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Why We Won't Avoid a Double-Dip Recession

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No matter what choices we make, the outcome will be the same.

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We've arrived at this particular economic moment in time by the choices we've made, which now leave us with choices in our future that will be neither easy, nor convenient, nor comfortable. Sometimes there are just no good choices, only less-bad ones. In this week's letter, we look at what some of those choices might be, and ponder their possible consequences. Are we headed for a double-dip recession? Read on.

An Uncomfortable Choice

As our family grew, we limited the choices our seven kids could make; but as they grew into teenagers, they were given more leeway. Not all of their choices were good. Yet how do you teach them that bad choices have bad consequences? You can lecture, you can be a role model; but in the end you have to let them make their own decisions.

I've watched good kids from good families make bad choices, and kids with seemingly no chance make good choices. And one thing I've observed: Very few teenagers make the hard choice without some outside encouragement or some help in understanding the known consequences from some source. They nearly always opt for the choice that involves the most fun and/or the least immediate pain, and then learn later that they now have to make yet another choice as a consequence of the original one. And thus they grow up.

What Were We Thinking?


As a culture, the current mix of generations, especially in the US, have made some choices, some of which, in hindsight, leave the adult in us asking, "What were we thinking?"

In a way, we were like teenagers. We made the easy choice, not thinking of the consequences. We never absorbed the lessons of the Depression from our grandparents. We quickly forgot the sobering malaise of the '70s as the bull market of the '80s and '90s gave us the illusion of wealth and an easy future. Even the crash of Black Friday seemed a mere bump on the path to success, passing so quickly. And as interest rates came down and money became easier, our propensity to acquire things took over.

And then something really bad happened: Our homes started to rise in value and we learned through new methods of financial engineering that we could borrow against what seemed like their ever-rising value to finance consumption today.

We became Blimpie from the Popeye cartoons of our youth: "I will gladly pay you Tuesday for a hamburger today."

The lay-away programs of our parents -- where they patiently paid something each week or month until the desired object could be taken home – weren't for us. Come to think of it, I'm not sure if my kids (ages 15-32) have ever heard of lay-away with credit cards so easy to obtain. Next family brunch, I will explain this quaint concept, though I've heard it's making a comeback.

As a banking system, we made choices. We created all sorts of readily available credit, and packaged it in convenient, irresistible AAA-rated securities and sold them to a gullible world. We created liar loans, no-money-down loans, and no-documentation loans and expected them to act the same way that mortgages had in the past. What were the rating agencies thinking? Where were the adults supervising the sand box?

(Oh, wait a minute. That's the same group of regulators who now want more power and money.)

It's not as if all this was done in some back alley by seedy-looking characters. This was done on TV and in books and advertisements. I remember the first time I saw an ad telling me to call this number to borrow up to 125% of the value of my home, and wondering how this could be a good idea.

Turns out, it is a great idea -- for salespeople who can package those loans into securities and sell them to foreigners, with everyone making large commissions on the way. The choice people made was to make a lot of money with no downside consequences to themselves. What teenager wouldn't do the same?

Greenspan keeping rates low aided and abetted that process. Starting two wars and pushing through a massive health-care package along with no spending control from the Republican Party ran up the fiscal deficits.

Allowing credit default swaps to trade without an exchange or regulations. A culture that viscerally believed that the McMansions they were buying were an investment and not really debt. Yes, we were adolescents at the party to end all parties.

Then there's the investment industry that tells their clients that stocks earn 8% a year real returns. Even as stocks have gone nowhere for ten years, we largely believe (or at least hope) that the latest trend is just the beginning of the next bull market.

It wasn't that there were no warnings. There were many, including from your humble analyst, who wrote about the coming train wreck that we're now trying to clean up. But those warnings were ignored.

Actually, ignored is a nice way to put it. Derision. Scorn. Laughter. And worse, dismissal, as a non-serious perpetual perma-bear. My corner of the investment-writing world takes a very thick skin.

The good times had lasted so long, how could the trend not be correct? It's human nature to believe the current trend -- especially a favorable one that helps us -- will continue forever.
And just like a teenager who doesn't think about the consequences of the current fun, we paid no attention. We hadn't experienced the hard lessons of our elders, who learned them in the depths of the Depression. This time it was different. We were smarter and wouldn't make those mistakes. Didn't we have the research of Bernanke and others, telling us what to avoid?

In millions of different ways, we all partied on. It wasn't exclusively a liberal or a conservative, a rich or a poor, a male or a female addiction. We all borrowed and spent. We did it as individuals, and we did it as cities and states and countries.

We ran up unfunded pension deficits at many local and state funds, to the tune of several trillion dollars and rising. We have a massive -- as in, tens of trillions of dollars -- bill coming due for Social Security and Medicare, starting in the next five-seven years, that makes the current crisis pale in comparison. We now seemingly want to add to this by passing even more spending programs that will only make the hole deeper.

Frugality is the New Normal

I could go on, but I think you get the point. The time for good choices was a decade ago. It would have been more difficult at the time, so that's not what we did. And now we wake up and are faced with a set of choices, none of them of which are good.

Reality is staring back in the mirror at the American consumer -- especially the Boomer generation -- whose psyche has been permanently seared. We're watching savings beginning to rise and consumer-spending patterns change for the first time in generations. Even as the authorities try to prod consumers back into old habits, they're not responding. Borrowing and credit are actually falling. Banks, for whatever reason, now want borrowers to actually be able to pay them back. Go figure

Frugality is the new normal. We're resetting the underpinnings of a consumer-driven society to a new level. It will require a major overhaul of our economy. The normal drivers of growth -- consumer spending, business investment, and exports -- are all weak, and it's only because of massive government spending that the second quarter wasn't as bad as the two previous quarters and the coming quarter will be positive.

But what then? How long can we continue with 10%-plus GDP deficits? We have an economy that's in a Statistical Recovery, fueled by government largess. In the real world, we're watching unemployment rise, and it's likely to do so through the middle of next year. Deflation is in the air. Capacity utilization is near all-time lows. Housing numbers are only bouncing because of the government program of large tax credits for first-time home buyers and lower home prices. It will be years before construction is significant.

We'll be faced with a choice this fall and early next year. If you take away the government spending, the potential for falling back into a recession is quite high, given the underlying weakness in the economy. A few hundred billion for increased and extended unemployment benefits won't be enough to stem the tide. There will be a groundswell for yet another stimulus package. Another 10% of GDP deficit is quite likely for next year.

As I've made very clear, deficits that are higher than nominal GDP cannot continue without dire consequences. Good friend Richard Russell writes today:

"The US national debt is now over $11 trillion dollars. The interest on our national debt is now $340 billion. This is about at 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let's say that by some miracle the interest on the national debt in 10 years will still be 3.09%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof."


That would be at least 30% of the national budget. How would your household do, paying that much as interest? How can you operate when interest payments are 30% or more of the budget? Do you borrow to pay the interest? And the Obama administration openly admits to deficits of over a trillion a year for the next ten years, under very rosy growth assumptions. Anyone outside of Washington or who isn't a rosy-eyed economist think we'll grow 4% next year? I'm not seeing many hands go up.

And Then We Face the Real Problem


If we don't maintain high deficits, it's likely we'll fall back into recession. Yet if we don't control spending, we risk running up a debt that becomes very difficult to finance by conventional means. Monetizing the debt can only work for a few trillion here or there. At some point, the bond market will simply fall apart. And it could happen quickly. Think back to how fast things fell apart in the summer of 2007. When perception of the potential for inflation changes, it changes things fast.



The problem is that we're now in a very deflationary world. Deleveraging, too much capacity, high and rising unemployment, falling real incomes, and more, are all the classic ingredients of the formula for deflation.

Let's look at what Nouriel Roubini recently wrote. I think he hit the nail on the head:

"A combination of higher official indebtedness and monetization has the potential to yield the worst of all worlds, pushing up long-term rates and generating increased inflation expectations before a convincing return to growth takes hold. An early return to higher long-term rates will crowd out private demand, as lending rates on mortgages and personal and corporate loans rise too. It is unlikely that actual inflation will emerge this year or even next, but inflation expectations as reflected in long-term interest rates could well be rising later in 2010. This would represent a serious threat to economic recovery, which is predicated on the idea that the actual borrowing rates that individuals and businesses pay will remain low for an extended period.

"Yet the alternative -- the early withdrawal of the stimulus drug that governments have been dispensing so freely -- is even more serious. The present administration believes that deflation is a worse threat than inflation. They are right to think that. Trying to rebuild public finances at a deflationary moment -- a time when unemployment is rising, and private demand is still contracting -- could be catastrophic, turning recovery into renewed recession."


There are no good choices. Nouriel -- optimist that he is (note sarcasm) -- suggests that there's a possibility that the government can manage expectations by showing a clear path to fiscal responsibility that can be believed. And thus the bond markets don't force rates higher, thereby thwarting recovery.

And technically, he's right. If there were adults supervising the party, it might be possible. But there aren't. The teenagers are in control. Instead of fiscal discipline, we're hearing increased demands for more spending. Please note that the very rosy future-deficit assumptions assume the end of the Bush tax cuts at the close of 2010. But raising taxes back to the level of 2000 doesn't make the projected future budget deficits go away.

Seriously, does anyone think Pelosi or Reid are going to lead us to fiscal constraint? Obama talks a good game, but he hasn't offered a serious deficit-reduction proposal, other than further tax increases. We need cuts on the order of several hundred billion dollars. The Republicans lost their way and their power (deservedly, in my opinion). Just as at the high-school prom, the few adult chaperons are being ignored.

We're between the proverbial rock and a hard place: Cut the stimulus too soon and we slide back into a deeper recession. Let the budget spin out of control for a few years and we'll see inflation return, with higher rates and a recession. Raise taxes by 1.5-2% of GDP in 2010 and we're shoved back into recession.



There are no good choices. If we do the right thing and cut the deficit, it means very hard choices. Can we keep our commitments to two wars and our massive defense budget? Medicare and Social Security reform aren't painless. Education? Research? The "stimulus"? But cutting the deficit by hundreds of billions while raising taxes by even more than is already in the works, isn't the formula for sustainable recovery.

We are still a nation of teenagers. We'll do whatever we can to avoid the pain today. We will kick the can down the road, hoping for a miracle. Will we grow up? Yes, but the lessons learned will be hard.

There are no statistical signs of an impending recession. We're not going to get an inverted yield curve this time, which made it relatively easy for me to predict recessions in 2000 and 2006. We're in a deflationary, deleveraging world; a far different world than in the past.

I see little room for us to avoid a double-dip recession. It would take the skill and speed of former Cowboys' running back Tony Dorsett hitting a very small hole in the line to break us into the open. I see no one in our national leadership with such ability. As I have outlined above, recession could be triggered again in any number of very different economic environments. It all depends on the choices we make. But in my opinion, the choices lead to the same consequences.

As I wrote in August 2000 and August 2006, I write again in August 2009: There's a recession in our future. I was early both of those times and I'm early now -- maybe two years early, though I doubt it. And as I pointed out both of those last times, the stock market drops an average of over 40% during a recession. In 2006, I was given a hard time about my recession call and prediction of a bear market. I think it was John Rutherford who dismissed my bearish vision. And he was right for the next three quarters, as the market proceeded to rise another 20%. I looked foolish to many, but I maintained my views.

You have choices. You can buy and hold (buy and hope?) or you can develop a strategic alternative. The next bear market, as I wrote in 2003 and in Bull's Eye Investing, will likely be the bottom. (It takes at least three of them to really take us to the bottom.) But the next one will change perceptions for a long time. Valuations will drop. Savings will rise even more. And a generation will grow up. The adults will return. Chastened. Scarred. Shaken. But we will muddle through. That's what we do. Including my own teenagers.

Choose wisely.
No positions in stocks mentioned.

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