Information about finance, the economy and business. Entertaining and informative. Seeking Alpha Certified Mark Sunshine Chairman & CEO

Goodbye Recovery, Hello Recession

I’m no pilot, but I imag­ine that if I were fly­ing a plane and a moun­tain appeared in front of me, I’d pull up to avoid crash­ing. Instead, I am an econ­o­mist and busi­ness per­son and I see an eco­nomic moun­tain loom­ing in front of the U.S. I only wish I could explain why Wash­ing­ton insists on fly­ing straight into the moun­tain rather than pulling up.

Wash­ing­ton politi­cians are point­ing the U.S. econ­omy straight into a liq­uid­ity trap and instead of a bright eco­nomic future, the U.S. is look­ing at years of high unem­ploy­ment, weak GDP growth and the pos­si­bil­ity of wide­spread deflation.

When the econ­omy is in a liq­uid­ity trap, mon­e­tary pol­icy is inef­fec­tive because indi­vid­u­als and busi­nesses hoard money rather than spend it. The more money the Fed makes avail­able, the more con­sumers hoard.

Will I be able to feed my fam­ily and pay the bills? Is my job secure? Is my house worth less than the mort­gage? Will the gov­ern­ment help me when I am old or will Medicare be denied when I need it the most? Why is the school board cut­ting pay and fir­ing teach­ers? Does a gov­ern­ment shut­down mean that I won’t be paid? Is the Trea­sury raid­ing my pen­sion to pay bondholders?

When ordi­nary peo­ple aren’t sure how to answer those ques­tions, they become gripped by fear and uncer­tainty. To assuage their fears, they spend their time and resources get­ting ready for what­ever bad news comes their way. They hoard cash and try to save for the rainy day that they are con­vinced will come. As a result, demand for goods and ser­vices falls caus­ing prices, wages and liv­ing stan­dards to plunge. Before you know it, we’re in the midst of what econ­o­mists call a defla­tion­ary spi­ral with no end in sight.

Last week the Fed­eral Reserve of Bank St. Louis pub­lished an update to its M1 Money Mul­ti­plier chart that shows ordi­nary Amer­i­cans are hold­ing on to cash. In the last six months the Money Mul­ti­plier has gone into a down­ward spi­ral. When the Money Mul­ti­plier falls, it’s tough for the econ­omy to sus­tain growth.

It’s not just the M1 Money Mul­ti­plier that is falling; M2 Veloc­ity is falling as well. M2 veloc­ity is a mea­sure of how fast broadly defined money sup­ply turns over each year. When M2 veloc­ity falls, con­sumers, busi­nesses and investors are slow­ing the rate at which they spend and invest their money. Annual GDP equals the amount of money avail­able to spend mul­ti­plied by the num­ber of times the money turns over in a year. When veloc­ity goes down it is a sure bet that a reces­sion is right around the corner.

As the below chart illus­trates, M2 Veloc­ity resumed its down­ward tra­jec­tory about six months ago after recov­er­ing a lit­tle from the 2008 finan­cial crisis.

Falling veloc­ity is a sign that con­sumers and busi­nesses are los­ing con­fi­dence in the future.

Beyond the obvi­ous incli­na­tion to hoard, one of the side effects of falling mon­e­tary veloc­ity is the ten­dency of investors to sell more risky and less liq­uid assets and invest in Trea­sury bonds which are con­sid­ered “as good as cash.” Right on queue in the last two months, the stock mar­ket has been in decline while the Trea­sury mar­ket has been rising.

Con­fi­dence in the future is needed to get money turn­ing over again. Yet, con­fi­dence is being destroyed by a lethal com­bi­na­tion of nat­ural and man-made disasters.

In the last six months there have been nat­ural dis­as­ters of epic pro­por­tion, but the worst dis­as­ters are man-made and caus­ing self inflicted wounds.

The earth­quake and tsunami in Japan were nat­ural dis­as­ters with wide spread eco­nomic con­se­quences for both Japan and the global econ­omy. Flood­ing in the Mid­west and tor­na­does through­out the East were no one’s fault, but still rocked the world of mil­lions of Americans.

Even so, it’s man-made dis­as­ters that are hurt­ing the most.

Con­flict in the Mid­dle East is a man-made dis­as­ter that has the poten­tial to take a turn to the dark side with last­ing con­se­quences. Also, the Euro­pean sov­er­eign debt cri­sis is a man-made cri­sis that still isn’t under control.

How­ever, by far the biggest eco­nomic dis­as­ter is being cre­ated in Wash­ing­ton and in state capi­tols. The deaf ear of politi­cians and pol­icy mak­ers to the unin­tended side effects of their words and deeds is almost beyond com­pre­hen­sion. Cer­tain politi­cians seem to think that they were elected to play Russ­ian roulette with the econ­omy and don’t under­stand the con­se­quences of their actions.

In the last six months investors, busi­nesses and con­sumers have watched the U.S. come within min­utes of defund­ing itself and shut­ting down.

This month every­one is won­der­ing if Con­gres­sional lead­ers will com­mit col­lec­tive sui­cide and fail to pass an increase in the debt limit. Every night on TV mem­bers of Con­gress seem almost giddy at the prospect of serv­ing the U.S. econ­omy cyanide-laced Kool-Aid.

Con­sumer and busi­ness con­fi­dence requires pub­lic sec­tor cer­tainty. It can’t be up for debate whether or not the gov­ern­ment should honor its commitments.

Sev­eral state and local gov­ern­ments aren’t doing any bet­ter. Solv­ing bud­get prob­lems by going to war with work­ers and con­stituents is like pour­ing acid on confidence.

The Fed’s abil­ity to help the econ­omy is very lim­ited when fear drains money from the pro­duc­tive econ­omy. For bet­ter or worse, when the Fed can’t help, it’s up to our elected offi­cials to fix the econ­omy. Unfor­tu­nately, it’s these elected offi­cials that led us into the shadow of the val­ley of eco­nomic death.

Despite evi­dence to the con­trary, politi­cians con­tinue to believe that their words and per­sonal deeds don’t mat­ter; that there are no con­se­quences to cre­at­ing uncer­tainty by threat­en­ing to uni­lat­er­ally break con­tracts and bank­rupt peo­ple that trusted the word of the United States.

Until our elected offi­cials stop threat­en­ing an eco­nomic Jon­estown, we are doomed for as far as the eye can see.

Posted in: Credit Crisis, Deflation, Economic Statistics, economy, Liquidity Trap, Monetary Policy, Public Policy, REGULATION

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