“The first quarter will be ugly,” said an analyst at Deutschebank after looking at the latest report on the fourth quarter.
In the last three months of 2007, the U.S. economy neither grew nor shrank. Instead, it just came to a halt. The official report shows GDP rising at an annual rate of 0.6%. The previous three months showed growth of over 4%.
What is happening is what is supposed to happen and what we’ve been waiting to happen but so far hasn’t happened – the United States is entering a recession and is probably in one now.
New jobless claims are up more than expected, says one report. The economy is softening more than expected, says another. More bad news: mortgage rates are going up.
The feds, you’ll recall, are far more interested in fighting recession than they are in fighting inflation. That’s why the dollar is falling… about which, more in a minute. But in the battle between the feds and deflation… it appears that the feds are getting their derrieres kicked. And they’re losing the non-battle against inflation too. The cannon to the left of us and the cannon to the right of us volley and thunder no matter what the Fed does.
Yes, dear reader, as you sow… so shall ye reap. The feds sowed inflation – and now they’ve got a bumper yield of it. They planted a good crop of deflation too – by encouraging so many bubbles and so much debt. They’re going to fill the silos with that too.
And what can they do about it?
“The Fed is not really in control of the situation,” says Paul Volcker, former Fed chairman and the last man at America’s central bank to protect the dollar.
In trying to fight deflation rather than inflation, the Fed chose the wrong enemy, in our opinion. At least it could win the fight with inflation. Paul Volcker proved it was possible. The fight against deflation, on the other hand, is a losing proposition. When Mr. Market wants to deflate, there is not much a central bank to do to stop it; Paul Volcker’s Japanese counterparts proved that.
Has it come to that? Are we finally come to the grim harvest we predicted in this spot eight years ago? Are we now, at long last, faced with a long, slow slump a la Japan?
The United States “risks a lost decade like Japan,” says a headline in the London Telegraph.
“Is America heading for a Japan-style crisis?” asks a headline in our own MoneyWeek magazine.
The answer to this question is yes… and no. Yes, there are definitely parallels. Yes, the U.S. central bank is fighting the downturn just as Japan’s authorities fought its slump. And yes, they will probably make the situation worse, just as Japan’s policymakers did.
We mentioned yesterday that Western kibitzers blamed Japan’s authorities for not allowing the banks to fail. Japan’s big bank had lent hundreds of billions to Japanese industry in the boom years. Then, when the boom was over, the loans went bad. But the banks were ‘too big to fail,’ so the bad debt couldn’t be marked to market and the financial sector couldn’t move on.
In America, the big financial firms have plenty of debt too. Much of it is certainly bad. So far, many Wall Street lenders have fessed up to losses – totaling more than $100 billion. But there is much more… still waiting to be discovered.
What’s more, America’s debt is not only broader and deeper than its Japanese equivalent… it is also more inscrutable. It’s not only the big players who have a lot of debt in the United States, in other words; the little guy has his share. And right now, U.S. authorities are looking for ways to keep the little guy from getting what he deserves – and, incidentally, protect the big lenders from further losses at taxpayer expense.
For example, there’s a proposal – originating with Goldman Sachs… and put on the Congressional agenda by Rep. Barney Frank – for the government to buy up mortgage contracts. This would permit homeowners to hold onto their digs – even though they can’t really afford them. Nobody mentions it, but this proposal would also get Wall Street off the hook, putting the government in as a buyer of last resort, rather than allowing the mortgage contracts to be marked to market properly.
Meanwhile, there are trillions of dollars worth of derivative contracts outstanding. Here, the problem is not so much that the banks are hiding their losses… but that they don’t know what their losses are. Even Robert Rubin, formerly the head man at Goldman and the U.S. Treasury, says he didn’t really know much about CDOs either, until they began to blow up last summer. And then, two weeks ago, the world’s leading insurance company, with a trillion dollar balance sheet, and net income greater than the GDP of some sovereign nations, announced that it had made a mistake. It had “discovered a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the super senior credit default swap portfolio.”
Anybody can make a mistake, of course. And whether AIG made a mistake when it first analyzed its swaps… or a mistake when it reconsidered its swaps… or will make another mistake when it rethinks them again… is anyone’s guess. Our guess is that there are more “mistakes” to be uncovered… because, as we will explain in some future Markets and Money ramble, the whole proud tower of modern financial business is based on a compounded series of frauds, subterfuges and mistakes-waiting-to-be-discovered. In retrospect, the $15 billion investors wiped from AIG’s market cap may turn out to be wishful thinking. The losses could go much, much higher… and take many years to be discovered.
Nevertheless, there’s a whole ocean of difference between an island nation with huge savings, a thrifty population and an enormously positive trade balance, and a stretched-out empire, possibly in decline, running record deficits in its external trade and internal government finances, with an aging, over-paid, over-indebted workforce. The former can tolerate deflation. The latter hasn’t got the stomach for it.
Markets and Money