Is the Recession Over?
Jude Wanniski
February 25, 2002


What I really want to know is when the equity markets will hit their nominal bottoms -- the true inflection point that tells me the bull market has resumed. Politicians are more interested in knowing when the "recession" will be over, so they can plan their policies and re-election campaigns accordingly. Some economists seem to think the shallow recession of 2001 is over and others think there will be a double-dip. The Bush administration economists are talking up the idea of a steady recovery to a healthy rate of growth, even enough to nibble away at the 5.6% unemployment rate by the November elections. But if this level of recovery were on the horizon, why hasn`t the market seen it coming? If we erase the effects of 9-11, the Dow Jones Total US Market at Friday`s close was still down 12.72% for the last 12 months and down 5.47% just from January 1. If there should be an expansion in nominal terms anytime soon, this broad measure of market activity would have to begin a sustained rise. The 30 blue chips in the DJIA have been the most promising, practically flat from January 1 and down only 4% or so from a year ago. When we factor in the rising price of gold and other commodities to account for the lessened deflation drag, there is at least an excuse for optimism. But at what cost?

A year ago the Bush administration was anticipating continued surpluses for the year ahead and next, but it is now seeing deficits around $100 billion for the next two years instead. State and local governments have had similar swings. Most of the federal deficit is the result of economic weakness and revenue shortfalls, but the increased spending on defense and healthcare that makes up the balance of the deficits has essentially bought our way out of the shallow recession. As we peer ahead, Congress will be eager to buy more GDP with the "war on terrorism" rationale, which of course feeds the government`s interest in broadening the war to the "axis of evil." The government can always increase "aggregate demand," as it did to end the Great Depression, if it has a good credit rating. Adjusting for the size of the population and dollar/gold, WWII cost the equivalent of $6 trillion in taxes and bonds, mostly bonds. To replenish the high-tech material exhausted in Afghanistan will take a year. Thus, it will be at least that long before the Pentagon is ready for an Iraqi campaign, The Washington Post reports. In speaking to a convention of defense contractors last week, Deputy Defense Secretary Paul Wolfowitz was almost gleeful in noting how easy it has become to fund projects that were on the drawing board prior to 9-11. War is good for business and bad for government budgets. Democrats and Republicans all want a piece of the business for their states and home districts and any talk of saving up surpluses for Social Security/Medicare is put aside for the "duration."

The deflationary drag is still with us and will be until wages and/or employment make further downward adjustment. (A worker`s wage falls by 100% when he is laid off.) The enormous volatility we have been seeing on Wall Street in recent weeks makes little sense within conventional models. It does fit with our Catch-22 concept, where more contraction eases the deflation and vice versa. When gold was at $265 the deflation drag was more pronounced, which is why it seemed the market would go four steps forward and five steps back. Now it feels more like a knife edge, a playground teeter-totter so sensitive that a "snowflake" of news sends it down on one side, then a snowflake of news sends it down on the other. If we take November 1, 1996 as the start of the monetary deflation, when gold was at $380, it has declined 23% to $292. The CRB all-commodities index has fallen 30% over that period, while the Dow Jones Soft Commodity Index has skidded 47%, copper 25%, nickel 16%, lead 32%, silver 10%. Platinum and palladium have gone in the other direction, but the overwhelming trend is consistent with the gold/deflation model, and with gold for the moment settling above $290, soft commodities and metals should be inching up from their lows while goods and services should still be in decline. Oil is back in orbit with gold at the knife edge.

We still don`t see the inflection point here because the fiscal picture does continue to worsen as the deflationary drag subsides. The blue chips and Dow industrials should be the last to adjust, most likely in the range of 9200 to 9400. There is still an upward bias to gold, and as it reacts to contraction in the national economy, that means nominal prices of goods or shares don`t have to fall as much to complete the adjustment. It is better for the world economy to have the deflation ease, because the dollar`s value affects so many other countries, especially in Asia, where Japan, China and Hong Kong are still linked to the dollar either de jure or de facto. The size of our federal, state and local budget deficits, on the other hand, are not as important to the economies of the rest of the world.

The political risks associated with terrorism have taken a turn for the better, especially with the initiative of Saudi Crown Prince Abdullah in presenting a peace plan for Israel and Palestine. The report today that Israeli Prime Minister Ariel Sharon is engaging the initiative in a positive way means that he could not reject the offer and maintain the support of the Bush administration for his hard line. We are probably closer to a resolution of the 50-year conflict between Arabs and Israelis than I`ve seen in my lifetime. With the entire Arab League getting behind the plan, this would resolve Israel`s concerns over its security. The Arab world could never again raise complaints about land to rationalize war against the Jews once the deal is done. It will no doubt take some more doing, but as it happens, Iraq becomes a friendly neighbor to Israel and plans to bomb Baghdad are put on hold as UN inspectors return to look around instead. Finally, with the U.S. Army no longer needed to guard Saudi Arabia against encroachment by Iraq, they can leave the Muslim holy land and thereby cool those Islamic extremists still pondering acts of terror.

Yes, this is a pretty picture, which could be dashed as others have before. And it would mean a firmer foundation for any rise in financial markets here and around the world. The optimism still needs to be pinned down with a dollar/gold link, however. Otherwise life again becomes complicated for the embattled world economy, gold and oil going out of orbit, windfall gains and windfall losses generating political tensions in the Middle East, and the Federal Reserve raising interest rates to stop the new inflation. 

Is the recession over? Maybe. Maybe not. Here comes another snowflake.