower growth and the threat of lower equity returns and bond yields might unleash the long-awaited run on the dollar.
This could put enormous pressure on the Fed to hold the line on
interest rates, or even raise them, despite a weakening domestic
economy. Setser:
The analogy is imperfect in lots of ways, but it is worth
remembering that Argentina had to pay more to attract financing from
1999 on even as an economic slump reduced its current account deficit.
Exactly who would play Evita in this Argentine tango isn't clear,
although maybe Ann Coulter or Jeff Gannon would like to give it a whirl.
Brad DeLong has already converted the Argentine-scenario into a
simple model. And if you want to know the mathematical equation for
"well and truly fucked," you can find here.
Don't Cry For Me -- Yet -- Argentina
I certainly wouldn't rule out the Argentine scenario, or at least, a
kinder gentler version of it. Brad Setser points to a table in the back
of a recent World Bank report
that shows just how much strain the U.S. current account deficit is
putting on the ability, if not the willingness, of the major Asian
central banks to keep propping up the dollar and the U.S. bond market:
The bars represent the dollars accumulated by the Asian countries
(chiefly Japan, China, Korea and Taiwan) as a result of their efforts
to keep their currencies from rising against the greenback. As Whiskey
Bar readers know, most of these dollars are invested in either U.S.
Treasuries or securities issued by Fannie Mae and Freddie Mac, the two
monster mortgage agencies. Which means communist China is directly or
indirectly subsidizing the U.S. currency, the bond market, the stock
market and the housing bubble.
With enemies like that, who needs friends?
The red part of each bar represents the share of all those dollars
held by the Chinese. As you can see, this share has been rising rapidly
in recent years, which is why I sometimes to refer to the PRC as the
Saudi Arabia of dollars.
Just as the Saudis have traditionally been the top dog in OPEC by
virtue of their role as "swing producer" -- capable of adding or
subtracting millions of barrels from the world oil supply almost
overnight, the Chinese have become the "swing buyer" in an informal
cartel that we can call the Organization of Dollar Importing Countries,
or ODIC.
By steadily increasing their share of total Asian reserves, the
comrades in Beijing have taken much of the financial pressure off
ODIC's other members, thus encouraging them not to drop out or cheat on
their fellow cartelists by quietly trading their dollars for pieces of
paper that are actually worth money -- like euros.
Without that support, ODIC (and the dollar) probably would have long
since crumbled. Which in turn would have long since brought America's
supply-side Mardi Gras to an abrupt end. So you can argue that instead
of holding hands
and whispering sweet nothings into Prince Abdullah's ear, Shrub really
should be over in Beijing spooning with President Hu Jintao, because if
the dollar were ever allowed to find (i.e. plunge to) its natural level
in the market, $2.25 a gallon for regular would quickly look like the
steal of the century. (Actually it is the steal of the century, but that's another post.)
Instead, the Bush administration has been leaning hard on Beijing to
float the reminbi -- a move which, in a non-deflationary environment,
would be like handing someone a straight razor and asking them to slice
open your carotid artery for you.
But we're still in a deflationary global environment, $50
barrels of oil notwithstanding. That means the Chinese aren't likely to
grant Bush's wish -- or at least, not to the extent that he and his
manufacturing donor base would like. Beijing needs export-led growth to
keep the social pot from boiling over and to prevent a painful
unwinding of their own economic excesses (which to a large degree
mirror our own).
That's why I think a U.S. economic slowdown would make China and the other Asian countries less likely, not more, to pull the plug on ODIC. It would be like cutting their own carotid arteries. So someone else is going to have to yank that particular chain.
Private Parts
Under normal circumstances, that someone would probably be private
investors. Unlike ODIC, they're in the game to make a buck, not protect
the buck. And other things being equal, a country with low interest
rates, a falliing stock market and a huge current account deficit (not
to mention a grossly incompetent ruling party) wouldn't offer much
profit incentive to the global speculator. So a U.S. slump could spark an exodus of private capital -- one so large even ODIC would have a hard time offsetting it.
It's certainly a risk, as the next chart shows. Although ODIC has,
out of necessity, assumed much of the burden of supporting the dollar,
private capital flows are still substantial -- accounting for about 70%
of net inflows so far in this decade, although only about half over the
past two years.
But the existence of ODIC also has a powerful effect on private
investors. Under normal circumstances, they would be nervously eyeing
each other at this point, wondering whether they should break for the
door before the rest of the herd gets the same idea. As the saying
goes: You don't have to be faster than the bear, you just have to be
faster than the other guy.
But as long as ODIC is committed to holding the doors open (i.e.
fixing the dollar market) the herd can graze confidently -- which in
turn makes it easier for ODIC to keep the doors open.
Logically, a U.S. economic slowdown should increase the
confidence of private investors that ODIC will continue to defend the
dollar and (by implication) the U.S. bond market -- for all the
deflationary reasons cited above. At the same time, a global bear
market in equities (the inevitable result of a Wall Street downturn)
should make yields on U.S. bonds more attractive, particular for hedge
funds and other high rollers active in the carry trade.
Carried Away
The carry trade -- not nearly as fun as the skin trade but a hell of
a lot more lucrative -- involves borrowing money at very short-term
rates (like overnight) and using the money to purchase longer-term
bonds. It can be an enormously leveraged game -- depending on the type
of bond being purchased, a $5 million stake might be enough to control
a $200 million position. Because long-term yields are normally higher
than short-term yields, the investor reaps the difference, or "carry,"
between the two.
When spreads between short rates and long yields are very steep, the
carry trade is basically like owning your own little Federal Reserve --
as long, that is, as: - Short-term rates (borrowing costs) don't rise too much.
- Longer-term bond prices don't fall too much.
- Your creditors don't call in their loans.
But
when carry traders borrow in dollars to invest in U.S. bonds (as many
did back when the fed funds rate was at 1%) it does absolutely nothing
to support the dollar or finance the current account deficit -- if
anything, it's dollar negative, since the trade tends to drive down
U.S. yields and thus makes them less attractive to foreigners.
But carry traders aren't limited to borrowing in dollars. If they're
bold (reckless) enough, they can borrow in another currency -- like the
Japanese yen -- swap those yen for dollars and then buy U.S.
bonds. Since the Bank of Japan has been keeping short-term rates a
fraction above zero for over a decade now, the carry on such a
yen-dollar position can be mouthwatering.
I've tried to get a sense of how important the yen carry trade
already is for the U.S. balance of payments, which isn't easy from the
sources I have available. The Commerce Department doesn't break its
international transactions data down enough to tell what's going on.
However, I see from the Treasury's monthly capital reports that
Japanese purchases of Treasuries and agency securities totaled over
$200 billion in 2004 -- even though the Bank of Japan itself withdrew
from active dollar support operations (and thus stopped adding to its
U.S. bond portfolio) in March of last year.
The Treasury reports also show sizable inflows into the U.S. bond
market from the United Kingdom and the Caribbean money laundering . . .
er, I mean, banking centers. It's possible some fraction of these flows
were financed with ultracheap yen borrowed in the euromarkets. But I
can't say for sure.
But borrowing in yen adds yet another way to lose money on the carry
trade: If the dollar unexpectedly rises against the yen, the trader
will have to pay his creditors back with a currency that's worth more,
while earning profits in a currency that's worth less. If the position
is highly leveraged, it doesn't take much of a move to wipe out the
profits all together -- or as they say in the business: Stay in a carry
position too long and you'll be the one carried out.
Currency exposure can be hedged, but it costs money -- enough, in
many cases, to make the trade unprofitable. It also offsets the flow of
capital into the U.S. bond market.
Reckless Speculators Wanted
What the U.S. bubble economy needs, then, is for even more
speculators to take even larger unhedged positions in the bond market
financed with borrowed yen. And the best way to persuade them to do that
is to convince them short-term yen rates will remain close to zero;
that the ODIC cartel will defend the dollar to the death; and that
long-term U.S. bond prices are unlikely to fall dramatically. It also
helps to make alternative uses of speculative capital look less
appealing.
A U.S.slowdown would seem to fit the bill nicely. Which means the
Fed may not be completely boxed in -- at least not yet. If private
capital can be coaxed into the bond market, yields can continue to
decline as the economy slows (they're already down almost 40 basis
points since the beginning of April.) The housing bubble can be
protected, the stock market will have a cushion to break its fall, and
capital spending will be more likely to revive later in the year. A
stable or only gradually depreciating dollar would also help keep the
"flation" part of stagflation under control.
Of course, this won't correct the underlying imbalances, although it
should at least keep the current account from completely shooting the
moon. At some point, U.S. interest rates will stop falling -- even if
the economy remains weak -- because the risks will seem too high (even
to carry traders) compared to the rewards. At that point even ODIC may
not be able to hold the doors open.
But a slowdown now could conceivably buy us another year or two before
the bubble bursts -- allowing the upper 10% to keep on partying even as
the bottom 90% increasingly feels the bite of a slumping economy.
Not great, but not doomsday, either. As I told a friend the other
day, the supply side hag may be aging rapidly, but she may still have a
few more, um, carnal moments left in her yet. And at this late date, that may be about the best we can expect. [Whiskey Bar]
4:45:05 AM 
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