Yours truly is actually a macroeconomist, indeed with a knack for financial markets, but still; a macroeconomist nonetheless. However, you would not have gotten that impression from the writings here end last week where I worried a lot about the worry of financial markets. I still do, worry that is, mostly because we are in a very delicate situation where a severe shock in financial markets can easily and quickly be transmitted into the real economy. Moreover and as Edward eloquently conveys in his recent post the structural challenges we face are complex and difficult.

Yet, in terms of the immediate evolution in the real economy, and in case you had not noticed, the recovery is coming along just fine.

(click on pictures for better viewing)

If ever there was a clearer sign of a v-shaped recovery I’d like to see it. On an annual basis the EMU industrial production index rose 11.6% in Q1 2010 and on the quarter the increase was 4%. Despite the emerging crisis in the Eurozone and with reservations for the final number of Q2-10, this suggests that the turnaround is intact so far. Naturally, the level of industrial production is still very low compared to before the crisis and, as I have argued, this is an important gauge in terms of the overall strength of the momentum. But, the recovery remains real at this point

Of course, it is not difficult to pick the positive discourse apart and this applies especially to the Eurozone there is a bound to be notable divergence between the growth rate of economies. In particular, it does not take much Roubinesque imagination to see what awaits the famed Eurozone periphery (Spain, Portugal and Greece) who are now about to embark on a very brutal spell of internal devaluation; kind of like in the Baltics who are undergoing the same [1].

This comparison may of course be inappropriate for a number of reasons, but it provides a good yardstick with which to look ahead into especially 2011 where the first part of austerity measures will really start to bite. Whether the Eurozone “core” remains enough momentum to pull the Eurozone forward is really not the important issue here. The real problem here is that from here on imbalances (not just external) will compound. In the lingo of development economics the convergence which was thought inevitable and on track is now about to unravel. In this respect, the comparison with key parts of Eastern Europe is well chosen I think.

And not just Europe…

Yet, if the outlook for Europe is still very uncertain the global outlook is positive for the remainder of 2010 even if the momentum appears to be flattening out;

On an annual basis leading indicators for the major emerging economies as well as the OECD are coming in very strongly for Q1-10 and also over the quarter (i.e. from Q4-10) do we observe growth with the notable exception of China where activity seems to levelling off a tad going into 2010 on the back of continuing measures by the government to restrain the economy.

It is difficult to deny that the leading indicators tracked by the OECD seems to be flattening moving into Q2-10 and it will naturally be interesting to see whether momentum will be sustained. As ever, divergence both in levels and actual growth rates will be paramount to factor in, but I am very confident that we are not going to see a double dip recession in for example the US let alone the emerging market edifice in 2010. In Europe, the tug-of-war will between growth in France and Germany (with the latter exporting to EMs as the only real source of growth) and a continuing slump in Southern Europe. However, since 2010 budgets are already passed to indicate very stimulative policies throughout Europe the growth momentum will be strong in 2010 although the medium to long term look decidedly awful.

Event Risk still High

As a natural finishing point it should not escape market participants and analysts alike that event risk is currently at a very high level. In many ways, we already have an event in so far as goes the crisis in Europe but I can think of plenty of more sources of potential market destabilisers. The point here is then that at the current juncture the transmission between market distress and the real economy is likely to be strong and relatively quick. In this sense, the recent news that the interbank market is freezing over once again is indicative that not all is well and I am watching this very closely.

As such I maintain my somewhat bearish inclination and deep skepticism for where aggregate demand is actually going to come from in the medium to long term; this especially the case in Europe whereas I am much more constructive on emerging economies who are, for all intent and purposes, doing well (indeed almost too well in some cases).

A number of well known proverbs spring to mind here; is the glass half full or half empty? Is this the end of the beginning or the beginning of the end? Whatever methaphor you prefer forward looking indicators point to strong growth in the first half of 2010 (at least). The key message on the real economy will thus be one of divergence and especially how some economies are doomed to deflation and negative growth in nominal GDP (in the context of internal devaluation) while others will fly on the back of excess global liquidity. For me, this is the main meta-discourse currently describing the global economy.

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[1] – Q1-10 GDP is only available for Lithuania so for the two others the calculations ends with Q4-09.

Economists have been arguing that the creation of knowledge responds to the inputs going into it. And there is no question that the number of people engaged in knowledge professions today is greater than ever before in human history. Information technology has added strength to this pursuit, amplifying what a puny unaided human mind could do on its own. Earlier, the West dominated the production of knowledge; now we have phenomena like R&D labs in India giving a new kind of low cost production of knowledge, and increased opportunities for risk-taking in research. These factors should increase the pace of progress of creating knowledge. It should take us closer to the scenario where the 21st century will be even more exciting than its predecessor in terms of creating new knowledge.

I find myself nervously looking around, in 2010, and wondering if we are actually doing that much better.

From 1900 to 1910, here are a few of the great things that happened:

• In 1900, Max Planck proposed quantum theory, Hilbert posed his 23 problems, and Louis Bachelier was the first researcher in finance.
• In 1901, Marconi did the first wireless trans-atlantic transmission.
• In 1902, the first car ride from San Francisco to New York took place, and the Wright brothers flew the first plane.
• In 1903, construction of the Panama canal began.
• In 1905, Einstein wrote four papers.
• In 1906, Mahatma Gandhi coined the phrase satyagraha, and the first `vitamins’ were discovered.
• In 1908, the first oil was extracted from the Middle East, and Henry Ford sold the first Model T.

I’m sure there were many interesting things going on, but these were the big things of that period that meant a lot to me. When I look back at 2000 to 2010 and … what cool things can we remember which would change the world?

Or is that all sorts of wonderful things have been going on and it is my lack of knowledge? E.g. if I had lived in 1905, I might not have heard about Einstein’s four papers.

If it’s not just me, and the pace of progress has slackened: Why did we not get amazing progress from 2000 to 2010, despite the expansion of inputs into the systematic quest for new knowledge? Are we hitting diminishing returns; are we in the sad stage of adding decimal places to fundamental constants? Is our production function faulty?

LAWS OF MOTION

Stated in layman’s terms the three great Newtonian laws of motion are:

1.  A body persists in a state of uniform motion or of rest unless acted upon by an external force.

2.  Force equals mass times acceleration” or “F = ma.

3.  To every action there is an equal and opposite reaction.

In regards to human action a body seems to stay at rest rather than work unless acted upon by some type of force.  The force can be either internal such as hunger, the desire for self-actualization or anywhere in between on the Maslow hierarchy of needs or external such as a saber-tooth tiger, boss or customer.  To sustain life the human body must consume fuel.

Capital is the means of production and the difference between production and consumption flows into or out of the store of capital.  Out of this dynamic human society has attempted to efficiently allocate capital to produce more and this has resulted in institutions, large and small, where individuals work in the attempt to produce in order to meet their needs and wants.  Of course, the great fiction of government is that everyone can live off someone else’s production.

MASSIVE FAILING INSTITUTIONS

The chains of habit are too weak to be felt until they are too strong to be broken.  The mass of the economy times its speed in the Information Age has resulted in a tremendous force.  But this mass has largely been built from the atomic level upon something which is inherently unstable and undefinable leading to chronic fingers of instability.  What Is A Dollar?

The problem is debt and because psychology is changing, The Great Credit Contraction has begun and the rate at which the mass of the economy is evaporating is truly scary.  While many attribute the ongoing financial crisis to the subprime mortgage mess, which is surely a contributing factor, the problem is much more systemic than a few defaulted mortgages.

UNEMPLOYMENT

But now the second wave of Option ARMs are getting ready to reset at the same time the Federal Housing Administration is requiring higher down payments.  But where are these renters going to find a job when over 6.1M people have been unemployed for 27 weeks or more?

And what about all the discouraged workers who are not included in the labor force because they have ceased looking for non-existant jobs?  The Detroit News reported:

Despite an official unemployment rate of 27 percent, the real jobs problem in Detroit may be affecting half of the working-age population, thousands of whom either can’t find a job or are working fewer hours than they want …

Mayor Dave Bing recently raised eyebrows when he said what many already suspected:  that the city’s official unemployment rate was as believable as Santa Claus.  In Washington for a jobs forum earlier this month, he estimated it was “closer to 50 percent.”

With so many unemployed almost all of the States, with California being the poster child, are under severe financial pressure.  For example, 40 state unemployment insurance funds are either broke or moving in that direction.  While there are people starving in the chaos of Haiti about 37M Americans are now on welfare state food stamp programs, the rate of acceleration is expanding at about 20,000 per day and 1.4M Americans filed for personal bankruptcy in 2009.  And this is a rosy situation considering the FRN$ is still the world’s reserve currency!

RETIREMENT CHAOS

The Baby Boomer generation has driven trends their entire lives because of their mass and acceleration.  From Gerber baby food to the housing booms and busts caused by costumed government officials gallivanting in genocide which caused serious aberrations in demographics and are now getting increasingly explosive politically as the 2016 election will see 78M Baby Boomers pitted against 112M Millennials.

Social Security and Medicare are out of control kudzu that are strangling the economy.  Additionally, virtually all pension funds in the United States are massively underfunded with epic games being played with the discount rate.  As Forbes reported:

The GAO study found that states’ cumulative unfunded liabilities were $405 billion, while Novy-Marx and Rauh figure $3.2 trillion is a more accurate number.

All those tax eating costumed government officials are going to be extremely happy when they realize their retirements evaporated.  But with unemployment benefits draining the capital of the economy like vampires while the productive members of society are punished via increased taxation and regulation the entrepreneur has either learned how to vanish or been turned to stone by the local Gorgons.

The result has been massive declines in State and local tax revenues.  Even Federal corporate income tax receipts were down 55% for the fiscal year ended 30 September 2009.

KICK THE CAN

So like a classic Ponzi scam the answer has been to attempt to bailout the State and local governments via Federal resources.

For example, a chief bailout recipient Citigroup is accepting California IOUs indefinitely at face value; a surreptitious Federal bailout of California in a preemptive attempt to keep them from seceding monetarily by taking the next step of unconstitutionally decreeing the IOUs legal tender for all debts public and private.  The Euro faces the same type of structural issues.

But if the States unconstitutionally decree FRN$ legal tender then why not their own little colored coupons? With 13% of US GDP a $30B deficit California should have nothing to worry about with a mere $30B+ cash-flow issue.  After all, the California Dollar could have a bear on it; the Florida Dollar an alligator, the Texas Dollar a long-horned bull and the New York Dollar a vampire squid.  They would be such fitting symbols!

And so the adjusted monetary base has exploded.

The FRN$ is destined to evaporate and the increase in debt is only hastening the rate.

CONCLUSION

Despite propagandist cheerleaders on television the economy is in horrible condition.  The Obama administration’s attempt to alter the speed and direction of the economy is textbook action for intentionally exacerbating the greater depression.  Like in the recently released movie Daybreakers soon the starving vampire squids of Wall Street, Washington DC, State and local governments will run out of their productive human livestock and only a few understand their true predicament.  They think they can ’save or create 3M jobs’.  Seriously?

No one knows how this ginormous mess will play out.  But the massive momentum of 2009 has largely shaped the direction for 2010.  While the FRN$ may rise in the short term it is an extremely risky play because of how fast hyperinflation could strike the FRN$.

Of course, among the chief uses of silver and reasons to buy gold, platinum and lead are to keep you and your property safe from the costumed vampire tax eaters who will likely spring Obama’s retirement trap by nationalizing retirement accounts and forcing purchases of US debt to bolster Treasuries.

Using force or intimidation against innocent people or their legitimately acquired property is unfair, immoral and unsustainable.  The current state of the economy and where it is headed is merely the result of cause and effect from economic law.  George Mason, the father of the Bill of Rights, observed this principle hundreds of years ago in his writings contained on page 966 of The Papers Of George Mason:

As nations cannot be rewarded or punished in the next world, so they must be in this. By an inevitable chain of causes and effects, Providence punishes national sins by national calamities.

Please, leave your thoughts on how you think 2010 will play out.

DISCLOSURE:  Long physical gold, silver and platinum with no interest the problematic SLV or GLD ETFs, the platinum ETFs or Treasuries.

In 1983, Friedrich Hayek commented that this view of J S Mill “is really an incredible stupidity, showing a complete unawareness of the crucial guide function of prices …” Hayek explains: “We must face the truth that it is not the magnitude of a given aggregate product which allows us to decide what to do with it, but rather the other way around: that a process which tells us how to reward the several contributions to this product is also the indispensable source of information for the individuals, telling them where they can make the aggregate product as large as possible” (Conference paper published in Nishiyama and Leube, “The Essence of Hayek”, p 323). This must have been one of the most intemperate remarks that Hayek ever made about anyone.

One of the things I have learned from Richard Reeves book, “John Stuart Mill, Victorian Firebrand” is that Karl Marx was also unimpressed by Mill’s attempt to separate the laws of production and distribution. Marx viewed this as “a shallow syncretism” (Reeves, p 210). He thought Mill was attempting to reconcile irreconcilables.

How silly were Mill’s views about distribution? In order to answer this question I think we need to understand Mill’s views about property and inheritance.

I see a lot of merit in much of what Mill wrote about property. For example: “The institution of property, when limited to its essential elements, consists in the recognition, in each person, of a right to the exclusive disposal of what he or she have produced by their own exertions, or received either by gift or by fair agreement, without force or fraud, from those who produced it” (“Principles of Political Economy”, II, 2.2).

It is when Mill writes about “landed property” that I begin to see problems: “When the “sacredness of property” is talked of, it should always be remembered, that any such sacredness does not belong in the same degree to landed property. No man made the land. It is the original inheritance of the whole species. Its appropriation is wholly a question of general expediency” (“Principles of Political Economy”, II,2.26). Given that land can be exchanged for other goods I don’t see how it is possible to argue that rights to ownership should not be recognized as the same for land as for other goods.

The problem that Mill had with “landed property” seems to be associated with the potential for a relatively small number of families to have a disproportionate amount of wealth and to exercise disproportionate political power. He was against the inheritance of “enormous fortunes which no one needs for any personal purpose but ostentation or improper power”. Richard Reeves points out that Mill was particularly concerned to distinguish between “earned” and “unearned” income. Mill viewed inheritances as “unearned” and argued that it would be socially beneficial to impose a limit on the amount any person could inherit.

Mill’s views about redistributive taxation were also influenced by his aversion to inherited wealth: “To tax the larger incomes at a higher percentage than the smaller is to lay a tax on industry and economy; to impose a penalty on people for having worked harder and saved more than their neighbours. It is not the fortunes which are earned, but those which are unearned, that it is for the public good to place under limitation. …I conceive that inheritances and legacies, exceeding a certain amount, are highly proper subjects for taxation: and that the revenue from them should be as great as it can be made without giving rise to evasions … such as it would be impossible adequately to check” (“Principles of Political Economy”, V, 2.14).

It seems to me that Mill’s claim that distribution of wealth should be viewed as entirely separate from production was silly – and contradicted by his own views about the adverse consequences of progressive taxation. Mill’s idea for an upper limit on the amount that anyone could inherit also seems extremely silly. I can see some wisdom in his views about taxation of inheritances, but even here it seems to me that he was fooling himself if he thought that inheritance taxes would impose no disincentives to working and saving. Despite all this silliness, however, Mill still had many sensible things to say about property rights and taxation.

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Although it is a seemingly rational response presented by “the world leaders” to satisfy surprised by the crisis public, but in effect the action by the governments through financial intervention is rewarding the inefficiency which is at the root of the present economic recession.

I think that big companies whether banks, investment firms, and hedge funds that run their businesses on a pro-forma basis because of weak regulation; or large manufacturers of non-competitive products, mainly located in the west, who were outmaneuvered by more inventive and agile competitors should be let to fall flat on their face and break into peaces. Indeed I understand that the consequence will be great for the host nations in terms of unemployment and human sacrifice but by putting more money into their hands it is just delaying the inevitable

Indeed there is no reason to believe, based on their past record, that they will improve, become more agile, and competitive because they will continue to operate within the same environment, with the same labor costs, with spending more money on employee benefits then on research and development, and spending even more money on lobbying and fighting regulation.

We are indeed spinning fast in the whirlwind of the destruction of individuals and small business who will have, if any, only small benefit of few hundreds of dollars per year as a result of the tremendous bailout package. The largest portion of the benefit will go to the large firms at the expense of small businesses and those individuals who will also often loose their jobs and as a result most that they have owned.

Inefficiency and unethical behavior should not be rewarded by the political machine. But let us not forget that this machine is oiled by funds from those big companies –unregulated and inefficient or not. Sadly, the race to the bottom will continue its course.

Joseph Schumpeter was right writing early in the past century that to make capitalism work we must allow inefficiency to fail and more innovative enterprises will pick up the pieces – that is where the bail out package should be spent. Since the resources are always limited they should be spent where they produce the most of results. Otherwise we are running a high risk of putting a bandage on a gaping wound that will only have a short lived minimal effect, if any, on the patient that is contemporary economy.

Long term planning is necessary and the solution can not be to outsource all manufacturing to China and customer service to India, or elsewhere. If the imbalance of production and trade is such that some nations can not afford to produce, because it is much cheaper to order their products to be produced in the developing nations, they must have alternative means of sustaining their own populations by providing them with sufficient and adequate opportunities to remain competitive. And it can not be by simply printing more currency. One can not perpetually consume without producing, earning, saving, and investing in the future.

A strategy for the recovery is complex and when developed it should not be final. It should be revised and transformed as we observe and measure the results of our investment – bailout. Although this option is not politically practical because altering the proposed maybe construed as flip-plopping or not knowing what one is doing and very costly when the next election campaign comes about.

The stakes are high however, and only the most innovative and agile should prevail. I am worried about those small businesses and large alike, and individuals who are able to innovate, offer efficiency, and are responsible in running sustainable businesses that they will be taxed out and disadvantaged by the machine of our governments and big business.

If the last worry will become true we will only temporarily delay the inevitable while piling up a tremendous debt and passing it to our children and grand children to pay off while at the same time not taking necessary steps to equip them, with the necessary technological and efficiency advancements, for that task in the future. Regardless of the recession it may be a time of opportunity if we will support the most prepared, and let them pick up the pieces.

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