Newsletter - MarketCommentary

A Shot Across The Bow

5/23/2013 7:00:00 PM

Wednesday’s market action revealed more about the overbought and overvalued status of the market itself than it did of the perceived reasons for the downturn, as the underlying monetary and economic fundamentals did not change anywhere near enough to justify such a reaction.

Briefly, the Dow jumped 155 points on release of Bernanke’s statement that eased market fears by stating that premature tightening of monetary policy would be undesirable. So far, so good. Shortly thereafter, however, in answer to a question by Committee Chairman Brady asking when QE could be expected to taper off, Bernanke stated “We could, in the next few meetings….take a step down in our pace of purchases.” The market immediately turned around and started downward. Within a short time the Dow was down 122 points from the previous day’s close, a total swing of 277 points.

A few hours later the Fed’s minutes of the last board meeting was released and re-emphasized the fear by stating that “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting.” The result was that the market ended up recording a so-called “key reversal day”, meaning a day in which the market makes a high that is significantly higher than the previous day’s high, only to close at point substantially below the previous day’s low. This is usually a sign of an important trend reversal, a signal further emphasized by the fact that Wednesday’s highs and lows exceeded the highs and lows of each of the prior three days.

The 7.3% decline of the Japanese market the following night was a separate event. Despite knowing about the monetary events in the U.S., the Japanese market opened higher, only to be shocked by the release of China’s Purchasing Managers Index, which came in at a recessionary 49.6, abruptly ending a powerful run that began with the Japanese central bank’s announcement of a massive easing program. The Chinese data also helped extend the downtrend in industrial commodities that are so important to many of the world’s economies.

We regard the action of the U.S.

Why We Remain Bearish

5/16/2013 6:30:00 PM

It has long been our underlying thesis that the huge amount of household debt accumulated during the housing boom would inhibit consumer spending and economic growth for some time to come, and this is what has been happening over the last few years. The errors recently found in the famous Rogoff-Reinhart (RR) book do not change this view.

Simply put, household debt averaged 77% of disposable personal income (DPI) over the 61-year period since 1952.

The Market Is Facing Deteriorating Fundamentals

5/9/2013 8:30:00 PM

As we watch the market climb to new highs in the face of lackluster and deteriorating fundamentals, we have the feeling that we’ve seen this movie before in 2000 and 2007, when we were one of very few voices of caution in the wilderness. A rise that was fueled by the perception of never-ending Fed liquidity injections has now morphed into a trend that is feeding on itself as investors are afraid of missing out on further gains. As a result, any news, no matter how negative, is being given a positive spin in the media and on “the street”.

For instance, take last Friday’s payroll employment report for April, which touched off a euphoric rise in stocks. While that was a positive surprise over the expected rise of 140,000 jobs, the reported increase of 165,000 for the month was nothing to write home about. It was well below the 1^st quarter average of 206,000 per month as well as the 4^th quarter average of 209,000. If anything, it looks as if employment increases are decelerating, certainly not a reason for celebration.

Another example was the headline following the recent annual Berkshire-Hathaway gathering, stating “Buffett says stocks will go a lot higher”. While the quote is accurate as far as it goes, it was made in the context of an interview with CNBC’s Becky Quick, in which he actually said, “stocks will go a lot higher in YOUR (caps are ours) lifetime.” Becky Quick is 41, and, according to the life expectancy tables, can expect, on average, to live to 82, which will be in 2054. So stocks will be a lot higher in 2054. Well, yes, but is that worthy of a headline?

In addition to the mediocre employment report there was a lot of other evidence that an already lackluster economy was slowing down further as we headed into the spring. The ISM manufacturing index fell for two consecutive months to its lowest level since December. The ISM non-manufacturing index also declined for two straight months and is now below its 1^st quarter average. April vehicle sales slipped to under 15 million units for the first time since October. First quarter GDP grew at a disappointing 2.5% following only 0.3% in the prior quarter. Average GDP growth for the last four quarters has averaged only 1.8%. Real consumer spending has increased only 2% over the past year, and this was accomplished on an exceedingly weak 0.9% rise in real disposable income over the period. Only a sharp drop in the savings rate enabled consumers to reach even that disappointing level.

Excessive Household Debt, Low Savings Rate Still The Major Problem

5/2/2013 8:30:00 PM

Simply put, household debt averaged 77% of disposable personal income (DPI) over the 61-year period since 1952. It crossed over the average line in 1985 and took a sharp upward turn in 2000, eventually peaking at 130% of DPI in 2007. Since that time, consumers have reduced their debt to a level that is now 105% of DPI, still significantly higher than in the past. The result has been a significant slowdown and tepid recovery in consumer spending growth, a process that is far from finished.

The role of household savings is a key element in analyzing both debt and spending. For 41 years between 1951 and 1992 household savings rates as a percent of disposable income were consistently between 7% and 11%. However, as income growth started to slow down, consumers increasingly maintained their old spending habits by going into more debt and reducing their savings rate. This reached an extreme during the prior decade, when the savings rate stayed below 2% from 2005 through 2007, while debt soared. We all know how that ended.

No matter what you hear from the politicians, the media and “the street”, keep in mind that the combination of the household debt, low savings rates and tepid increases in income has been the reason for the deep recession and subsequent below average growth, and will continue to be the reason why economic growth will likely be slow for some time to come.

In the last two years, between the 1^st quarter of 2011 and the first quarter of 2013, real consumer spending has increased by a meager 3.8%----and this was accomplished on an increase of only 1.1% in real disposable income as households reduced their saving rate from 5.1% to 2.6%. It therefore should not have been a surprise that spending looked so weak in March, and it should be no surprise when spending remains subdued in the period ahead. With consumer spending accounting for about 70% of GDP, it is easy to see why this puts a damper on the rest of the economy, particularly in a time of fiscal drag. The Fed is undoubtedly well aware of the outlook as they continue their attempt to try and offset, at least in part, the major headwinds elsewhere in the economy.

None of the above analysis depends on the Rogoff-Reinhart (RR) research, some of which was recently found to be erroneous. First, RR emphasizes mostly government rather than consumer debt. Second, they maintain that when the government debt-to-GDP ratio crosses 90%, economic growth slows down. The idea that there was some specific threshold of government debt-to-GDP that led to slower growth was probably not valid in the first place.

The Noose On The Economy Is Tightening

4/25/2013 8:30:00 PM

As the evidence of an economic slowdown continues to mount, corporate revenues are feeling the pressure and the effects of the sequester are beginning to seep into the economy.

Last week we enumerated the overwhelming majority of economic reports that declined or fell short of expectations. These included payroll employment, the ISM manufacturing and non-manufacturing indices, retail sales, the University of Michigan consumer confidence survey, the NAHB housing market index, single-family housing starts, the NFIB small business index, the Empire State index and manufacturing production. Since then, additional releases have shown a meager 0.2% increase in March core capex orders following a drop of 8% in February. The Philadelphia Fed Index dropped in April, while the Richmond Fed index was down in both March and April. Overall, the ISM weighted composition was the lowest since November. Existing home sales have been about flat since November. The Chicago Fed National Activity Index was also down in March.

Substantial Evidence Of An Economic Slowdown

4/18/2013 7:00:00 PM

To gauge the current state of the stock market, look no further than the economy. As far as the market is concerned, everything else is random noise. Recent data releases make it quite clear that the economy lost momentum in March and is continuing into April as the overwhelming majority of reports come in below expectations. We cite the following evidence:

1) March payroll employment dropped to a disappointing 88,000.

2) The ISM manufacturing index dropped to its lowest level since December.

3) The ISM non-manufacturing index declined to its lowest level since September.

4) Retail sales fell in March and the prior two months were revised down. The weakness was widespread through various categories.

5) The University of Michigan consumer confidence index declined to its lowest point since July.

6) The NAHB housing market index dropped for the third consecutive month to its lowest level since October.

7) While housing starts were up 7%, more than the entire gain was accounted for by multi-family units as single family starts were down for the second time in the last three months. New building permits were similarly down the second time in three months.

8) The NFIB small business index declined in March and is only two points above the lowest level of the past year and three points lower than a year earlier. Moreover, the majority reported weaker sales over the last three months and expect a drop in sales over the next six months. This does not bode well for new hiring or capital expenditures from an important sector of the economy that is often not well represented in other key indicators of the economy.

9) The Empire State Index fell to 3.1 from 9.2 and 10.3 in the prior two months.

10) Although March industrial production increased 0.4%, it was almost all accounted for by a 5.3% rise in utility production while the manufacturing sector fell 0.1%.

11) The IMF cut its 2013 forecast for global growth to 3.3% from 3.5% and the Eurozone to -0.3% from +0.1%. Eurozone GDP has declined for five consecutive quarters and the first quarter will probably be the sixth. The Eurozone periphery nations are already in recession and getting worse, and now France and Germany are slowing down as well. This will be felt in the U.S.

Blind Faith In The Fed Is Not Enough

4/11/2013 9:00:00 AM

The move of the S&P 500 into new all-time highs is based on neither the economy, nor earnings, nor value, but almost completely on the blind faith that the Fed can single-handedly flood the market with enough funds to keep the illusion going. In this sense the similarity of the current stock market to the dot-com bubble of the late 1990s or the housing bubble ending in 2007 is glaring.

Although first quarter GDP growth looks as if it could come in at 3%-to-3.5%, the economy was clearly losing steam in March. The NFIB small business survey slipped in March, and is just two points above its lowest point of the past year and three points lower than a year ago. The breakdown indicated lower sales, weak expectations and historically low plans to hire. March payroll employment dropped sharply to only 88,000 while the ISM manufacturing index declined to its lowest level since August with drops in new orders, employment and export orders. The March ISM non-manufacturing index declined to 51.3 from 54.2 a month earlier, the lowest point since December.

Real consumer spending has been growing at a mediocre 2% rate over the past year despite growth of only 0.9% in real disposable income over the same period. This was accomplished mainly by decreasing the savings rate to only 2.6% in February, compared to rates of 7%-to-11% in more prosperous times. With employment growth diminishing and the negative effects of the January tax increases and the sequester yet to kick in, consumer spending is likely to slow markedly in the period ahead. While March year-over-year comparisons may benefit from an earlier Easter, the reverse will probably be true in April. Keep in mind, too, our over-riding theme that consumers, still burdened with most of the debt built up in the housing boom, are in no shape to jump-start their spending.

Investors have also apparently forgotten the January tax increases and the sequester. The combination is likely to reduce GDP growth by 1.75%. First quarter GDP would have to grow 3.6% just to maintain the 2% trajectory of the past two years. Subtracting 1.75% from the 2% leaves very little room for growth.

Corporate earnings, too, are no longer behind the rise in the market. S&P 500 operating earnings were up only 0.4% in 2012 with the third and fourth quarters down from a year-earlier. The consensus is looking for a 15% rise in 2013 earnings, a number we regard as highly unrealistic given the substantial headwinds facing the economy. We note that year-ahead earnings forecasts have historically been extremely inaccurate, and have usually erred by being too optimistic.

In addition the market is actually substantially overvalued. Those who believe that the market is either undervalued or reasonably valued use year-ahead estimates of operating earnings. In our view this method of valuation is flawed. As we stated above, the estimates are usually wrong, and mostly on the high side. Furthermore, the use of operating earnings is not compatible with generally accepted accounting principles (GAAP). Historically, the use of GAAP earnings always results in significantly higher P/E ratios than operating earnings.

Another distortion occurs as a result of the volatility of earnings over the business cycle. The P/E at peak earnings are almost always lower than the P/E at trough earnings. Therefore the use of P/E ratios at periods of high earnings tends to show misleadingly low P/E ratios. The way to solve this distortion is to smooth earnings over a longer period that includes one or more complete business cycles. Our estimate of smoothed trailing GAAP S&P 500 earnings is about $81, resulting in a P/E ratio of 19.6 at current levels. Other estimates of smoothed earnings by Robert Shiller and Ned Davis result in even higher P/E ratios than ours.

In sum, the lack of support from the economy, earnings or valuation leaves the Fed as the only game in town. Although the old adage says “Don’t fight the Fed”, it did pay to fight the Fed in 2001 and 2002 and again from late 2007 to early 2009. In our view, the Fed can only try to offset the tightness coming from the fiscal side, but cannot get the economy growing on a sustainable basis

A Topping Pattern In The Market Is Underway

4/4/2013 8:30:00 PM

The market appears to be running into some technical problems at the same time that the fundamentals are showing sign of deterioration. Recent U.S. economic releases have tended to be disappointing, while the global economy is either in recession or reporting slower growth. At the same time the situation in Cyprus is still festering, Italy is without leadership, North Korea is making serious threats and the Mid-East is----well, the Mid-East.

Happy Easter

3/28/2013 3:30:00 PM

We wish all of readers a happy Easter. Our next comment will be on Thursday, April 4^th

The Market Is On Shaky Grouind

3/21/2013 5:30:00 PM

A number of factors are pointing to a developing market top, including a disappointing first quarter earnings outlook, the effects of fiscal restraint, the continued ineffectiveness of Fed policy on the real economy, the crisis in Cyprus and the world-wide recession.

Third and fourth quarter S&P 500 earnings were not only disappointing, but actually down from a year earlier. Historically, two consecutive down quarters have occurred only in recessionary environments.

The Case For A Triple Top

3/14/2013 8:00:00 PM

Whenever the vast majority of investors, pundits and the media agree on the direction of the market, they are usually wrong. In the past few days as the indexes have either broken or approached new highs, an apparent wave of euphoria has been evident. The “experts” cite the gains so far in 2013, the Fed’s willingness to keep its foot on the gas for however long it takes, a perception of improvement in the economy, rosy earnings forecasts and reasonable stock valuations. The still significant major problems facing the market are now being mostly ignored.

The market’s positive beginning to the year is far from unique, and is not much different than the start of each of the last three years. 2010 began with a gain in the S&P 500 of 9.2% only to be followed by a 15.6% correction. Similarly, the next year started with an increase of 8.4% and then corrected by 19.4%. Early last year the market gained 13.1% before dropping 10.5%. So far this year the market has jumped 9.6%, similar to the gains of the prior three years. With investor sentiment extremely high and serious domestic and foreign problems still unresolved, we think that not only are the chances for a major correction quite high, but that the entire market rise since March 2009 may be coming to an end.

Economic growth has been staggering along at barely a 2% annual growth rate, and recent economic numbers give us little reason to believe that the pace is increasing. Although February retail sales jumped 1.1% from a month earlier, the number appeared at odds with the non-seasonally-adjusted figure, which was down 0.4%.

It's 2000 And 2007 All Over Again

3/7/2013 6:00:00 PM

"I have to get into this market; otherwise it's just dragging on me" (A portfolio manager quoted in the Wall Street Journal just prior to the March 2000 peak in the S&P 500.)

"..as long as the music is playing, you've got to get up and dance. We're still dancing." (Citigroup CEO Chuck Prince in July 2007) You know how that turned out.

It's that time again. The Dow surpassed its all-time high and the S&P 500 is not that far from the tops of 1553 on March 24, 2000 and 1576 on October 9, 2007. Just as in 2000 and 2007, the economic, valuation and political background does not support the budding euphoria.

The economy has been limping along at about a 2% growth rate despite the near-zero percent Fed Funds yield and huge amounts of Fed bond purchases. At the same time fiscal policy has become a significant headwind. The agreement to avert the fiscal cliff could slice about 1% off GDP with the sequester reducing it by another 0.5%. A 1.5% hit to a GDP that was only growing at about 2% leaves the economy on awfully thin ice, and very close to recession. Consumers are still in the process of deleveraging their debt, and with wages climbing so slowly, are in no position to go on a spending spree anytime soon. Businesses, sensing a lack of consumer demand, and worried about the dysfunction in Washington, are not likely to step up capital expenditures to any great degree. Unlike the stock market, they are building up their cash in anticipation of the next crisis.

The market has climbed on the basis of an almost childlike faith in the Fed as well as record corporate profits. As we have previously stated the Fed has not been successful in channeling money into the real economy. Moreover, corporate earnings growth has come to halt and is threatening to turn down. In fact, third quarter S&P 500 operating earnings declined from a year earlier, and fourth quarter reports seem to be falling short as well with the vast majority of companies having already reported. Two quarters of declining year-to-year earnings growth has been seen only in recessionary environments.

Death By A Thousand Cuts

2/28/2013 2:00:00 PM

For some inexplicable reason, the stock market seems to be ignoring the "sequester" that goes into effect tomorrow (March 1^st), and we believe the economy will be significantly affected by it. The consensus is that if the Sequester goes into effect, GDP will drop by approximately .6% and there will be 750,000 to 1 million jobs lost. Even if we strike a "grand bargain" to avoid the "sequester," any significant rise of revenue by taxing, and spending cuts by the government, will negatively affect economic growth.

The consensus GDP estimates of nine economists interviewed by Steve Liesman from CNBC, range from 2.1% to 2.9% during the four quarters of 2013. The total GDP for 2011 was only 1.8%, 2012 was 2.2% and the fourth quarter was a positive 0.1%. Therefore, the consensus estimates from these nine economists is for a better economy this year than last year, and even this tepid forecast should be taken with a grain of salt, as the consensus has now erroneously predicted a better economy for the last three consecutive years.

We have explained in other comments and "special reports" this year that there are only 4 ways to increase or decrease GDP. The four ways are: 1.

Sometimes you CAN "Fight the Fed"

2/21/2013 9:00:00 AM

The Fed's current attempt to control long term rates, "QE to infinity", is based on the hope that by providing cheap money, banking and financial firms will lend and thereby stimulate the economy. This would be a sound plan if the problem with the US economy was a shortage of credit. With corporations holding back cash and depending on productivity gains to drive earnings, the typical recovery scenario where the private sector borrows money for investment and drives job growth and ultimately demand, is not materializing.

Demonstrably cheap money is not the answer. The real constraint on the economy is two pronged: 1. expectations of low growth keep corporations from investing funds and instead they hold large sums of cash on their balance sheets and 2.

CURRENCY WARS WILL ONLY GET WORSE

2/14/2013 4:00:00 PM

When massive private and public sector debts result in a credit collapse and recession, the efforts to pare down the debt is deflationary. Measures to inflate our way out of the situation are likely to fail as households are attempting to pay down debt and increase savings, rather than start a new round of debt accumulation.

This Week's Comment will be a Special Report on Home Page

2/4/2013 3:00:00 PM

There will be no Market Commentary this week or next week. Please read our "Special Report" "The Consumer, the Debt, and Competitive Devaluation" on the right side of our home page.

1/25/2013 12:00:00 PM

Market Strength Based On Dubious Assumptions

1/17/2013 7:30:00 PM

Despite the problems facing the U.S. economy, the dysfunction in Washington and slowing global growth, stocks continue to rise on the basis of what we view as false assumptions. These assumptions are as follows:

1) Since almost every central bank in the world is aggressively easing, the market cannot go down.

2) Although the U.S.

The Disastrous Consequences Of Not Raising The Debt Limit

1/10/2013 7:30:00 PM

As we face another brutal fight over the federal debt ceiling at a time when the economy still remains fragile, the stock market is oddly complacent. Even if the debt ceiling crisis is resolved, the result would be some combination of spending cuts and tax increases that would weaken the economy in 2013. A settlement, however, is far from a done deal as both sides remain far apart and determined to defend their positions. Far worse, if the debt limit is not raised or eliminated, the effect on the economy and markets could be disastrous.

Republicans are insisting on major spending cuts in exchange for raising the debt limit while President Obama is adamant in saying that he will not negotiate on that basis. A number of Republicans have voiced the opinion that government shut-downs have occurred in the past without any great consequences, and that we can do it again. However, a failure to reach agreement this time would involve not only a shut-down, but a failure to pay many billions of dollars of U.S.

The Difficult Part Is Still Ahead

1/3/2013 6:30:00 PM

The explosive market rally following the fiscal cliff agreement was based more on what didn't happen than what did. What didn't happen was the implementation of automatic tax increases and spending cuts that would have shaved about 5% off GDP and cause a recession. What did happen was an agreement that would still reduce GDP by about 1.5%, an amount that still looms as significant in light of an economy that is only slogging along at a growth rate of about 2%. Even more important is the potential mess that lies ahead. The Treasury Department's extraordinary measures to extend the debt ceiling runs out at the end of February or the beginning of March. The sequester requiring automatic across-the-board spending cuts of $110 billion for 2013 goes into effect on March 1^st. The federal government's spending authority for the current budget expires on March 27^th.

The combination of the debt limit, the sequester and the government's spending authority, all expiring within a short period promises to make the turmoil over the August 2011 debt limit fight look like a day at the beach in comparison-----and that fight led to a U.S. credit downgrade and a near default on paying federal obligations on time. Already, the Republican congressional leadership has declared its intention of using the debt limit to press for significant spending cuts, even at the risk of another credit downgrade and the shutting down of the federal government. Senator Pat Toomey of Pennsylvania said "We Republicans need to be willing to tolerate a temporary partial government shutdown."

President Obama, on the other hand, has drawn a line in the sand, saying that he would not negotiate the debt limit and would not allow the issue to be continually used as a weapon to slash spending. He stated that Congress has already passed the legislation authorizing the spending and should not renege on paying the bills. As in August 2011, this could lead to another period of brinksmanship and uncertainty about the possibility of a U.S.

Happy Holidays

12/27/2012 5:00:00 PM

Happy holidays and best wishes for the New Year to all of our readers.

Our next comment will appear on Thursday January 3^rd.

The Market Rally Is Based On Hope Rather Than Substance

12/20/2012 7:00:00 PM

Is the market rally since the low of November 16^th signaling better times ahead? We don't think so. It seems to us that Wall Street is automatically assuming that the fiscal cliff will be settled by year-end, that the economy will subsequently recover at a stronger pace and that the market is significantly undervalued. We disagree on each count.

While we don't know the outcome, the odds that we go over the fiscal cliff are greater than the market is discounting. Although Wall Street and Washington are only 250 miles apart, they speak different languages, and market experts have never been too good at interpreting political events. The investment community's main interest is to find some solution that will help the market, while Washington's main goal is to get incumbents re-elected.

The Street doesn't understand Washington and, in turn, Washington doesn't understand the Street. It is entirely conceivable that the White House and Congress cannot find common ground in time, simply because doing so could harm somebody's chances at re-election. Getting to an agreement in time requires complex compromises leading to a delicate balance that ensures enough votes in both houses to ensure passage. We also note that something would have to be done about the debt limit that will be reached again sometime in February. If not, another crisis would be upon us early in the new year.

Market Rally Based On Shaky Assumptions

12/13/2012 7:00:00 AM

The stock market has been kept afloat only by an expansive Fed and the widespread expectation that the administration and congress would have the sense never to let the nation actually go over the fiscal cliff. As the old saying goes, however, hope is not a strategy, and this optimism is not supported by the recession in some major economies and the economic slowdown elsewhere.

Despite all the chatter about yesterday's Fed meeting, it was certainly no game changer. As expected, the Fed will buy $85 billion per month of mortgage-backed securities and Treasury securities , basically a continuation of previous policy. It also announced its intention of keeping short-term rates near zero at least until the unemployment rate dropped to 6.5%. Separately, the Fed's newly issued economic projections estimated the unemployment rate dipping to 6.0% to 6.5% by 2015. While this is the first time the Fed has set an actual unemployment target, it had already promised to keep rates down until 2015, meaning that the overall policy remains about the same as before.

Some pundits have already dubbed the policy QE4. So far each successive QE has been less effective than the last, a pattern we expect to continue. As we have previously stated, the Fed has used all of its conventional tools and lot of new ones, resulting in a huge increase in the Fed's balance sheet. So far, however, the transmission mechanism between the creation of excess reserves and a robust economy has broken down, as the excess reserves have not resulted in a commensurate increase in the money supply. Similarly, the increase in the money supply that did take place has not resulted in a strong economic recovery. In addition the new methods implemented by the Fed have never been tried before and have the potential to lead to unintended negative consequences.

As for the fiscal cliff, most of what we know about the negotiations is public posturing by both sides as they seek to avoid blame for any failure and convince their followers that they fought as hard as they can. Although it is possible that more progress is being made in private negotiations, we don't know that. The market is assuming that a settlement is likely by year-end, and has run up on that hope.

The New Era Of U.S. Fiscal Austerity Is About To Begin

12/6/2012 5:00:00 PM

In discussing the fiscal cliff issue, the one big takeaway not to forget is that it is all about austerity----extreme austerity if we go over the cliff and a lesser amount of austerity if we settle it before year-end. More than likely, this is the start of a new era of fiscal austerity in the U.S. In no way do we see this as a solution to the myriad of problems besetting the U.S. economy and stock market. These problems include the continuing excessive level of household debt that is the main culprit holding back economic growth, a loss of economic momentum in the last few months, declining earnings estimates and guidance, the European recession and the growth slowdowns in the BRIC nations and emerging markets. As we explained in last week's comment, it was the huge buildup in household debt resulting in a major credit crisis and great recession that caused most of the budget deficit, rather than the other way around.

Going over the cliff would result in roughly $500 billion of increased taxes and $100 billion in spending cuts in 2013, a total that amounts to about 4% of GDP, and would surely throw the economy into recession within a fairly short period of time. This is a totally undesirable outcome that both sides want to avoid, although even then, a settlement is not a sure bet. Our main point, however, is that even a resolution of the problem would have to involve some combination of tax increases and spending cuts that would add fiscal restraint to an already fragile economy, thereby causing the very recession that everyone is seeking to avoid. The result would be an actual increase in the deficit.

The current consensus is also convinced that additional fiscal restraint will not hurt the economy at this point since it is in a recovery mode and, in any event, is backstopped by an easing Fed. We have our doubts. Even before hurricane Sandy, the economy was slogging along at a barely 2% growth rate, and was showing signs of losing momentum in recent months. Based on numbers prior to the hurricane, the so-called consumer recovery was not solidly based as real disposable income actually declined 0.2% from June through September. Consumers were able to increase spending only by dropping their savings rate from 4.4% to 3.3% over that period.

The Deficit Did Not Cause The Recession; The Recession Caused The Deficit

11/29/2012 7:30:00 PM

Both Wall Street and Washington have lost sight of the major cause of the deep recession and exceedingly slow economic recovery. To hear all the talk, the major concern is about the impending fiscal cliff and the federal budget deficit. Fix the fiscal cliff and make major reductions in the deficit, they say, and all will be ok. We think they've got it wrong.

As we've been writing about for a number of years, the major problem affecting the economy is the credit crisis of 2008, brought on by the preceding housing boom, explosion of household credit and the associated sleazy practices by the mortgage banking industry. Also culpable were the various enablers such as Alan Greenspan, overall Fed policy and the major credit rating agencies. When the boom collapsed, households were left with a severely depleted asset (their homes), record debt and low savings. Since that time consumers have been faced with the problem of paring down debt and increasing savings at a time of extremely limited increases in wages, a process that is still ongoing today. The result is the weak recovery that typically follows major credit crises.

The federal government deficit, far from being the cause of the lackluster economy, was actually a result of it.