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  • Consensus of economists: No recession in 2007... unless one happens

    Consensus of economists: No recession in 2007... unless one happens

    by Eric Janszen - January 16, 2007


    Yesterday we wrapped up iTulip reporter Jane Burns' series on the fate of the Monthly Payment Consumer. She interviewed a distinguished group of economists:

    Peter Morici, University of Maryland business school professor and former chief economist of the U.S. International Trade Commission under the Clinton administration
    Kevin Hassett, director of economic policy studies at the American Enterprise Institute
    Lakshman Achuthan, managing director of the Economic Cycle Research Institute and a governor of the Levy Economics Institute at Bard College
    James O’Sullivan, a UBS economist
    Ken Goldstein, an economist with the Conference Board
    Dean Baker, co-director of the Center for Economic and Policy Research; Russ Roberts, a professor of economics at George Mason University
    Ron Blackwell, chief economist of the AFL-CIO
    Dr. Richard Curtin, director of the Surveys of Consumers at the University of Michigan.


    The consensus among them is that–barring some unexpected shock to the US economy that causes a spike in unemployment–the consumer will keep chugging along this year, albeit with reduced enthusiasm as declining home values cuts into cash-out refinancing income.

    We'll see no recession.

    I disagree with the consensus. My view is closer to Dean Bakers' of the CERP, who said in his interview by Jane, "A mass change in consumption would mean a recession, and it’s very likely to happen." We will have a recession this year, likely toward the end of the year, even without any new events to add to the depressive impact of events already in progress. Here they are from my four part Recession 2007 series.

    Housing: Market collapsing and will continue to do so until about 2015.


    January 2005 Housing Bubble Collapse projection still tracking


    Latest data confirm the prediction and the potential for a recession.

    Permits down 30% over previous period as of January 2007. All recessions
    since 1955, except for the technology stock bubble collapse induced recession
    in 2001, started after housing permits issued declined > 30% for more than
    15 months versus previous annual period. Different this time?

    Private Equity: Will start to collapse this year and continue for a few years in the manner of Venture Capital 2000 - 2003.



    As with Venture Capital, so shall go Private Equity. The fuel has been the
    "out of control" Collateralized Debt Obligation (CDO) market. The pin will be
    widening yield spreads followed by downgrades by ratings agencies.


    Hedge Funds: Hedge funds are continuously closing and new ones starting. The difference is that starting sometime this year, more will be closing than opening. The reason is that many more funds will lose money at the same time hedge fund investors are becoming more risk phobic due to other market events, such as the ongoing decline in emerging markets.



    Source: Amanda Cantrell, CNNMoney.com. 2006 and 2007 are WAGs.

    Foreign Investment in US Financial Assets: Private investment in the US has been declining for years. Last year, foreign central bank investment in the US will declined as well, except for a special friend to the US, the UK. If not for the UK doubling down last year, year-over-year net foreign holdings of treasury securities declined.



    Of the $2.2 trillion in foreign owned Treasury securities outstanding, between Oct. 2005 and Oct. 2006
    the UK doubled down, increasing their bet from $100 billion to $207 billion while China stepped in with
    a 12% increase from $302 billion to $345 billion, perhaps not coincidentally only a few billion more
    than Japan's 4% cut from $667 billion to $641 billion.
    Close to 80% of treasury debt purchases since
    2004 have been public versus private, via foreign central banks.





    It's not how much you buy that matters, but how much you buy relative to what you can
    afford–as measured in GDP–and need–as determined by vendor financing of exports
    (e.g., China), military protection (e.g., Israel and Taiwan), or both (e.g., Japan).


    Fifty economists were interviewed by Bloomberg two weeks ago. All forecast the Bank of England to not raise interest rates last week, except for one. The BoE raised rates a quarter point. Not merely the consensus–the majority–misjudged, but the entire group did except for a lone dissenter. How can this be, you ask? Because the career risk in taking the same wrong position as everyone else is less than the career risk in taking a position one is convinced is correct, even though it runs counter to the consensus. The consensus is safe, even if it's wrong. Why do I insist on taking a position whether it agrees with the consensus or not? I was thinking about this the other day and concluded that it's because have spend my career in roles, such as CEO and VP Sales, in the high tech industry, in positions in business where one's reputation and income depend on achieving a goal–a forecast of revenue, expense, and profit–as promised to a board of directors. You can be 80% right in the wrong direction a couple times, but not many. You can't be more than 50% correct, ever. Even if you are far off in the right direction and beat your goal by 50%, you are demonstrating that you don't understand your business. A world where one can be 100% wrong, over and over, and continue to make projections and have them quoted and taken seriously–where there is no apparent accountability–is an odd place. But this is apparently how the system works today.

    Many contrarian sites start with the premise that the consensus is wrong, take a contrary position–usually bearish–and then seek out supporting evidence to the exclusion of contradicting information. This is an effective way to build up an audience that is sympathetic to the spirit if not the letter of the site's main argument, but doesn't do them much service. The iTulip way is to look at the consensus view skeptically, develop a contrary hypothesis, and then seek out reasons why it is wrong.

    The main hypothetical framework for iTulip is Ka-Poom Theory. It predicts a period of disinflation followed by a period of inflation at the end of each asset bubble, most recently, in stocks then housing. I'm fond of the theory not only for the usual reason–an inventor's love of his own idea–but because it's made me money. Past performance is no guarantee of future results, as they say in the fine print of any US financial product's brochure, but a model that frames a repeated process and makes it more or less predictable potentially allows for timely shifts in asset allocation within one's portfolio to at least protect if not benefit from the cycle. The venturesome investor can even speculate on it.

    A brief review of Ka-Poom Theory. At its heart is the idea that the Fed operates under four immutable rules:

    Rule #1: Asset bubbles are a natural feature of financial markets.
    Rule #2: Don't try to pop an asset bubble: the law of unintended consequences will defeat you (see Fed 1929, Bank of Japan 1989, Fed 1994).
    Rule #3: When they pop, do not under any circumstances allow the rate of inflation fall below zero (see USA 1930 to 1940, Japan 1990 to 2000.) Drop interest rates quickly (see Fed 2000 - 2001).
    Rule #4: If that doesn't work, have contingency plans to print money and buy assets–mortgages, long term treasury debt, or equities–directly (see No Deflation! Disinflation then Lots of Inflation).



    The disinflation/reflation/asset inflation Ka-Poom cycle:
    1. Post asset bubble monetary reflation (inject money by cutting interest rates and taxes, increase deficit spending)
    2. Asset inflation (asset bubble stocks, bonds, housing, etc.)
    3. Monetary tightening (money extraction via rate hikes, increased reserve requirements, etc.)
    4. Bubble collapse (2000 stock market crash, 2005 to ? housing bubble collapse, 2006 - ? junk bond, private equity, CDO, and MBS bubble collapse)
    5. Goto 1
    Borrowing from Everett Rogers' Diffusion of innovations theory, as Geoffrey A. Moore did in his book Crossing the Chasm, within the disinflation/reflation/asset inflation Ka-Poom cycle, an asset bubble inflation cycle occurs in eight stages. Here they are listed by name and type of new bubble market participant that joins and leaves at each stage.


    1. Discovery in Liquidity–Innovators: A new invention or discovery (railroads or the Internet), or re-discovery of an old invention (property), at a time when there is ample money available for speculation.
    2. Valid Core Beliefs–Early Adopters: Development of Valid Core Beliefs that are based on fact–such as the value of the Internet during the Internet bubble or of a home to a middle class household–that drive early adopters into the market.
    3. Invalid Apocryphal Beliefs–Early Majority: Invented to explain extreme price increases that go far beyond the level justified by the Core Beliefs, Apocryphal Beliefs are popularized by those who benefit the most from the bubble, such as investment banks and venture capital firms during the Internet bubble, realtors during the housing bubble, and are readily accepted by the vested Early Majority which is also benefiting–notably owners of capital and politicians including government regulators. At this stage now exists a well developed system of sales, marketing and distribution, that includes the mainstream press, and employs an army of analysts, consultants, lawyers, accountants, and so on, all of whom adopt first the Core Beliefs and later buy into the Apocryphal Beliefs, reaching out to the next wave of potential buyers, the Late Majority.
    4. Religious Enthusiasm–Late Majority: Extremes of popular, positive investor sentiment–the general belief that the price of a stock, house, or commodity can only go up, such as gold in 1980, technology stocks in 1999, and housing in 2005. The vested Late Majority owns the asset and universally feels wealthy and special and thinks, "We're all Rich!" It's at this stage that Central Banker begin to reduce the money that fueled the bubble, ostensibly because the spill-over from the asset bubble into the so-called "real economy" is beginning to show up as wage inflation. The impact is not immediate because government money may have kicked off the bubble but earlier, in the Invalid Apocryphal Beliefs stage, the market has already figured out how to generate its own money in the bubble system, such as the cycle of money going into technology start up equities, monetized via IPOs, and re-invested in new technology start up via venture capital, a kind of bank that funds losses. Without a market mechanism to support such a cycle, the Invalid Apocryphal Beliefs stage never develops.
    5. Anxiety–Laggards: At this point asset prices are so out of line with the historical mean that vested Innovators and Early Adopters start to get nervous. The last wave of new buyers, the Laggards, view the Late Majority's get-rich-quick wealth with envy and enter here.
    6. Trigger and Collapse–Everyone: An event occurs, sometimes random, sometimes not–to inform the vested believers what they already suspect, that they are participating in an asset bubble and their beloved "can't lose" asset is about to lose most of its value. The Early Majority, Late Majority, and Laggards tend to ride the crash down to the bitter end, feeling that they "should" make money as the Innovators and Early Adopters did. The Innovators and Early Adopters are the most aware of what is happening and are the first to sell, usually close to the top.
    7. Group Punishment–The Innocent: Politicians, after pocketing the capital gains taxes that asset bubbles produce, in order to placate voters who lost money in the bubble enact legislation designed to prevent a bubble from occurring again in the same market. This is unnecessary because markets take care of that on their own. In the words of Robert Reno, after the 1987 crash: "Nobody who has ever been on a falling elevator and survived ever approaches such a conveyance without a fundamentally reduced degree of confidence." Consider that the technology IPO market remains moribund seven years after the 2000 crash. The game moves over to markets where regulation is scarce, in the post technology stock instance, to hedge funds and private equity. However, legislation such as Sarbanes-Oxley puts glue in the wheels of capitalism.
    8. Hangover–Everyone: Regulatory glue, the re-distribution of wealth from suckers to Wall Street, and unemployment in the industry that is the focus of the bubble are the remnants of an asset bubble.
    (Which type of bubble market participant are you? Are you an Early Adopter or a Laggard or somewhere in between? Think of how you reacted to the stock market bubble in the 1990s and the housing bubble since 2002. Were you quick or slow to realize that each was a bubble? Where in the cycle did you join, if ever, at the stage of Religious Enthusiasm or later, after you saw our neighbors getting rich quick? When it comes to making investment decisions, it helps to be self-aware, to step outside yourself to see how your own nature colors your perception of markets and affects your decisions, or leads to indecision. Events going on inside you have a greater impact on your decisions than events going on outside you. If you can step out of yourself, you can make more sound investment decisions. If you can't, best to give the job to someone else.)

    A collapsing asset bubble sucks both the money supply and demand down with it, dragging down interest rates, equities, and commodity prices. In the "Ka" disinflationary part of the "Ka-Poom" cycle, one moves to cash. In 2000, the way to move to cash was simple: buy 10 year US treasury bonds. Today, the situation is much more complex than in 2000.

    Multiple asset bubbles
    • Some will decline slowly (e.g., housing), others rapidly (e.g., Private Equity/LBOs)
    • Involves debt versus equity
    • Involves the banking system
    • Involves the Asset Backed Security (ABS) and Collateralized Debt Obligation (CDO) markets
    • Involves the junk bond markets
    • Involves hedge funds
    • Involves credit derivatives
    A lot of moving parts against a more complex backdrop
    • War vs peace
    • High energy prices versus low prices
    • Structural inflation versus little inflation
    • Euro alternative versus no dollar alternative
    • High gold prices versus low gold prices
    • Low bond yields versus high bond yields
    • Low taxes versus high taxes
    • Fiscal "surplus" versus structural deficit
    The way a central bank will tend to manage through it is to take advantage of the fact of a diversified national economy. Some areas of the economy and country (geographically) will be allowed to decline into recession while others are encouraged to boom. The Fed's challenge is that housing bubbles deflate slowly and give off conflicting data, especially with a background of high energy prices and rising wage rates. This makes the monetary response more challenging than the simple prescription of cutting rates fast and furious after a stock market crashes.

    No one said predicting the end of the current asset bubble portion of this cycle would be easy. Merely listing and prioritizing all the variables it is a major undertaking.



    Adrian Ash writing over at BullionVault makes an eloquent case for how this Ka-Poom cycle–without actually calling it that–ends: with a few hundred trillion dollars of illiquid securities trying to escape through a opening a couple of trillion dollars wide. Whether the System is likely to become dysfunctional (resulting in disinflation) or goes completely haywire as Ash predicts (resulting in hyperinflation), is a topic for another day.
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    Last edited by FRED; 01-19-07, 01:46 AM.

  • #2
    Re: Consensus of economists: No recession in 2007... unless one happens

    A world where one can be 100% wrong, over and over, and continue to make projections and have them quoted and taken seriously, where there is no apparent accountability, is not a world I'm used to.
    Sounds like Lereah these past few months, with the repeated "housing is bottoming" call. It makes me wonder how long he can repeat the same incorrect platitudes, yet still have "journalists" and the MSM flock to quote him. As Lereah speaks for the NAR, one can ask the same question on a larger scale--how can "journalists" quote an industry trade group as an unbiased source when the data they are spewing not only doesn't reflect reality, but doesn't reflect incentives either? Maybe it's these kinds of #' s economists are using to make their no-recession predictions...

    As an aside, what is a "special member" and how did I garner that title? At least special isn't in quotations...;)
    Last edited by nikki; 01-16-07, 03:44 PM.

    Comment


    • #3
      Re: Consensus of economists: No recession in 2007... unless one happens

      ej, a nice review and summary, bringing us square to the problem of predicting how assets will react in these complex times.

      one caveat- you refer again to the purchases of u.s. treasuries by the u.s.'s "special friend," the u.k., implying these are politically motivated purchases by official uk institutions. is that fact? do we have data saying that these holdings are those of the bank of england? or are these just the money flows being ascribed to uk sources, in which case i again point out that a number of observers have commented that these appear to be the flows generated by the london-based investment offices of petrocountries.

      Comment


      • #4
        Re: Consensus of economists: No recession in 2007... unless one happens

        Excellent... I love the inverted money/liquidity pyramid from the BIS! That's almost exactly what I outlined a few forum posts ago with my "real monetary hierarchy"! Glad someone else sees it...

        I also like the Ash metaphor: "a few hundred trillion dollars of illiquid securities trying to escape through a opening a couple of trillion dollars wide". This should be something else to watch, that's for sure.

        Comment


        • #5
          Re: Consensus of economists: No recession in 2007... unless one happens

          I'm next in the lineup to offer big kudos on the full picture, with a lot of lines filled in. Very nicely done.

          My only question regards the Asset Bubble Cycle. The length of it at 6 years seems quite short, given that major cycles usually run 11-22 years. There's obviously something I'm missing...
          http://www.NowAndTheFuture.com

          Comment


          • #6
            Re: Consensus of economists: No recession in 2007... unless one happens

            I'm not finished with the commentary yet, but isn't the right y axis label wrong in the hedge fund launch/shut gaph?

            Looks like it should be shut/launch

            And what a remarkable statistic that is!

            Comment


            • #7
              Re: Consensus of economists: No recession in 2007... unless one happens

              Originally posted by Charles Mackay
              I'm not finished with the commentary yet, but isn't the right y axis label wrong in the hedge fund launch/shut gaph?

              Looks like it should be shut/launch

              And what a remarkable statistic that is!
              OK, I see you corrected it... but didn't post anything here that you did!

              Comment


              • #8
                Re: Consensus of economists: No recession in 2007... unless one happens

                Originally posted by Charles Mackay
                OK, I see you corrected it... but didn't post anything here that you did!
                Thanks for pointing out the error. The "Reason for Editing" field doo-dah doesn't seem to be working. Hmmm.
                Ed.

                Comment

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