Conflicting Opinions

What can we make of the huge variations in economic predictions by quite reasonable analysts? I briefly touch on the topic from my perch in Halifax where I am cool, if not calm or collected. We then go on to Part Two of Art Cashin's excellent essay on how the world of economics really works.

For the last few days, I have been catching up with the reports which accumulated in my email inbox while I was in Cape Breton with my bride. I have been struck by the veritable chasm between analysts for whom I have a great deal of respect. I am not talking about market cheerleaders or professional bears, but those who simply try to sort out the ying and yang of the economy, with no axe to grind. There are those who see the economy recovering sharply and those who are clearly worried about future prospects. In a conversation with Dennis Gartman, no slouch himself at the forecasting game, I told him I could not remember a time when competent analysts disagreed so much.

He averred that he could. In fact, he could remember two such times: 1974 and 1980. I will defer to his clear seniority in this matter, as I was parsing Greek verbs in the former period and was still trying to learn to simply spell analyst in the second.

With that said, let me see if I can help us peer through the forecasting fog, which at times is as dense as the fog I am currently watching roll over the Northwest Arm in Halifax.

In economics, as well as history, there are those who tend to focus on the large events and major players. They look to see what moves the masses to revolution or market mania. Which leaders acted decisively and which watched as their world collapsed around them. To them, it is the kings and presidents, the generals and revolutionaries, the business titans and the central bankers, who set the course to which the economic and political ships sail. The rest of us are passengers, and while we do play a part, we can (and perhaps even need to) be led. The large portion of society is seen to be responding to economic tides and forces. If the leaders can simply set a wise course, then all will be well. If you leave the masses alone to fend for themselves, you subject the country to an unfriendly business cycle, not to mention panics, market manias and depressions.

Then there is the view that the economy is made up of individuals making various self-interested decisions, along the lines of Adam Smith's invisible hand. These compounded decisions create the tides of economy, and the various leaders mentioned above can only respond and influence on the margin the various factors. You can lead a horse to water, but you can't make him drink. You can lower interest rates but you can't make them borrow. You can increase the money supply, but you can't maintain the value of money if you do so. Manipulation of the economy by the government and central banks will result in excess and imbalance and will lead to recessions to correct the government created imbalances or worse.

Between these two poles are a variety of economic schools of thought. Each of these schools argue passionately for their view of the world, and many have good points. But which is right, you ask? Ignoring the more simplistic and politicized (and obviously wrong) schools like communism, in the short run, which is to say the world we live in, the answer depends upon what your question is and how long is your time frame?

As an example, bulls point (and rightly so) to the probability of excellent economic growth over the next few quarters. Not only is the stimulus of a tax cut taking effect, the recent (in the second quarter) tidal wave of home re-financing will introduce monthly payment savings into many households, plus supply fresh fodder for consumer spending as many home owners took out some equity in the deal to improve their homes, pay off debt or finance other items they wanted.

They point out that new applications for unemployment are below 400,000 for the 4th straight week, the unemployment rate dropped to 6.2%, plus housing construction and new home buying is still strong. Yes, rates have backed up, but they are still below the level they were a year ago when everyone was suggesting that low rates were the reason for the housing boom. The economy grew at 2.4% in the second quarter, which is much faster than anyone projected and clearly a sign that we are recovering and on the way back to above trend growth, if not spectacular growth, in the 5% range.

In the shorter term I might agree (well, not with 5%). But if we look a little further down the economic road, the numbers don't give us the same comfort. And thus the bears begin to weigh in.

Where Are the Jobs?

First, this recovery is not doing the one thing recoveries are supposed to do: create jobs. Unemployment didn't actually fall. The authorities who count such things only count those who are actually seeking jobs as unemployed, which makes some kind of sense. But last month, they dropped around one half million of our fellow citizens from the unemployed ranks, not because they had found jobs, but because they had become so discouraged, they stopped looking.

Continuing claims, which are those people who have been unemployed a lengthy period, are continuing to rise. Challenger Gray reports unusually high announced lay-offs for the month of July. 76,000 jobs went poof last week.

Now, is 6% unemployment necessarily cause for alarm? No, would say the statistics. But until this economy begins to create net new jobs, we are on a glide path to slower growth, even if the current quarters will not suggest that. Growth in consumer spending can only come from employed consumers.

The economy grew at 2.4% (in the second quarter) only because of one time spending by the government on the Iraqi war. Otherwise, the economy probably grew at less than 1%.

The recent monster wave of refinancing was another 'one-of' event. While there will still be re-financing in the future (as long as rates stay where they are), it will not be the huge stimulus it is this second half. As an aside, I have seen estimates that a large drop-off in mortgage refinancing could result in the unemployment of tens of thousands of people who have been hired recently to process them. More unemployment pressure.

All this being said, the economy is not ready to fall off a cliff. The bulls would argue that there will be other positive things that will happen to keep things rolling along. I personally see a scenario where we bounce around but remain below trend for quite some time. It is entirely consistent for me to see the possibility for above trend growth this quarter but a below trend Muddle Through Economy and even Decade for the longer term, with recessions and recoveries thrown into the mix.

For instance, if interest rates stabilize, as they look like they might, we should have a decent second half. If the Bush team can get Iraqi oil back on line, somehow figure out how to get Nigeria settled and if Venezuela will stop its implosion, we could see a drop in oil prices later this year. Given the propensity of OPEC members to cheat, the drop could be significant and stunningly fast. Oil in the low $20's would do more to stimulate the economy and stem the dollar slide than any tax cut.

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Eventually, if we do not produce net new jobs, we will have to deal with a recession, but that is in our future, and not today. And thus you see the answer to the question of "who is right" depends upon your time frame and the way you see the data unfolding.

Now, since I am technically on a working vacation, my bride has determined that it is vacation time and I must leave the world of economics and wander into the beautiful and cool world of Nova Scotia. So, we turn to Part Two of Art Cashin's explanation for how the world works. As noted last week, Art wrote this not for economists, but as a way to explain things to the average person. I should note that all of my readers are way above average, but you might find this useful when explaining things to your brother-in-law or send it to your children who have only had the confusion of a college economics course. (You can see Art every Tuesday afternoon on CNBC.)

Part Two: How the World Really Works

Inflation and Deflation

The theory that inflation and deflation are primarily currency problems was the basis for the concept of central bank control of the business cycle. Some modern economists argue that these two problems have more to do with structural things such as capacity. Messrs. Greenspan, Bernanke, et al have spent recent months discussing deflation as a monetary question so we'll stay on that thesis, as that is the premise under which they conduct their business.

To over-simplify again let's go with the conventional definitions. Inflation is too much money around. Deflation is too little money around. When there is too much of anything around, we tend to be careless about it. So it is with money. People tend to buy without bargaining. Prices rise. Rising prices inspire folks to pay even higher prices lest the price go even higher tomorrow. In a rapid inflation cash is trash. You want to own goods.....not green pictures of dead presidents.

In a period of deflation (monetary) cash is scarce. Like a handful of matches in a snowed-in cabin, people tend to conserve that which is scarce - even money. When people are reluctant to spend, it is tough to sell things. Whether you make shoes or sandwiches, you are willing to cut prices or give incentives to get some of that precious cash. Lower and lower prices inspire people to postpone purchases. That tends to feed on itself as sellers offer even lower prices.

Why does the Fed appear far more worried about deflation than inflation? The obvious reason is that inflation is more controllable. As Paul Volker proved in the early 80's, all you need is an iron will and the willingness to inflict a lot of pain as you choke inflation to death.

There are two other reasons why deflation is more feared. Both of these are cultural. Deflation was part and parcel of America's great economic trauma - the Depression.

The other cultural reason is that we are a nation of debtors. We owe out more than we save. From mortgages to business loans, Americans have been encouraged to build up debt through tax policies and the like.

Inflation punishes the saver and the lender. The purchasing power of the savings goes down every time prices go up. Deflation punishes the spender and the borrower. The purchasing power of the money he must repay goes up as prices go lower. Worse, the house or car he borrowed to buy no longer goes up in value. That has enormous potential for culture impact were it to hit the U.S.

We'll come back to this, but we need to examine one other phenomenon right now.

Since the most over used word in English today appears to be "Bubble", we thought we would go there next. We'll examine the nature of bubbles. We'll look at the tech bubble (one theory). We'll even discuss post bubble problems.

Bubbles are booms on steroids. Instead of just being frenzied bouts of over enthusiasm, they morph into the delusional. All caution is lost. All financial rules have been repealed.

A key ingredient in most bubbles is the concept of novelty. Usually it's a new invention or technology. The automobile, the radio, the telephone and the like were all accompanied by bubbles. One of the biggest bubbles in American history was the one involving the beginning of the railroads. It is the novelty that promotes - "this time it's different". The novel new technology will "change the way we live" so all the old rules have been repealed. This "opportunity" will be a great leveler. If you and I are bright enough to seize this opportunity, we believe we may become rich as Henry Ford, Carnegie or Vanderbilt. (Well, maybe as rich as one of their junior partners.) To pass up such an opportunity surely proves you are a fool.

One of the more bizarre bubbles in history did not involve a new technology. But it did involve a novelty - tulips.

When tulips were first brought to Europe from Asia Minor, they were a popular novelty. Suddenly, however, a frenzy developed in Holland. Could they evolve a black tulip? Within days people were paying huge prices for promising bulbs. The mania fed on itself. A house was traded for a tulip bulb. Then a bulb (maybe the same one) was sold for two houses....then three houses.

The mania occurred so quickly it had odd consequences. A sailor, who had been on a voyage for several months returned with an important message for a wealthy merchant. He gave the merchant the message. Gratefully the merchant gave him a florin and invited the sailor to make himself a sandwich while the merchant went off to act on the message.

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The sailor took some cheese and some bread but yearned to spice it up. An onion would be perfect. Up on the shelf sat a yellow bulb. The sailor took the "onion" down and sliced it for his sandwich. When the merchant returned, he was horrified to see that his prize tulip bulb, costing a year's salary, had been turned into a sandwich topping.

The tulip bubble lasted less than a year, but was so frantic and frenzied that when it burst it brought the nation to its knees.

What about the tech bubble? Why did it happen? Why did it happen when it did?

To understand the possible causes of the bubble we need to put it in context. In the early 90's, the "problem" of Social Security was front-page news. There was much talk of possibly investing Social Security funds in the stock market. When the topic of risk came up, proponents marched out academic study after academic study demonstrating that "over the long haul" stocks had outperformed everything else. Prudent people, we were told, didn't worry about illusions of risk. About the same time 401K's and the like, began to proliferate as companies moved from pensions.

By the middle of the decade, the economy, fully recovered from the Gulf War recession, was performing nicely. A key ingredient we were told was the productivity miracle. Technology was beginning to fulfill its promise at last.

Enter the novelty or new technology. The Internet began to bloom. It promised to change our life and our culture. We would shop from home, work from home, do anything we liked from home. It would be a new world.

Okay, we have all the ingredients - a diminished sense of risk, public involvement and a new technology. But what about timing? Why just then?

Remember the Y2K curse.? I suggest to you that the tech bubble was to some degree the Y2K curse.

From 1997 on everyone talked of the Y2K curse. When the calendar turned 2000, havoc would occur. Elevators would stop or maybe plunge, so might planes. ATM's would stop working. Your bank records might disappear. Every person, every company would need to buy a new computer. In fact, to be safe they would need a brand new everything in the field of technology.

Tech sales soared. Folks who might not have ordinarily upgraded for five years rushed to buy new equipment. We were cannibalizing future sales - although we didn't know it at the time.

The nation would need lots of money to pay for all that new equipment. More importantly, if the fears about banking took hold, people might starting hoarding. That could collapse the money system (recall the velocity of money).

The Fed also had to keep things loose for other reasons like Long Term Capital Management and the ruble crisis.

About the middle of 1999 talk of YK2 horrors diminished. Companies filed preparedness reports with the government. Folks had bought all the tech stuff they needed and then bought tech stocks. There was clearly no sign of hoarding.

Seeing all of this, the Fed began to take the punchbowl away. Six months later, the game was over. Tech sales stopped and tech stocks sank. The bubble had burst.

Now we should discuss the aftermath of bubbles.

Economists and economic writers tend to throw about lots of terms relating to portions of the business cycles. There are booms, busts, panics, bubbles, and the like. Unfortunately, the same term is often applied to different conditions. Just as most of us might say someone has a "touch of the flu" when it is really the common cold or maybe a perverse allergy, economic writers see terms and symptoms as interchangeable. That may be convenient but it tends to confuse the analysis.

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For purposes of our exercise please accept some imposed definitions. A "boom" is an expansionary phase of an economy or culture that runs ahead of its support system (money: resources; work force, etc.). This, historically, results in a "bust".

The "bust" is the corrective phase that is needed to remove the excesses of the boom. It can be extreme. On a cultural level it might result in the disappearance of a city or even a civilization. In economic terms its occurrence is more frequent and less severe (usually - though your respective nation may no longer be top dog). The pains and problems of the bust are usually proportional to the excesses of the boom.

This "bust" correction phase has a lot to do with the concept of "reversion to mean". That is an economic (or mathematical) concept that often starts a major fight in a post boom environment. We'll deal with that in a minute.

We'll call a "panic" a monetary or financial event. Frequently they occur when a boom goes bust or a bubble bursts. That's because the promise of the boom or bubble encourages the normally prudent to borrow heavily to buy companies or capacity or whatever. When the game of musical chairs suddenly ends, the borrowers default, the bankers buckle and the depositors panic.

Historically many "boom/bust" or even "bubble" cycles have tended to be local or national. But, with some frequency, especially in the last century, the global interactivity of finance can have "panics" spread across national lines. In the old days (pre-central banking) credit was often the result of a "down payment" or special collateral. In a bust the liquidation of the collateral might spill over into banking causing a panic.

Okay, let's get back to that troublesome concept of "reversion to mean". It has some theological or, at least, parental aspects in that your "punishment" will be proportional to our "excesses". But, in the "bust" slowdown many folks claim all you need to do is slow down the posted speed (your former rate) rather than go slower.

The debate has a lot to do with whether your example is medical rather than mathematical. If you are a parent you know a couple of things. The "average" human temperature is 98.6. You also know that any number of bacteria, viruses and allergic reactions can cause little Johnny or Suzie to suddenly run a fever of 104, or even 106. You and your doctor administer aspirin, alcohol baths or whatever to bring the little tyke's temperature back to the "normal" 98.6. You don't expect or need to go to 92.6 just to offset the excess. Rather, it will be a victory if you get back to the normal (healthy) 98.6.

With similar logic, or analogy, some economists argue that all you need is to get back to the "normal" rate of growth. Bears, however, argue a purge is in order.

The difference has a lot to do with statistics, sampling and how you evolved our premise. The 98.6 is based on an overall sampling. It has a lot to do with the concept of norm. But averages and medians are constructed differently.

The Reversion Machine

Look at a different temperature. The average, or even median, temperature of any town U.S.A. is 61. But in late July, for two weeks the temperature hung near 100. In most climates "too hot" gets balanced by "too cold". Even if the temperature returned to the "traditional" 61 for the other 50 weeks of the year, the two hot, hot weeks would skew the average.

Thus, in math and economics "reverting to mean" usually means hangovers are needed to balance some excess. The "post bubble" analysis, such as we are now having, is possibly the most debated aspect of the economic cycle. Witness the current acrimonious exchange between economists.

Historically, booms or bubbles lead people to build capacity for the new "super" demand. That's not just in the product du jour but in all aspects of support. To avoid alienating the internet/tech group, we'll allude to an earlier bubble - railroads. Railroads were also seen as an agent of cultural change. Railroads hinted - new goods from afar, new clients from afar, even new spouses (or spouse choices) from afar.

In the railroad bubble money was borrowed to build railroads, locomotives, cars, rails, ties, etc. Despite the fact that these new railroads were redundant (too close to other potential railroads), money poured in. Money also poured in to build factories to make the locomotives, rails, ties, etc. And, then there was the added capacity needed to service all those folks adding to the capacity in all the railroad-related areas.

Suddenly - at some point - reason intervenes. All these railroads cannot prosper. And - by extension - neither can all these support services.

Two things occur. The excess debt for the excess capacity must get paid. But how will we do it? We begin to sell cheaper - even below costs. We work longer and harder (productivity increases). Yet too many still produce too much for too few to consume. Prices lay flat (today) or even fall (deflation). If prices begin to fall, you sell whatever you can - for you now can buy it cheaper - later.

The other thing that occurs is that there is a capacity overhang. Businesses do not invest in expanding capacity when sales are flat and part of your factory or store is idle.

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To make things comparable to today's environment, we need to examine global capacity and competitiveness. That means we must explore the role of currencies and the very concept of "money". That's where we'll go next. (end of Part Two)

Trend Watching and other Past Times

One of the things I like to do on vacation is read a wide variety of books. Let me recommend two books to you. The first is Ron Insana's book on investment bubbles, Trend Watching . Ron (from CNBC) takes us in this well written (and well researched) tome through scores of bubbles, noting how similar they are, and suggesting ways we can spot the next one. Bubbles are endemic to the human experience. There will always be another bubble somewhere. Sometimes they are broad and powerful, and sometimes they are narrow. But if you recognize them for what they are (brief moments when investors lose rationality) they are tradable. If you can recognize them in their developing stages, then so much the better. You can get the book at your local bookstore, or from at ( I intend to write a few e-letters on this book (and topic) in the future, as understanding bubbles also helps us understand more normal investing strategies.

The second book is Walter Isaacson's Benjamin Franklin: An American Life . I read David McCullough's Pulitzer prize winning book John Adams last Christmas. Both are more than dry history, and each treat their own character sympathetically. I find significant parallels to the problems of Adam's and Franklin's age and our own. It is especially interesting to compare how Franklin viewed these problems and their solutions to how John Adams viewed the world. Sometimes we tend to think of the "Founding Fathers" as a group who sagely guided our nation's birth. The reality is they were a cantankerous group of revolutionaries who could (and did) argue everything. The politics of their day, the sheer meanness, makes our own times seem positively tame. Franklin's life and writings, as Isaacson depicts him, will give me food for thought for many days.

San Francisco

To those of you who are waiting for me to contact you about meeting in San Francisco this week, I apologize. I will get to it Monday. (I am at the Agora Wealth Conference at the Fairmont in SF the 14th through the 17th.) But for now, my bride and I take a long weekend to explore Halifax (even in the cool rain), which is better than exploring Texas in the 108 degree heat of August.

Finally, I would make fun of the spectacle of the California political scene, but alas, the comedy happening in Texas as our Democratic state senators attempt to avoid political reality and leave Texas for the more pleasant surroundings of Bill Richardson's New Mexico is almost as absurd, thus leaving Texans little room to poke fun. Actors become politicians and politicians become clowns. Somehow, I think that Franklin and even the dour Adams are chuckling at their kids.

Your hoping it cools off before I get back to Texas analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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