The only surprise in the President’s “State of the Union” speech was the depth of his hawkishness. In deciding to build a case for unilateral action to depose Saddam Hussein, he threw in Iran and North Korea as window dressing. The surprise was in the fact that Secretary of State Colin Powell seems so thoroughly defeated by the GOP War Party, the intellectuals he privately refers to as “the bombers.” Even more surprising was that Mr. Bush used language that Powell must have objected to, as it practically closes off any diplomatic solution to grievances, referring to the three governments as “the axis of evil.” I was among those who cheered when President Reagan referred to the USSR and its Gulag Archipelago as the “Evil Empire,” but Moscow had 10,000 nukes aimed at us at the time and was actively seeking to expand hegemony in the Third World. There is no “nuclear” threat from Baghdad, although the President asserted there is, according to the findings of the International Atomic Energy Agency, which continues to inspect Iraq and certify its compliance with the Non-Proliferation Treaty.
As the NYTimes noted this morning, Mr. Bush made no reference to Pyongyang’s vow not to build long-range missiles, nor to Tehran’s active support of our military intervention in Afghanistan. For the last year, the War Party has tried to thwart any moves that might bring reconciliation with old Cold War enemies, as the Bombers really do prefer war. The President did throw a bone to the Islamic world in his speech, noting its religious and spiritual values are consonant with the Judeo-Christian world, and he did seem more comfortable in delivering this element of his speech than the saber-rattling laid out for him. The “axis of evil” threats will get the biggest play in the Islamic world, I’m afraid, further fueling the conflict in Israel and inviting a terrorist escalation here. Where does it go from here? Reality may dictate cold assessments in how to turn the threats against the “axis” into concrete plans. If the economy were booming and revenues were pouring into federal, state and local treasuries, there might be nothing holding back the President’s enjoyment of his popularity as commander-in-chief. He increasingly will be pulled back into the problems of the economy, and there are no indications he is aware the recession will deepen. It does not help him to hear happy talk from Fed Chairman Alan Greenspan or that military outlays grew Gross Domestic Product in the fourth quarter, thus “ending the recession.” The monetary deflation continues to grind away, first at Wall Street, then the real economy.
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In the last five years, I have written at least 100,000 words about the deflationary process that has been chewing away like termites at the foundation of the world economy. Imagine my shock yesterday when I e-mailed a senior editor at The Wall Street Journal who I have known for decades and told him to forget about the “money supply” lifting us out of recession, that it was deflation that was undermining the economy. He e-mailed back: “As to deflation, why don`t I see a slump in the gold price?” He just has not been paying attention. You can picture a fellow sitting in his living room watching tv for five years, never realizing termites were all the while nibbling away at the price of gold, and now he wonders why the roof is crashing down upon him as the deflation drags other prices down. We had a nice little rally the first few days of 2002 due to the “January Effects” we have come to expect from automatic changes in the tax schedules. But January is coming to a close and we can almost hear the termites coming through the walls.
As Enron’s demise illustrated, the greedy critters love to eat debtors, especially leveraged debtors. And while the U.S. economy can function gloriously with sophisticated, sensitive financial instruments when it has a stable unit of account, it goes haywire when there is no Golden Rule to keep debtors and creditors in balance. Archimedes could move the world up with big levers and fulcrums. He could also move it down with fancy derivatives and a little monetary deflation. If you are too young to remember the inflationary days of the early 1970s, you would be surprised to learn that almost nobody in the world believed inflation was the result of President Nixon turning off the dollar/gold signal. First, they thought it was workers demanding more pay for less work. Then it was the Arabs who jacked up the price of oil. Then it was the “twin-deficit theory,” that budget deficits and trade deficits were causing prices to rise, and that this could be solved by tax increases and currency devaluations. Now, when the solution is a dollar devaluation, President Bush is promising to pull the economy out of recession with tax cuts, more spending and no dollar devaluation.
Some sort of “stimulus package” actually may emerge when Congress returns next week. House and Senate Republicans have gone into “retreat” this weekend to contemplate strategy between now and the November elections. There is one more shot at a tax cut next week in the Senate, when the “stimulus package” will be up for debate, open to floor amendments that can be tacked on as long as they can collect 60 votes. As the Democrats do not wish to seem “obstructionist,” some elements with genuine supply-side effects may sneak in, but nothing that might offset the deflationary tide. We have never expected the termites to bring down the house all at once, which is why the kind of selling sprees we saw Tuesday do not cascade. But as the market sees little chance of a turnabout in the broad economy, instead of going up four steps, then five steps back, it will pick up the pace. Households and enterprises that have been leveraging debt in hopes of a V-shaped recession will have no choice but to open their books to the bankruptcy courts. Lots of little Enrons all over the place.
Supply-Side Analytics: Deconstructing GDP
The preliminary report on 4Q real GDP (0.2% growth vs. expectations of a 1.1% decline) has cemented the view that recovery is just around the corner. A deeper look at the data, though, reveals that almost the entire rise in reported 4Q GDP was the result of a 9.5% burst in government spending and an outsized 5.4% increase in real personal consumption expenditures. On a quarter-over-quarter basis, state and local spending was up 9% in 4Q while federal spending rocketed from a 0.3% rise in 3Q to a 9.5% rise in 4Q. In addition, the bulk of the rise in personal consumption expenditures was due to a huge 38.4% rise in durable goods expenditures in 4Q (compared with 0.9% rise in 3Q). The bulk of this gain was from motor vehicle purchases which likely were due to zero interest rate financing and deep discounting pulling sales forward. Other data were generally negative, although some line items show lessening of the rate of decline:
Real non-residential fixed investment decreased 12.8 % YoY in 4Q after rising 1% in 3Q;
Real exports of goods and services sank 12.4% YoY in 4Q vs. an 18.9% YoY decline in 3Q;
Real imports of goods and services decreased 3.4% compared with a 13% YoY fall in 3Q.
As we expected, nominal GDP registered -0.1% in 4Q from the previous quarter. For the year, dollar GDP rose 3.3%, which is nearly a 50% drop off from the 6.5% rise posted in 2000. We expect dollar deflation and a lack of corporate pricing power to continue to frustrate a return to the robust level of nominal GDP growth typical to most recovery cycles. As a result, we do not think the Fed will be hiking rates by June 2002 as futures markets now suggest. The most important thing Greenspan could do for the bond market would be to signal restraint in moving rates back up. This would immediately remove a good portion of the “Phillips Curve” rate-hiking risk premium currently weighing on bond prices.
Michael T. Darda