Reintroduction of fire 45 years after last burn
Photo: Dale Wade, Rx Fire Doctor, Bugwood.org;
Is it all and only about “Aggregate Demand”?
I admit it. My mind works in strange ways. A recent example of off-beat connections started when reading reactions to Christina Romer’s Princeton University remarks made this past weekend. One of her remarks that perhaps has received the most attention was about the “title that was not”:
… [the] levels of overall and long-term unemployment are not a separate, structural problem, but largely a cyclical one. It reflects the fact that we are still feeling the effects of the collapse of demand caused by the crisis. Indeed, at one point I had tentatively titled my talk “It’s Aggregate Demand, Stupid”; but my chief of staff suggested that I find something a tad more dignified.Romer described various prescriptions for what she diagnosed as the U.S. economy’s principal malady: too little demand. I don’t want to spend time reviewing the prescriptions but rather the diagnosis --- is it really “It’s Aggregate Demand, Stupid?”
The Legend and Legacy of Smokey Bear
Now, here’s where the off-beat connection comes in but first some context is needed. For the better part of a century a sizable effort within U.S. forestry was aimed at preventing wildfire by aggressively locating where it started when it started and putting it out as soon as possible to limit its damage. Foresters were treating the “effect”, wildfire, if you will. Who could be against putting out wildfires? After all, didn’t you see the Walt Disney movie Bambi and all the woodland creatures who lost their homes due to fire? Didn’t you ever hear the story of Smokey Bear, the little bear cub who was orphaned by a forest fire? Everyone could agree --- we need to stamp out wildfire!!
The good news, at least initially, was the effort to stamp out wildfire from the forest was largely successful. However some troubling things began to happen. Trees began to grow more slowly and eventually became weak enough they were overtaken by disease and epidemic insect infestations. The reason why? Without periodic fire vegetation accumulated to such an extent the site was no longer able to support healthy growth by the plants and trees growing on the site. The weakened trees were more susceptible to other pests. Some trees died and all were weakened. Eventually a careless moment or a lightning strike started a fire. When these dead and dying trees, along with the abundance of underbrush, finally caught fire there was so much vegetation to burn in many cases the fire couldn’t be controlled. Often the ensuing devastation was mind-boggling – worse than had ever been seen before. The term of art was “uncharacteristic fire”.
Thus, forestry learned that in many ecosystems to keep the forest healthy periodic fire was necessary. Fire still caused damage and still posed dangers but trying to exclude fire entirely was not possible and when it occurred after it had been excluded for an extended period of time the set of dominos it toppled led to unspeakable negative outcomes. And so, fire had to be re-introduced into many forests to begin to restore a healthy balance.
Applying Lessons from the Forest
So what does this have to do with the recession? Only that I fear for too many years economic policy makers have tried to avoid or minimize the impact of the economy’s version of a wildfire – a recession. During a business cycle growth proliferates but eventually the rate of growth begins to slow as “imbalances” occur throughout the economy. A recession, while unquestionably causing damage, also clears the way for new and sustainable growth in the future.
However, in an economy interest rates can be kept low so the cost of borrowing is minimal. Tax credits and subsidies can induce investment that would otherwise not pencil out to produce more. Special programs can foster development in chronically depressed areas to add to production but often the investment survives only as long as the special program is in place. In each of these cases the aim is to increase productionm which in this context is analogous to demand --- if you will, to extend the forestry metaphor --- pour on more fertilizer to get more growth. It’s the Smokey Bear Economy --- keep the forest green and growing and stamp out all wildfire. I see in Romer’s comment, “It’s aggregate demand, stupid,” an example of this type of Smoky Bear economy philosophy. Sometimes you can’t simply foster new growth by whatever means possible; sometimes you need to bring growth back in line with the fundamental capacity of the land, or by analogy, the fundamental capacity of the economy.
Industrial Production, Capacity, and Capacity Utilization
To me this point of emphasizing production and not appropriate alignment was highlighted again with the recent release of industrial production and capacity utilization. Of the pair much attention is given to the return of higher production levels throughout the U.S. economy. Pundits from across the spectrum talk about it: it’s increasing (good), it’s not increasing fast enough (bad), will it increase faster than it has been (hope), will it ever increase enough to bring the economy back to where it was before (despair), etc. Personally, I’m glad U.S. production is increasing; it’s what is necessary to meet both domestic and foreign consumption demands.
However, what of the other part of capacity utilization --- capacity levels? While analysts discuss capacity utilization, usually it is only to point out it is low and because of that there is economic slack and so the risk of price inflation is remote. Full stop. However, usually not much is said regarding capacity itself. What has been happening to capacity during the current economic recovery?
Dangerous Fuel Build-up?
As can be seen in the graphic below, capacity utilization has been rising since June 2009. Capacity utilization increases either by more production from the same capacity, the same production from less capacity, or some combination of both increased production and lower capacity.
I set out to sort out on a proportionate basis how much of the capacity utilization increase was due to increased production and how much was due to capacity declines. This can be seen in the column chart on the right-hand side of the graph. Initially 92 percent of the improvement in capacity utilization was due to increased production and only 8 percent lost capacity. However, since that time the proportion of the increase in capacity utilization attributable to lost capacity has been steadily increasing. In March 2010 cumulatively 14 percent of the improvement since June 2009 is due to lost capacity while 86 percent due to increased production.
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But something else caught my attention as I reviewed the numbers: what capacity utilization has done over the past decade, shown on the the left hand side the above graph. The blue-gray horizontal line in the graph above signifies the average capacity utilization for the period 1987 to 2007 (recession started in December 2007 so I excluded 2008 to present from computations). Notice that during this decade capacity utilization crossed the “average line” at the start of the decade and then only barely touched the line again in 2006 and 2007. Otherwise the rest of the decade capacity utilization has been below the 20-year average starting in 1987. Typically with an average you’d expect some of the data points to be above the line and some below the line. But here for practical purposes capacity utilization this entire decade has been below average.
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I dug a little deeper and put together the next chart (see immediately above). On that chart I calculated the “compound growth rate trend” of capacity and production to maintain the 20-year average rate of capacity utilization. Then I plotted the actual capacity and production against those trends for the period 1987 to 2007. What becomes readily apparent is capacity has been well above trend for most of this decade.
To make the areas of surplus and deficit more obvious I plotted those alone in the next graphic (see below). What leaps off the page was capacity did not significantly decline either during or in the immediate aftermath of the 2001 recession. As a result capacity utilization swooned as production, while above trend, fell off more quickly than capacity did. In essence for much of the decade we had too much capacity to support the demand, i.e. production. We were only starting to get capacity and production aligned with average utilization rates ---- usually at a business peak we’d expect utilization rates well above the average --- when the current recession hit.
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The Legend and Legacy of “It’s Aggregate Demand, Stupid”
There has been much written about low interest rates were responsible for both the housing and consumer credit bubble. However, low interest rates also prolonged the life of many manufacturing assets that would have been otherwise shut down. How many assets were re-capitalized by private equity firms during the first half of the decade using a generous dose of low-interest debt? Further, low interest rates dropped hurdle rates on capital projects resulting in yet more capacity being built. Keep piling on the growth, keep putting out the fires and presto: the Smokey Bear Economy.
However, the problem is the Smoky Bear Economy is now choking; it can’t sustain itself. Take recent reports of increases in consumer spending. This is something of a dilemma to understand as incomes haven’t increased, unemployment remains high, and consumer debt continues to decline (see page 3 of April 2010 Macro Pulse). So how are consumers purchasing more in light of these numbers? Some argue it’s because of strategic default – people electing to stop paying mortgages with the expectation of some government-sponsored workout and diverting the mortgage payment to purchases. One naysayer to this theory, when asked to account for the increase in retail spending despite the aforementioned apparently contradicting data, offered the following “best guess” : 1) tax refunds; 2) Pent up demand (psychology) 3) Government transfer payments; 4) New hires.
To this I say take your pick --- strategic defaults, tax refunds, pent up demand, government transfer payments --- it’s probably some of all of this. I agree the economy will continue to grow through much of 2010; after all, despite reports that would imply most of the impact of the stimulus is already past, I still believe most of the impact is yet to come. According to the government’s website tracking stimulus spending as of 60 percent of the funds have yet to be paid out as of April 9, 2010. You simply cannot pour $470 billion (the amount remaining to be spent) of stimulus into an economy and not see an effect. The point is, beyond new hires, which given latest employment figures I expect are offering little support in this regard, very little of what is currently happening can be considered sustainable.
Recently housing starts and new home sales are up --- but most commentators acknowledge a sizable share of the improvement at present is with an eye toward a tax credit. The sideways movement of the housing market since the middle of last year occurred while the Federal Reserve subsidized the mortgage market to the tune of $1.25 trillion. Not sustainable. Usually the magnitude of economic growth coming out of a recession is proportional to the depth and severity of the recession --- the deeper the recession, the more robust the recovery. But not this time. The spurt of growth we had in 4Q2009 (5.6% based on the last revision) was principally due to a slow down in the rate inventory was de-stocked during the quarter (see page 1 of March 2010 Macro Pulse). That doesn’t look sustainable.
Re-introducing Fire in the Forest
My take of the U.S. fiscal and monetary policy landscape is policy makers don’t want to re-introduce fire back into the forest, they only want to stimulate more growth, i.e. they want more production while minimizing the loss of capacity. However, fire comes sometimes whether it’s wanted or not and the Great Recession is now re-introducing fire to the economy to “clear the forest” for future healthy growth.
As noted above, the loss of capacity in improving capacity utilization has been growing in importance since last June and I expect this trend will continue to accelerate. Let me offer one line of evidence from the CPI and PPI (finished goods) data. The PPI index represents the cost of materials for firms producing goods for sale to consumers. The CPI represents the cost of consumers buying goods. When the PPI increases faster than the CPI profit margins are squeezed and ultimately less competitive capacity will be lost. The average year-over-year change in CPI from the start of the recession (December 2007) to March 2010 is 1.9 percent; the corresponding average for PPI is 2.4 percent. While this difference between the two seems modest at first glance, the PPI rate is 26 percent higher than the CPI rate and when compounded over time the impact becomes significant. However, what is even more important is the margin difference is widening as of late (see March 2010 Consumer and Producer Price Indices: Bottle Rockets and Duds); since November 2009 year-over-year change for both have been positive, with CPI averaging 2.3 percent and PPI averaging 4.3 percent. Profit margins are being squeezed and as a result the pace of capacity curtailment is quickening.
Ironically, it is the policy makers’ actions that are setting the stage for the re-introduction of fire to this economy. Early in the crisis the Federal Reserve reasoned if it lent to financial institutions at low rates those institutions would lend to businesses and consumers, again at low rates, and this would re-stimulate the economy. However, with the federal government’s appetite for debt and the heightened risk of default by businesses and consumers due to recessionary pressures financial institutions chose to lend to the federal government, not the private sector. As a result, the financial sector’s profits are soaring on the margin between borrowing at very low rates from the Federal Reserve and lending back at higher rates to the Treasury. Meanwhile businesses faced with mounting costs and few sales are faced with the grim prospect of shutting down, exacerbating unemployment as their employees lose jobs. Capacity declines. Fire is re-introduced, even if unintentionally.
Fire Survival Skills
So if this is what is ahead what needs to be done to perform in such an environment? Extending the metaphor, while it is unavoidable, and even necessary, it is a dangerous gambit to have fire re-introduced after years of unchecked growth; a sudden wind gust or wind shift could result in what had been a seemingly contained fire suddenly become an inferno engulfing otherwise healthy portions of the economy. The keys to survival are being alert to subtle changes in conditions, being aware of surroundings, establishing firebreaks where possible and having protection equipment "on standby", having pre-planned exits, and reacting decisively.
Specifically, in the process of “reintroducing fire” to the U.S. economy it is important to understand "fuel and weather conditions". They are different than they were over the past 30-odd years. Those differences include elevated levels of public debt, a less dominant position for the U.S. economy globally, higher energy costs, and demographic changes with baby boomer generation transitioning into what has been traditionally retirement age (registration required). To briefly flesh out one of these conditions, the developed world is carrying significantly higher levels of public debt. Currently interest rates are low but they won’t stay low (more in the next paragraph). When rates increase the cost to service that debt will skyrocket and governments will cut back on services. As a result I expect infrastructure will falter in places: roads, communications, transport, and above all, interaction with government agencies which will be stretched thin. Expect that whatever you have to get done will take longer to get done than it used to and plan for it.
Along these lines supply chains will be tested and sometimes break. Consequently risk management, anticipating uncertainty, and planning for it will be an essential success factor. In the future low cost will only be truly low in the context of appropriate consideration of risk. Prior leverage rules will no longer apply as interest rates rise so managing debt service will be a critical success factor. Interest rates will increase whether the Federal Reserve wants to raise them or not. While I believe other factors will be at work as well the most fundamental is this: there is and will be simply too much demand for debt, both public and private around the globe, to imagine the Treasury will be able to borrow the massive amounts of debt it needs to run the federal government without interest rates increasing.
In terms of markets, the focus will be on competitiveness not gaining market share. Also, I believe the U.S. dollar will enter an extended period of weakness relative to the experience of the past two decades. China will diversify its U.S. dollar holdings and whenever the dollar shows momentary signs of strength China will sell (or not buy) until the dollar loses enough value China stops selling (or starts selective buying), preserving the total value of its portfolio while diversifying. That means currency exchange rates will likely yo-yo more than they have in the past. However, because the trend will be a weaker dollar there may be opportunities for exports that were not viable in the past due to currency risk. These must be weighed against supply chain risks and higher energy costs but I do believe success will often include more market diversification than was the case in the past.
Finally, isolating, enhancing, and leveraging sustainable competitive advantage will be the difference between surviving or being consumed. Doing this effectively requires decisive reaction. I purposely say “reaction” because fire is unpredictable; there are clues, there are danger signs, but the unexpected does occur and occurs suddenly. At those times reacting, and reacting decisively is essential.
Fantastic Read. Incredible Detail. Thanks.
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