by Walter J. (John) Williams
Current Economic and Inflation Conditions in the United States
Economic Activity and Inflation. Before examining how the current circumstance can evolve from a severe recession, with a recent short and shallow bout with formal deflation, into a hyperinflationary great depression, it is worth defining the nature of the current economic and inflation conditions in the United States and likely near-term developments.
As discussed in the regular SGS Commentaries, the U.S. economy remains in a structural recession/ depression, where recession recognition as of December 2007 became official following the prior hyperinflation report. At the same time, due to extreme fluctuations in oil prices, where an oil-price collapse eliminated oil-induced inflation pressures building at the time of the prior report, consumer inflation experienced a brief and shallow dip into official (year-to-year) deflation, through the October 2009 CPI. The November CPI will resume positive annual inflation, partially due to a renewed upturn in oil prices.
The current downturn, as reported, already is the longest and the deepest business contraction since the first downleg of the Great Depression in the early 1930s. Such is reflected in payroll employment and GDP growth plotted in the following graphs. The payroll graph adjusts for the size of the recently announced pending benchmark revision to the series. The quarterly GDP numbers are published only back to 1947. If one counts the war production shutdown at the end of World War II as a normal business cycle, then the current downturn is the deepest since then, but still the longest since the early 1930s. The respective depths of the Great Depression and post-war production contractions are based on annual data available back to 1929.
While the official peak-to-trough contraction in the current downturn, per official real GDP is 3.8% (second-quarter 2009), most of the better economic series are showing contractions of greater than 10% (depression range), such as retail sales and industrial production, while others are showing contractions of greater than 25% (great depression range), such as new orders for durable goods and various statistics indicating the level of housing activity. Revisions to the GDP over several years eventually should show the current level of GDP activity to have been at depression level. The evolving depression quickly will move to great depression status, at such time as the hyperinflation hits, since that will be extremely disruptive to the conduct of normal commerce.
Net of gimmicked methodologies that have inflated GDP reporting over the decades, the U.S. economy has been in recession since late-2006, entering the second down-leg of a multiple-dip economic contraction, where the first downleg was the recession of 2001, which actually began back in late-1999. The current downturn may evolve into a further multiple-dip circumstance. The Great Depression was a double-dip contraction.
The current economic downturn has been so protracted and severe that regular year-to-year comparisons and the seasonal adjustment process have forced new types of analyses and have led to major warping of regular economic reporting. Where a number of series, again, such as retail sales and industrial production, have leveled off at low-level plateaus of economic activity, year-ago comparisons have become less negative, but there has been no meaningful pick-up in economic activity.
Economic activity has sunk to such lows that regular measures of change that are followed closely by the financial markets — such as new claims for unemployment insurance — are not signaling economic recovery, as they turn less negative, only that activity is beginning to plateau at an unusually low level. With stimulus packages having had their initial impacts, with broad domestic liquidity (see money supply discussion) contracting at a pace that would promise an economic downturn in the best of times, and with consumers’ liquidity problems intensifying, the contraction in U.S. economic activity likely will accelerate anew in the early months of 2010.
Consumer Liquidity Structural Problems. The U.S. economy is in a deepening structural change that has resulted from U.S. trade, social and regulatory policies driving a goodly portion of the U.S. manufacturing and technology base offshore. As a result, a large number of related, high paying jobs have disappeared for U.S. workers. Accordingly, U.S. consumers have found increasingly that their household incomes fail to keep up with inflation. Without real growth in income, there cannot be sustained economic growth. Growth driven by debt expansion, as encouraged by the Fed in recent years, ultimately is not sustainable, as has become painfully obvious to many in the current systemic solvency crisis. Greater detail on these and related comments are found in the Consumer Liquidity Special Report.
As shown in the next graph, the U.S. trade deficit has narrowed in the current downturn, with lowered U.S. consumption and with a brief collapse in oil prices. There has been, however, no fundamental shift in circumstances to suggest a healthy move in U.S. economic activity towards a fundamentally improved trade balance or a shift towards reinvigorating the U.S. manufacturing base.
The deterioration in median household income has resulted in greater variance in income, as shown in the second graph, which has negative longer term economic implications. A person earning $100,000,000 per year is not going to buy that many more automobiles that someone earning $100,000 per year. The stronger the middle class is, generally the stronger will be the economy. Historically, extremes in income variance usually are followed by financial panics and economic depressions. Income variance today is higher than it was coming into 1929 and 1987, and it is nearly double that of any other “advanced” economy.
The next two graphs show official weakness in inflation-adjusted income. The top plot of the solid line shows real average weekly earnings, as reported and deflated by the Bureau of Labor Statistics (BLS) using the regular CPI-W. Real wages never have recovered their pre-1973 to 1975 recession peak. As wages dropped over the decades, the number of people in an average household that had to work, in order to make ends meet, increased.
The second graph reflects median household income over the years. The thicker line shows income deflated by the regular CPI-U, a measure somewhat broader than the CPI-W. Those inflation-adjusted numbers show that median household income, as of 2008, never recovered its pre-2001 recession peak and stood below its level of 1973. Deflated by the CPI-U-RS (current methods), discussed below, the pre-2001 recession peak also still has not been recovered.
In the last several decades, the BLS introduced a variety of new methodologies into the calculation of the CPI, with the effect of reducing the level of reported CPI inflation. The general approach has been to move the CPI away from its traditional measuring of the cost of living of maintaining a constant standard of living. The lower the rate of inflation used in deflating a number, the stronger is the resulting inflation-adjusted growth. The CPI-U-RS is the CPI with its history restated as if all the new methodologies had been in place from day one. The impact of the changes is evident in the two lines, with the thinner CPI-U-RS deflated line showing stronger relative growth. It would run higher than the top line if the years set equal were 1967 instead of 2008.
The broad point on income is that it is inadequate to sustain positive, inflation-adjusted economic activity. In the absence of income growth, debt expansion can act as a short-term prop for the economy, but that is not available at present. The system is in the throes of a solvency crisis, with banks reducing lending to consumers.
The broad point on the inflation measure is that by reverse-engineering the CPI-U-RS, current inflation reporting can be estimated as though it were free of the inflation-dampening methodologies. Such has been done with the SGS-Alternate Consumer Inflation Measure. In the plot of the real average weekly earnings, the dotted line reflects the series deflated by the SGS-Alternate CPI, and that shows the consumers’ liquidity squeeze to be more severe for those hoping to maintain a constant standard of living, than as indicated otherwise by official reporting.
Inflation. Inflationary pressures have started to surface from the Fed’s efforts at dollar debasement. A weakening U.S. dollar has placed upside pressure on dollar-denominated oil prices, which in turn have begun pushing annual inflation higher. This is not inflation generated by strong economic demand, but rather inflation driven by Federal Reserve efforts to weaken the dollar.
Though still well shy of the peak levels seen in 2008, oil and gasoline prices have soared since their near-term lows at the end of last year. The relative collapse, in latter 2008, of gasoline and oil prices triggered a period of year-to-year decline — formal deflation — in the CPI-U. Now with relatively high prices going against falling prices in year-ago comparisons, annual CPI inflation will turn positive, once more, as of November. As reported by the BLS, annual CPI-U inflation for October 2009 was not statistically distinguishable from zero; the SGS-Alternate Consumer Inflation Measure was about 7.1%.
For all of 2009, CPI-U average annual inflation should be less than a 0.5% contraction (deflation), with the SGS-Alternate at something shy of 7%. As measured December 2009 over December 2008, official annual CPI-U inflation should be close to 2% with the SGS-Alternate around 9%. A strengthening pick-up in official annual CPI inflation should be evident in early 2010.
The recent annual declines in CPI inflation were the biggest since 1949 to 1950. CPI reporting methods used in then, however, would have generated current inflation rates that did not drop below 5%, at worst, in the current cycle. The brief and shallow formal deflation that now is at an end — based on official CPI-U reporting — appears to have been about half the depth and half the length of the negative inflation bout in the 1949 to 1950 circumstance.
The SGS-Alternate Consumer Inflation Measure adjusts on an additive basis for the cumulative impact on the annual inflation rate of various methodological changes made by the BLS. Over the decades, the BLS has altered the meaning of the CPI from being a measure of the cost of living needed to maintain a constant standard of living, to something that no longer reflects the constant-standard-of-living concept. Roughly five percentage points of the additive SGS adjustment reflect the BLS’s formal estimate of the impact of methodological changes; roughly two percentage points reflect changes by the BLS, where SGS has estimated the impact, not otherwise published by the BLS.
Political Considerations. What lies ahead for the economy and inflation will have significant impact on the U.S. political process, as recent economic woes did on the 2008 election. Historically, the concerns of the electorate have been dominated by pocketbook issues. Prior to gimmicked methodologies making the reporting of disposable personal income largely meaningless, that measure was an excellent predictor of presidential elections.
In every presidential race since 1908, in which consistent, real (inflation-adjusted) annual disposable income growth was above 3.3%, the incumbent party holding the White House won every time. When income growth was below 3.3%, the incumbent party lost every time. Again, with redefinitions to the national income accounts in the last two decades, a consistent measure of disposable income as reported by the government has disappeared. Yet, even with official reporting, 2008 annual growth in real disposable income was 0.5%, well below the traditional 3.3% limit. As was suggested would be the case in the prior report, such contributed to the Republicans losing the White House in 2008. Where I always endeavor to keep my political persuasions separate from my analyses, for purposes of full disclosure, my background is as a conservative Republican with a libertarian bent.
A wide variety of possibilities would follow or coincide politically with a hyperinflationary great depression, but the political status quo likely would not continue. Times would be financially painful enough to encourage the development of a third party that could move the Republicans or Democrats to third-party status in the 2012 presidential and congressional elections. Present economic conditions are bleak enough to impair re-election prospects severely for incumbents in the 2010 mid-term election.
Untenable Positions for the Federal Government and the Federal Reserve. The effect of the structural income problems on the economy has been that most consumers have been unable to sustain adequate income growth beyond the rate of inflation, unable to maintain their standard of living. The only way that personal consumption — the dominant component of GDP — can grow in such a circumstance is for the consumer to take on new debt or to liquidate savings. Both those factors are short-lived and have reached unsustainable extremes. Debt expansion and savings liquidation both were encouraged by the investment bubbles created by Alan Greenspan; he knew that economic growth could not be had otherwise. Part of what is happening today is payback for those policies.
This circumstance places both the federal government and the Federal Reserve in untenable positions, where they cannot easily or rapidly address the underlying problems, even if standard economic stimuli would work. From the standpoint of the federal government, traditional fiscal stimulus in the form of tax cuts or increased federal spending have reached their practical limits, with the actual annual budget deficit running out of control at roughly $9.0 trillion per year. Yet, that likely will not keep political Washington from pushing its deficit spending until the markets rebel. After all, there is an election in 2010. It is that market rebellion, however, that will set the hyperinflation stage.
From the Fed’s standpoint, it can neither stimulate the economy nor contain inflation. Lowering rates has run its course and done little to stimulate the structurally-impaired economy, and raising rates may become necessary in defense of the dollar. Similarly, raising rates will do little to contain a non-demand driven inflation, such as seen developing in the current circumstance so heavily affected by oil prices. Continued efforts to debase the dollar should be successful, but not in stimulating economic activity, only in triggering an accelerating pace of inflation.
With the economy in depression, hyperinflation kicking in quickly should pull the economy into a great depression, since uncontained inflation is likely to bring normal commercial activity to a halt.
Part III will be published tomorrow.
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