Thursday, April 29, 2004

Circling back to where we began, Serpent eats its tail - GDP faked

As a reader on my post below commented, for some reason my economic blogging is more well recieved than my foreign policy blogging. I'm not entirely sure why, since I got my start in logistical, strategic, and tactical applied modeling in security and foreign operations analysis, handling agents, and field work. If I made a mistake, the price was paid in blood, sweat, and tears. Economic analysis is something of a derivative interest, though I have predicted successfully years ahead of time the Asian economic meltdown, the Mexican peso collapse, the failure of export dominated and debt ridden economies like Argentina, and the failure of foreign development models, as well as market timed the Internet bust quite successfully. I was wrong about some details, like I felt that there was no way that Amazon could remain solvent - and I have to admit that surprisingly their market share dominance strategy worked - but it worked because I had misread the willingness of lenders to protect their interest by extending additional credit. It was the "too big to fail" model, and that's one thing I'm not good at predicting is political choices.

That's because political choices are often sub-optimal, to paraphrase Gailbraith they're often a choose between the awful and the truly dreadful. I'm all about optimization. That's why my advice in order to focus on consumer goods companies in China a while back turned out to be good now that the G7 is warning that China could overheat or cause worldwide inflation. It's also why my advice to invest in oil futures would have yielded a handy profit. I also successfully predicted the restoration of the oil market after it's slump in the 90's and the new interest in gold.

However over the years, my economic analysis which kind of started out as a hobby have recieved more and more interest from people interested in obtaining neutral financial analysis. It started out really because of the 90's stock craze which pushed a greater interest in those around me, and whose encouragement increasingly egged me on for advice. Possibly this was because even then it was completely apparent to most knowledgeable observers that the standard fund managers, stock brokerage advice and service, and mutual fund companies were become complacent, greedy, and finally manipulatively abusive.

I guess I stopped blogging about the economy because well it all seemed so dreadfully clear to me that for me it wasn't much to say at this point in the cycle. Recent comments however have made me aware that it's not so clear for the average person, so I've decided to return to blogging about that.

It's not as if btw I know for certain the definite outcome of specific financial events. It doesn't work like that. What I focus on is the "inevitables". There are certain factors in every economic analysis that represent inevitable choices to be made. If freedom is money and money is value and value is choice, then financial events can always be described by the constraints of the system. Indeed the more constraints on the system, the more it approaches however many parameters it has a definite end. You don't know exactly how things are going to get there, or who necessarily is going going to be left standing, but when there is a mad scramble for the musical chairs you can pretty easily guess how many are going to be left standing and sitting and from a quick perusal determine the likely winners and losers. Hint: Like Survivor and politics in general, it's usually the people who are the most ruthless while perserving the appearance of morality.

It's quite Machiavellian actually, which explains how I got into the economic end of analysis from private security interests in my less than up-and-up past. Cut-throat competition is pretty much the same on an abstract level, whether or not the long knives are banker's drafts or sharp steel. In both situations, it's usually best to maintain Plausible Deniability while sending out proxies to do the dirty work for you. In reality, the good financial operations guy or the good foreign operations guy is like a chess player. He moves the pieces, he doesn't run around on the board.

So even though I personally consider the outcomes in Fallujah and Najaf to be terribly interesting, let's face it the events there don't effect average ordinary people to a great degree. What does effect them is that we are effectively in a stage of inflation generated money supply shrinkage.

One way to determine this is simply to look at the Money Supply year over year growth versus the present inflation rate. I did this back here in the bottom half of this article.

Interesting this is also the article that notes Nathan Newman's and the Economist's debunking of the GDP figures.

This especially important because it notes the role of trade - or rather offshoring - in distorting GDP figures. To quote:

***
"For example, when American firms outsource call-centre and information-technology-support jobs to India and other Asian countries, the result should be higher imports of services, yet official statistics do not show such an increase. America's recorded imports of software services from India are also much smaller than India's reported exports of such services to America. "
***

This puts the kibosh on unabashed boosting like Dan Drezner's here.

As a matter of fact, this is why this 4.2% GDP number here is truly ominious as reported by MSNBC.

***
The reading on gross domestic product for the January-to-March quarter, reported by the Commerce Department Thursday, marks a slight pickup from the 4.1 percent rate registered in the final quarter of 2003. While the first quarter figure suggests that the recovery is in good shape, it fell short of the strong 5 percent pace that economists were forecasting.

GDP measures the value of goods and services produced within the United States and is considered the most important barometer of the economy’s health.

***

Actually as the Economist article points out, the GDP measures estimates of the values of goods and services. The IP chart measures industrial production measures actual industry reports. So if you rely on the estimates, they're actually overcounting the production of other nations as our own. That's right, the work done by Indian software firms is being recorded as US economic activity and growth because it's been offshored.

But in actually, the actual industrial production number (look here) is clearly trending sidewise or plateaued in normal language. There is of course no reason why we can't break out of this, but the economic indicators from retail sales growth to factory orders - proxies for the service and manufacturing segments of the economy - do not show supporting pickups.

So again, that GDP growth doesn't seem real and is inflated by bogus estimates. What is the actual GDP? Probably slightly higher than 2% - say about 2.2% rather than 4.2%.

How do I get this number? Take a look here at at the total production utilization chart from Econo-magic.

Then scroll down to the bottom and click the option: Percentage change from same period last year and tell it to redraw the graph.

Of course, the total capacity grew as well - a measure of capital investment. More capital investment, more production capacity as well? So we have not only a growth in utilization but a growth in capacity.

Unfortunately if you click on this chart and then go down and do the percentage change from same period of last year you'll see that the percentage change in capacity is slightly more than one percent (1%). So one additional percent growth in capacity should both be a warning sign that this is not a fundamentally business expansion led asset valuation - meaning it's a speculative bubble more or less.

If production capacity (to invoke Say's law) is nearly constant but valuations rise, we must have expanding price-book ratios. What is an asset book ratio? It's the value of the stock divided by the total assets having subtracted the liabilities.

It's showing across the economy in situations like the Real Estate bubble that Brad Delong writes about here.

So once again if we look at the capacity number and the utlization number, then the message is quite clear. The economy is growing at best at about 2.5% rather than 4.2%

If we uncritically accept the popular line that inflation was 2.5% (they're probably discussing core rate subtracting food or energy - hey who buys those anyway? Otherwise it'd be at 5%) then the story is that economic growth is stagnant - zero.

Zero? How can that be? Well if you look at the Fed's own numbers on money supply year over year it's 4.5% for M2 and M3, but if actual inflation is about 5% annualized that means that we're at a -0.5% situation. Net given inflation, we're actually tightening our belts.

Now certainly housing starts are still rising, but given that car sales have fallen 18% I think we can attribute this to a late surge of home buyers trying to lock in the still relatively low rates before they rise too much further. Given all the pressures on the Fed in this financially led financial inflation surge, weakening the dollar and leading to import-driven inflation (Financial Times) will in fact put the nail in the coffin. Inflation will rise - benefits alone are rising at 2.4% for employers - and interest rates will have to rise sooner or later to combat them and stablize the dollar.

The housing market which has always been a lagging indicator, people will sit on their houses hoping for an eventual return of prices, and we'll be stuck with a housing slump which will help turn down the economy into a classic double-dip recession if the downturn lasts long enough to be called a recession. Consumer confidence is rising and jobless claims are still falling, but remember like the housing market these are lagging indicators. They won't fall until the last chips are called in by the House.

So this is pretty characteristic of a "liquidity extraction" phase of an speculative asset valuation bubble and as monetary policy tightens then in the short term money supply will shrink as inflation grows some more before it is checked - once inflation starts going it's hard to rein in - and we'll have the monetary stimulus taken out of the economy which should start slumping hard by late fall to X-mas.

Right now the oldman's advice to everyone's money is to stick in an old fashioned FDIC savings account and wait it out, because even money markets aren't safe anymore.

When interest rates were low and so money market yeilds were low, some managers turned to derivaties which are complex betting instruments that were developed to manage risk but can also greatly increase returns in order to shore up their bottom line. If the market goes belly up with a correction, then a great many of these money market funds could start smelling like ten-day-old rotten fish.

Now I don't know whether or not this particular money market fund uses its derivatives rightly or wrongly, but if you look at the fine print it reads:

may use derivatives to protect against losses from changes in interest rates. For example, the portfolio manager may be concerned about the impact that rising interest rates may have on the fund. The fund will only use derivatives as permitted by Canadian securities regulators.

Yeah, well the problem is that derivatives are so complex that it's easy to accidentally set them up so as to create risk instead of hedge against it - ask Long Term Capital Management which was headed by two Nobel Laureates how easily these things can turn in a bad market.

To quote:
"Long-Term Capital Management [LTCM] was a hedge fund using derivatives so arcane even some of the people at LTCM who created it apparently did not understand it."

A lot of these funds are more exposed than they appear on the surface, and all the more deceptive since money market funds are sold as secure investments to put your money in if there's a storm going on in stock or debt markets. Well they are - as long as you don't put volatile derivatives into the mix unless you extremely careful with them.

More than one company has been breached or wrecked on the shoals of careless or greedy abuse of derivatives already!!!

As Jim Coomes one of the readers here put it so pithily, this is a sucker's rally or as I put it a "late surge in a top-heavy market about to turn over".

So that's another edition of Oldman on the economy, and don't let the banks, brockerages, or government statistics fool ya with slippery numbers. Keep your eye on the bottom line, and you'll always be in plenty of money.

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