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    Default Recession 2007: Part II - Eric Janszen

    Recession 2007: Part II

    What makes a prediction?

    by Eric Janszen - November 6, 2007


    Last week, we cut a path through the autumn leaves swirling in the wake behind my bicycle as I blew into town from the suburbs on a bike path–a slalom of toddlers and waddlers on a hot summer day–cleared by cold. Today as I ride, the air whispers winter. The path wide open, abandoned. Forever goes by without another person in sight. The sole survivor in a beatific post-apocalypse world, I'm alone to ponder the nature of what is to come.

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    "Recession 2007: Part I" centered on the notion of balance. While I come down on the global credit system that has led to massive imbalances in debt and savings among nations and peoples, I count my blessings in the range of technologies this system has brought us, such as the one that is delivering this article to your home or office for next to cost. While I poke at the Bureau of Labored Statistics with a sharp stick for a politically convenient accounting of inflation, such as valuing real estate inflation via imputed rents when rents are at historical lows and home prices are rising bubble-style, the notion of hedonic pricing is not without merit. Take a new $15,000 loss-leader car advertised in the Sunday paper back to 1980 and recreate just the automatic braking system and airbags that today save so many lives. Those two features alone, not counting the R&D, would cost, what, $100,000 per car? Taking the value of new technology into account when measuring the prices of products is not dishonest. The question, again, comes down to balance. To what extent should the impact of the added utility of technology be counted in real goods prices?

    Only when taken to extremes do imbalances become apparent, as in the charts we showed in Part I. For example, households since 2000 have taken on unprecedented liabilities. The picture is of an economy dependent on ever-increasing foreign borrowing and ever-greater household debt, a global economic system operating without the mechanisms that used to keep it in balance.


    In "Recession 2007: Part II" we scale out our view, from the whirling leaves on 17 miles of road between my home and the city, to 30,000 feet and a hundred million square miles of earth.

    As CEO of a couple of venture capital backed companies, and while in various executive sales and marketing roles in the high tech industry, I have traveled regularly for over 25 years. Hong Kong, London, Taipei, Paris, Tokyo, Madrid, Singapore, Rome. So much so that more than once I have needed a new passport before the last one expired, for lack of space for stamps and visa stickers.

    There are few cities and towns in the U.S. that I have not visited at least once–Bangor, South Bend, Los Angeles, Palo Alto, Tampa, San Diego, San Antonio, Bozeman, Kansas City, and on and on. During these trips, domestic and foreign, I had a habit of collecting notes of two kinds: written, on what I saw and what people said, and the spendable kind–currency. A few samples relevant to our story follow.

    Notes collecting is a habit from childhood, when I'd travel with my family. A couple of the earlier artifacts are displayed in my piece "Can the U.S. Have a Peso Problem?"

    I miss the giant, colorful French franc bills, the Spanish peseta, the Italian lire, the German deutsche mark, works of art replaced by the bland Disneyland euro, a currency by committee.



    Artful but awkward





    Bland and efficient

    The price of monetary progress. Trade now moves as freely across borders as do people. Long gone are the days when traveling through Europe felt like moving through countries so small, in the words of P.J. O'Rourke, "you can't swing a cat without putting it through customs." Trade and travel in Europe feels ever more like the United States of America, except without the third world look of telephone poles and wires littering the sky. And drivers know how to use a highway in Europe: when in the left hand lane, drive fast. And they have health care. I could go on, but this piece is not about making invidious comparisons between the US and Europe. Europe has its problems, as evidenced by the riots in France. But, generally, my travels tell me the U.S. may now be over-rated as a dynamic economic power while Europe is under-rated; the younger generation of Europe, now in power, has changed Europe to adopt many of the better qualities of the old United States, while the new U.S. has adopted many of Europe's earlier bad habits. This fact has implications for the dynamics of the next recession.

    As I ride today, before I recount my flash-backs to these trips, we start at a town I pass through on my way into the city.

    It's late 2000. I'm sitting drinking coffee in Harvard Square with Dudley Fishburn III, then the managing editor of The Economist. He was visiting Harvard where he was on the board of trustees and where his son was attending. He's asking, "Why do you think the Dow has not declined more than it has? It doesn't make any sense to me." I answer that I believe the Dow is largely the product of monetary inflation. We talked about post-bubble reflation. He comments that when governments borrow, they take from private sector, it's not a zero sum game. "What if the U.S. can get investors outside the country to buy even more sovereign and agency debt?" I ask. "Then you get a free lunch, if only for a while," he replied. And so it went.



    Global free lunch: Deficit spending, wars and housing bubbles

    It's October 2001. I'm in Japan, as CEO of Bluesocket, on a two day trip to take care of a problem that popped up at our largest distributor there, and to respond to interest from two Japanese venture capital firms. Two weeks after the 9/11 attacks, no one is flying. A JAL 777 holds 440 passengers full-up, but on this day we have 18 plus 12 flight attendants. Twenty six hours of flying for a few hours of meetings right after 9/11 may sound extreme, but in those days such measures were frequent, as I'm sure readers in the information technology industry can recall. An IT depression predictably followed the bursting of the tech stock bubble. A housing depression will follow the collapse of the housing bubble, but the process, which started in June 2005, will be more gradual and take a lot longer.

    As bad as the economy was in the US, it was worse in Japan. This downturn I saw on my visits in 2001 was one of many that Japan had experienced since their stock market crashed in 1990 followed by their housing market in 1993. The Hyatt in downtown Tokyo where I stayed cost US$180 a night on that trip. I'd stayed at the same hotel in the late 1980s during the top of the Japanese stock market bubble, while working for Stratus Computer. The rate was $590. Accounting for dollar inflation, the price had declined over 70%.

    I watch TV briefly before going to sleep for a few hours before getting up to fly home. Two men dressed as women crack jokes. At least the Japanese haven't lost their unique sense of humor. At the time, the Fed was fretting about deflation. I figured this meant a wild money printing spree was already in progress. The Japanese were then instructed by the likes of Paul Krugman to turn up the printing presses to maximum, except that the good professor may not have considered that the last time Japan went broke, the mechanism was not a deflationary depression as happened in the US in the 1930s, but a hyperinflation in the 1940s. That crisis left the Japanese as culturally inflation-phobic as the is US population and policy markers are deflation-phobic. A level of inflation that Americans take in stride may send Japanese households and businesses running for inflation safe havens. The cultural legacy of each nation's last economic calamity colors economic behavior for generations.

    Humor is culture-specific, as are attitudes about debt and inflation

    When I arrived in Tokyo on a trip three months earlier, I took some money out of an ATM at the airport, some more in Tokyo, and more than I needed. I was collecting evidence, as I have during visits to Europe and across the US. Evidence of what? you might ask. To support my "Ka-Poom Theory," that the collapse of the stock market bubble was due to create a brief period of disinflation followed by inflation as monetary, fiscal, and other government policies were applied to reflate the economies in distress. Collecting cash from ATMs was one way of measuring where we were in the Ka-Poom process. Before getting into how ATM cash can be interpreted an indicator of disinflation, a quick aside on the quantity theory of money, from wikipedia.
    M is the total amount of money in circulation in an economy at any one time (say, on average during a month).

    V is the velocity of money, i.e., how often each unit of money is spent during the month. This reflects financial institutions and other economic conditions.

    P is the average price level for the economy during the month.

    Q is the total quantity of items purchased during the month with the particular kind of money represented by M.

    For example, if M represents Central Bank notes (for example, green paper U.S. dollars) then Q is the quantity of goods or assets bought with Central Bank notes. If M represents Central Bank notes plus checking account balances, then Q represents the quantity of goods or assets bought with paper or checking account balances. Textbooks carelessly define Q (or "Y") as the total quantity of goods produced in the economy (i.e., real gross domestic product). But this can lead to serious errors. For example, if only 30% of goods are bought with paper or checking account balances, and if the quantity of this type of money doubled, then it might happen that the quantity of goods bought with paper or checking account balances would double from 30% to 60%, while real output of goods (and P and V) are unaffected. Besides money can be used to buy goods produced in another time period (especially assets).

    M * V = P * Q

    The left-hand side of the equation above equals the total amount of money spent during the month. The right-hand side equals the amount of money received.

    Given this identity, the velocity of money can be measured as: V = P * Q / M
    In countries experiencing deflationary pressures, I expected the central bank–Bank of Japan, ECB, and Fed–to print money like there's no tomorrow. Not only the digital kind that winds up as bits on disk drives that hold the data for bank accounts, but notes, too. I expected the velocity of money to remain low early in the reflation process. Late in the "Ka" disinflation phase and early in the "Poom" inflation phase, ATMs should be filled with the freshly printed cash, versus the recycled bills you find in circulation during flush times. Sure enough, here is what I found.

    October 2001, fresh cash indicated an early reflation process
    Click to Enlarge

    What you are looking at is a sample of some of the uncirculated 5000 yen and US$20 notes I collected, in sequential serial number order, just as they arrived from the local central bank. They smelled strongly of barely dried ink. The Japanese do not date their currency, for reasons maybe one of our readers can explain; only the design indicates that these bills were issued in 2001. These 65,000 yen are today worth about US550, then $537, as the yen has continued to appreciate against the dollar. This evidence of where we stood in the Ka-Poom cycle was one of many inputs into the analysis that led to my call of a bottom in the price of gold for the cycle, in September 2001, "Questioning Fashionable Financial Advice":
    "One can buy physical gold now for around $270 and have gold provide the same "fundamental strength" to one's personal balance sheet as it provides the IMF's. As a long term investment I conclude that it's value is far more doubtful. The environment for capital appreciation is more likely to persist long term than not. Progress marches on. One is best off owning an index of stocks that will tend to grow in line with world economy, an inevitability in spite of occasional setbacks. Still, it's hard to go wrong with a small gold bullion position. Gold is now trading near 13% of its inflation-adjusted peak price of $1973 whereas U.S. stocks as a class are trading at a premium never before seen, even after recent declines. It's possible that the price of gold will fall the remaining 13% to zero and the DOW to 36,000 in the next few years. But is the collapse of the price of gold the remaining 13% toward zero more or less likely than a return of stock prices to their mean P/E ratios and a counter-cyclical return of the price of gold toward a price ratio closer to one to one from the current ratio of 37 to one?

    "If gold indeed falls another 50% to $135 you have paid a small risk premium for owning the world's oldest and most widely held financial catastrophe insurance, and a lot less than the 84% you'd have lost investing (speculating) in the widely touted New Economy stocks represented in the iTulip.com Index when we first warned you to not buy them back in January 1999."
    My advice to buy gold in 2001 is circumspect. The world's central banks were in full PR mode about deflation in 2001, gold had recently hit a 20 year low, and most commentators were confidently predicting a continued decline. Many iTulip readers, in spite of the advice to sell their tech stocks in March 2000, had recently lost fortunes in tech stocks. Suggesting anyone buy gold with the money they had left was a crackpot notion. I decided to tread carefully on the notion of buying gold then, positioning the advice as "insurance" versus a bet on appreciation due to reflation.

    Today, you may notice when you take cash out of your local ATM, the bills are well circulated, worn. Friends who do business that occasionally find them in transactions that involve large quanties of cash (no, not drug dealers, real estate people), they report that some of the bills are so ratty they have had to go to the bank to exchange them. These friends also report that back in 2001, freshly printed cash as shown above was typical in such transactions. Today, the velocity of money remains high. The printing presses continue to run hard, but not ahead of demand for notes or money in its other forms, at least not yet. Will the trick of watching currency in ATMs work again when we go into our next Ka-Poom cycle? Maybe, but only if the US experiences a severe and sudden negative wealth effect event, such as a bond market crash.

    I provide this cash quality indicator not as the sole indicator of the validity of a theory that allowed me to make a prediction that helped me make a profitable trade: just as I'd moved from stocks to cash and bonds from March to July 2000, and took a 15% asset allocation in gold in 2001 as I suggested in the Questioning Fashionable Financial Advice piece. The point is that economists tend to have a dismal record of recession prediction; alternative methods are needed.

    Philip Ball's recent "Baroque fantasies of a peculiar science" for the Financial Times:
    It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.

    The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start." The tenets are so firmly embedded that economists who think it is time to move beyond them are cold-shouldered. It is a rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.

    That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas favouring unfettered market forces may determine whether Britain adopts the euro, how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.

    It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.

    One can go through economic theory systematically demolishing all the cherished principles that students learn: the Phillips curve relating unemployment and inflation, the efficient market hypothesis, even the classic X-shaped intersections of supply and demand curves. Paul Ormerod, author of The Death of Economics, argues that one of the most limiting assumptions of neoclassical theory is that agent behaviour is fixed: people in markets pursue a single goal regardless of what others do. The only way one person can influence another’s choices is via the indirect effect of trading on prices. Yet it is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.
    In addition to the author's points, neoclassical economics has another fatal flaw: it is not predictive. For this reason, I gave up on it years ago and found myself developing my own theories, borrowing from the Austrian school–which also has its limitations–Keynesian economics, and others.

    What probably has helped me the most in making predictions is that I avoid excessive reliance on theory and rely more on observation. This is my other major beef with neoclassical economists: they are weather forecasters who tell you that, theoretically, your skies are partly cloudy when you can see rain falling outside your window. There are literally hundreds of people I talk to regularly, and have been doing so for over 20 years. Every conversation yields insight and valuable data. From the tales told by my card game buddies, colleagues in the high tech industry I have known for more than 20 years, childhood friends, and stories told to me on airplanes by strangers, I can get a good sense of what's going on and what's coming. Their experiences, the rise and fall and rise again of their fortunes, their challenges as employees and homeowners and parents, as investors, as travelers, add up to a picture of changing trends. This approach should not come as a surprise to long time iTulip readers who know that my mother was a psychologist, my father a physicist. My antecedents make me partly analytical and partly interested in the psychology of market participants.

    Then there is the challenge of discounting one's own personality and experience from the interpretation of the data. I have friends who are perennially optimistic, others are perma-bears, others are natural realists. I average their opinions to inform my prognostications. I have observed, by the way, that over the long run the optimists tend to do best in life. My role is the disinterested observer.

    Three conclusions from Recession 2007: Part II. One, no one has a chance at predicting future events from economic theory, and by reading books and surfing the Web; first hand experience collected over long periods of time are essential. Two, I labeled the tech stock market a bubble in 1998 when most still called it a New Era when I launched iTulip.com, I asserted in August 1999 that Y2K was likely going to be a non-event, called the end of the tech market bubble in March 2000, called a bottom in gold in 2001, predicted "Not a Typical Postwar Recession" in January 2001, warned about a developing housing bubble in August 2002, called a top in the housing bubble in June 2005, and explained in January 2005 how the housing bubble collapse was going to unfold. Making these predictions was a piece of cake compared to timing and defining the character of the recession I believe we are likely to experience in 2007. The reason is that the key events that will shape this next recession will be dominated by complex geopolitical forces. Europe, Asia and the US are very different places than they were eight years ago when the bubbles drama began. Three, while using personal experience, one has to work hard to discount personal bias when interpreting the data.

    In Recession 2007: Part III we will return to my 2001 recession prediction analysis to see what I got right and what I got wrong in order to learn as much as possible from that exercise. We will also survey the broader landscape of geopolitical and economic pre-determinants that will have the greatest influence over a 2007 recession and how various nations can and will respond to it.

    When I head out for my bike rides this week, maybe I can hang up the Gore-Tex™ socks, pants, and jacket for the week. The neoclassical weather forecast calls for temperatures near 60 degrees, and partly cloudy skys. But I can already see rain drops streaking down on the window.

    Recession 2007: Part III.
    _____

    For a layman's explanation of financial bubble concepts, see our book americasbubbleeconomy
    For guidance on how to play the coming currency corrections, see "Crooks on Currencies"
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    Last edited by FRED; 09-16-07 at 12:19 AM.
    Ed.

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