I am on record as saying I think there is a 50-50 chance we slip
back into recession in 2011, as I think the economy will soften in
the latter half of the year and a large tax increase in 2011 (from
the expiring Bush tax cuts) will tip us into recession.
This was not based on data, but rather on research which shows
that tax cuts or tax increases have as much as a 3-times multiplier
effect on the economy. If you cut taxes by 1% of GDP then you get
as much as a 3% boost in the economy. The reverse is true for tax
increases. Christina Romer, Obama's head of the Council of Economic
Advisors, did the research along with her husband, so this is not a
If the economy is growing at less than 2% by the end of the
year, then a tax increase of more than 1% of GDP could, and
probably would be the tipping point. Add in an almost equal amount
of state and local tax increases (and spending cuts) and you have
the recipe for a full-blown recession - at least the way I see
I was asked at my recent speech in Milan, what sorts of things
could make me wrong? There are a few. First, it could be that tax
increases and cuts don't matter. Some very smart people (like Paul
McCulley) feel that tax increases on the wealthy don't really
figure into Romer's analysis.
Or maybe bank lending starts to pick up and the economy is
actually growing at 3-4% by the end of the year - although the
chart below suggests that bank lending is still in freefall. Notice
that if this trend continues just a little while longer, bank
lending will have fallen by 25% in about two years. This is a truly
scary chart. It is unprecedented in modern history. Also notice
that after the 2001 recession bank lending continued to fall for
over two and a half years.
Click to enlarge
Or perhaps Congress decides to extend the Bush tax cuts or
phases in the increase over time. That would be better and maybe
not push us into recession. Maybe they vote for more stimulus,
although that does not look likely. If Congress cannot extend
unemployment benefits, as happened this week, then other stimulus
The uber-Keynesians that are in control of our economic policy
clearly do not think that large tax increases matter, or if they do
think so they are not speaking out about them. They are conducting
an experiment on our economic body without benefit of anesthesia.
Here's a prediction about which I can feel confident: if we do slip
back into recession, they will blame some factor other than the tax
increase and call for massive stimulus. In fact, they will probably
say that the lack of stimulus was the problem in the first place.
Paul Krugman will be the head cheerleader.
(For a quick, fun, and instructive read, go to Joshua Brown's
web site [
] and read about the
Econ Gangs of New York
, where Joshua describes the various groupings of economic
thinkers. Seems I am in the gang led by my friend Mohamed El-Erian,
the New Normalers. Krugman, of course, is the leader of the New
Jack Keynesians, a most vicious and pernicious gang, in my
Going into the last two recessions we had an inverted yield
curve (where short-term rates are higher than long-term rates),
which made it easy to predict a recession. Let's look at a graph of
the yield curve from my e-letter of February 16, 2007. Notice that
the 3-month T-bill is about 45 basis points higher than the 10-year
bond, which is what the studies use as the basis for their
analysis. The curve had been like this since before September of
2006, when I was predicting a recession about a year out. (An
inverted yield curve is the best predictor we have of a recession
one year out. A yield curve like the one below has always been
followed about one year later by a recession.)
Here is today's yield curve. It is normal (if you can call
anything in a 0% Fed rate environment normal), and while not as
steep as it used to be, is still quite steep. (Bloomberg)
We are not going to get an inverted yield curve when the Fed is
holding rates at 0%. The curve we have today is not signaling a
recession. It suggests that those who see continued recovery are
I am not so sanguine. I was on a panel with Martin Barnes (of
Bank Credit Analyst, and one of the best economic minds I know) at
David Kotok's shindig in Paris last week. Martin and I are very
good friends, but we do tend to go at one another. It makes for a
very interesting panel for the audience.
I posited that I think the chances are better than even that we
have a recession in 2011. Martin said (insert deep Scottish
brogue), "John, double-dip recessions are very rare." And he's
right. The last (and only) one we had was because Volcker was
stamping on the brakes trying to bring inflation under control in
My rejoinder was along these lines: We are not coming out of a
normal business-cycle recession. We went through a debt crisis and
a balance-sheet, deleveraging recession. The old data that we used
to judge recoveries by just does not apply here. At best, it is
It wasn't just a bubble in housing, it was a bubble in debt. And
now we are reducing that debt. We are coming to the end of the Debt
Supercycle (a term coined long ago by ... Bank Credit Analyst). We
now have a bubble in government debt that is getting ready to burst
in one country after another. What is indeed a very rare thing (a
double-dip recession) is a very real possibility. Since we don't
have the yield curve to guide us, let's look at what we do
The Leading Indicators Are Starting to Turn
Even while I was on vacation in Italy, I had to regularly feed
my addiction for economic and investment information. Over the
course of a few days I ran across several studies on the Economic
Cycle Research Institute's [ECRI] Index of Weekly Leading Economic
Indicators. The index has turned down of late. Chad Starliper of
Rather & Kittrell sent me the following charts and analysis. (I
love it when someone else does the work for me while I'm on
"The ECRI has been getting some news of late. I did a
little work on it, played with the rates of change, and found
something a little ominous you might be interested in. The
normal reported growth rate is an annualized rate of a
smoothed WLI. However, when the 13-week annualized rate of
change is used - shorter-term momentum - the decline in
growth has fallen to a very weak -23.46%. The other times it
has fallen this fast? All were either in recession or
pointing to recession in short order (Dec. 2000)."
Jonathan Tepper (coauthor of the next book I am working on) sent
me this piece from a group called EMphase Finance, based in
Montreal. They wrote this back in April, as the Weekly LEI was
beginning to turn over. They have found a bit of data that seems
very good at predicting the economy of the US 12 months out. Let's
take part of their work:
Terms of Trade and US Real GDP
"Many market participants are debating whether or not a
double-dip recession will occur within the next quarters. As
we are writing our report, ECRI Weekly LEI fell quickly to
122.5 points from 134.7 in April. This indicator did a good
job leading U.S. Real GDP Y/Y by 6 months over the last two
decades. However, ECRI Weekly LEI recently became quite
unreliable as it increased up to 25% Y/Y in April, a level
consistent with an unrealistic 8% U.S. Real GDP Y/Y! You can
notice the problem on the left chart below.
"We discovered a new leading indicator to forecast U.S.
Real GDP Y/Y, and it is simply the U.S. Terms of Trade [TOT].
It is defined as the export price / import price ratio. We
are pleased to be the first to document this, at least
publicly. On the right chart above, TOT leads U.S. Real GDP
Y/Y by 12 months. The only drawback: underlying time series
are monthly instead of weekly, but this is not really an
issue with that much lead. Also, the relationship still holds
well if we extend to the maximum data (1985)."
"As you probably noticed earlier, TOT is suggesting a
decline of U.S. Real GDP Y/Y to nearly 0% within the next 12
months. Q2 2010 Real GDP Q/Q Annualized to be released on the
30th July may match expectations as it reflects data of the
last three months, which were positive in general. However,
we are most likely going to see weaker numbers in the next
quarters. Will this lead to a double-dip recession? We
believe the odds of a double-dip recession within the next
9-12 months are minimal, but odds may increase to 50-50 in
2011, depending on the evolution of variables we follow in
the upcoming months."
And while we are on leading indicators, let's end with
this note from good friend and data maven David Rosenberg of
Gluskin Sheff (based in Toronto).
"For the week ending June 11th, the ECRI leading index
(growth rate) slipped for the sixth week in a row, to -5.7%
from -3.7%. Only once in the past - in 1987, but the Fed
could cut rates then - did this fail to signal a recession.
But a -5.7% print accurately signaled a recession in the
lead-up to all of the past seven downturns.
"The consensus is looking at 3% real GDP growth for the
second half of the year, but as Chart 2 suggests, the two
quarters following a move in the ECRI to a -5% to -10% range
is +0.8% at an annual rate on average. So right now the
choice is really either a 2002-style growth relapse or an
outright double-dip recession - pick your poison."
My take is that Bush cut taxes in 2001 and again in 2003 in the
face of weak economic circumstances. Unless something changes, we
are going to enact the largest tax increase in US history. And that
will be matched by equally large tax increases and spending cuts by
state and local jurisdictions. And we are going to do it at a time
when the above research suggests that growth may be in the 1% range
and unemployment will still be in the 9-10% range. Extended
unemployment benefits will be long gone for many people. Housing
will still be in the doldrums and housing prices are likely to fall
Growth in the first quarter was revised down (again!) to 2.7%,
or about half that of the 4th quarter of last year. Much of what
passed for growth was inventory rebuilding and stimulus. The
underlying economy may be weaker than the headline number reveals.
And by the 4th quarter, there is very little stimulus.
Given the above, I think we have to increase the odds of a 2011
recession to 60%, and those odds will rise and fall based on the
economic performance of the next two quarters.
Do tax increases matter? We are about to find out.
And if I am wrong, I will be spectacularly wrong. And I hope I
am. But you have to call it as you see it.
Bernanke at the Crossroads
I went to the crossroads, fell down on my knees
I went to the crossroads, fell down on my knees
Asked the Lord above, have mercy now
- Robert Johnson
If I am right about the potential for a recession, it is going
to bring Ben Bernanke and the Fed to a very serious crossroads.
Recessions are by definition deflationary. But inflation is already
as low as it has been in a very long time. Core CPI is less than
1%. The Dallas Fed's Trimmed Mean Inflation Index is down to 0.6%
for the last 6 months.
If we enter into a recession, it is quite possible that the US
could go into outright deflation. That is what M3 is saying. Take a
look at this chart from John Williams of
, who still tracks M3. But all the measures of money-supply growth
are turning down. This is signaling deflation.
Albert Edwards of SocGen noted this week, "We are now walking on
the deflationary quicksand." Treasury markets seem to be pointing
to a deflationary outcome. In the next recession, we could all
become Japanese, unless ...
You have to understand that when you become a Fed governor you
are taken into a back room and given a DNA change. Henceforth, you
become viscerally and genetically opposed to deflation. (Well,
except for Tom Hoenig, president of the Kansas City Fed. His DNA
change did not take. He wants to raise rates now, and is the lone
dissenter at the Fed meetings.)
What's a central banker to do? Bernanke gave us the road map
back in 2002 in his famous helicopter speech. As a last resort, you
print money. But the Fed already has a very pregnant balance sheet.
Can they push another $2 trillion into the economy to combat
deflation? Will they?
Deflation is the antidote to debt, and especially those who are
over-indebted. Great Britain seems to be purposefully pursuing a
little inflation to make its debt burden easier. Will the US do the
If we slip into recession and deflation, I expect the Fed to
react with more quantitative easing. They will start to take down
longer-dated paper as they move out the yield curve. Could they
expand the Fed balance sheet? Oh yes. We are in uncharted
territory, gentle reader.
John Mauldin is president of Millennium Wave Advisors, LLC, a
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French Property Prices Take a Step Back