Henry David Thoreau, Journals.

Governments may come and go, fiscal and monetary policy chop and change, but the business cycle goes on forever. It marches to an internal rhythm, largely unaffected by external considerations. It accelerates and decelerates with a recurring 5½ year periodicity.

Activity troughed at the end of 2008 and has been recovering ever since. It’s due to peak in early autumn 2011. Be-tween now and then, there’s likely to be growth, but at progressively slower rates.

Is that a picture that’s consistent with published data? It certainly is. Though conditions have varied a good deal from one country to another, most have experienced (anaemic) recovery during the last eighteen months, and a slight loss of momentum recently.

If that’s the case, there’s little danger of immediate recession. But a substantial risk of renewed debility in 2012 and 2013. It’s in those years that the threat of financial default (and social bloodletting) will peak.

In public, Governments and Central Bankers disagree. They claim that the recovery is robust, that it’ll persist for several years, broadening and deepening as it does. Indeed, they fear inflation quickening again. They hint at the need for higher interest rates next year!

Wishful thinking. In 2007, they’d also reckoned the expansion to be vigorous, inflation to be likely to rise. They were hopelessly wrong, of course. The cycle had already turned. Their interest rate increases were imposed after re-trenchment had begun. They didn’t dampen the economy’s swings, but emphasised them.

It’s likely to be worse in 2012. The public sector will be cutting its spending and the personal sector scaling back its debt. It may take five years for economies to re-establish equilibrium, possibly ten.

In the meantime, there’ll be furious competition for export markets. Countries that are uncompetitive will be hard pressed. Devaluation may consequently become more frequent. Protectionism can’t be ruled out.

Europe’s problems are particularly intractable. The single currency is a disaster. It requires that Greece and Spain and Portugal be competitive with Germany. The former’s relative costs will have to be cut by 10% in the midst of a downturn, and at a time when the latter’s may also be falling! It’s true that withdrawal from the EZ would be pain-ful. But more so than staying in? Of course not!

In global terms, Europe’s financial eccentricities are of no great importance. The preservation of free trade is. How great is the danger? Significant. In recent years, the benefits have not been equitably spread. It’s been the countries of Emerging Asia, China most obviously, that have scooped the lot.

The less competitive parts of the world, those mired in persistently anaemic growth, are getting restless. They’re thinking of retaliation. Trade, they say, should be fair rather than free. The jingle goes down well with electorates.

Will protectionist sanctions therefore be imposed? It’s not impossible. In somewhat similar circumstances in the thirties, they were. And it may have been that which turned severe recession into depression!

The good news is that asset markets—bonds and equities—are likely to continue to rise. Negligible inflation, expan-sive credit and resilient corporate profits will be the driving forces.

Certainly not in economics; nor, probably, in securities markets!

Economics data are sometimes seen through rose-coloured spectacles.
Last week’s economics news wasn’t good, just less bad than it had been during the summer. A fine distinction! But one that most investors were not minded to make. They’d become accustomed to downgrades and disappointments. They’d begun to think recession was imminent. Suddenly, realising it wasn’t, they reacted jubilantly. They went on a buying spree, bidding equity valuations sharply higher.

Stock market reactions depending more on investor psychology than fundamental logic.
Investors shouldn’t have been surprised by the statistics. The current business cycle wasn’t due to peak until autumn 2011. Until then, it was to be expected that activity would advance, albeit at a decelerating pace. There was nothing in last week’s numbers to necessitate a change of perspective.

Recession is still possible, probable even—but not until end 2011.
The dangerous period lay, not immediately ahead, but in 2012 and 2013. That was when recession was most likely. That was when the risk of financial default and political bloodletting was highest. By comparison, the near term was going to be almost serene. Economies would advance modestly, inflation fall sharply, interest rates stay low and asset valuations rise significantly.

Public spending austerity is about to begin.
The big change in Britain in the next twelve months concerned the social environment rather than the economics one. Spending in the public sector was going to be cut sharply and employment in it fall accordingly. It’d not be a painless process. Where it had already begun, in Europe for instance, there’d been strikes and demonstrations. Similar disturbances were likely here.

There’ll be lots of dissention.
They’d not alter the fundamentals, though. Economics logic tends usually to be on the side of the big guns: it favours creators of wealth rather than consumers of it. Accordingly, there might be twelve months or more of labour market contention, but the process would end with a more balanced economy: large numbers of public sector employees dismiss¬ed, and lower rates of pay increase for the remainder.

But, eventually, a more sustainable economy.
If the authorities were to be sensible, they’d use the endgame negotiations to bring sanity to public sector pensions. Either defined benefits would be abandoned, or the retirement age at which they started to accrue would be raised. As currently structured, public pensions were insupportable. Politicians had ignored the problem for too long. An immediate increase in the retirement age for civil servants and local authority workers was the obvious first step.

One not burdened by senseless wars.
An equally obvious second step would be the cessation of military hostilities in the Middle East. If the authorities were honest, they’d recognise that the wars in Iraq and Afghanistan had been unmitigated disasters. Their cost in lives and finance sizeable; their effectiveness in containing terrorism negative.

It’d be helpful if political leaders knew something of history.
Thankfully, the one seems almost to be over, the other beginning to wind down. The Americans are marvellous. With a fine disregard for battlefield reality, they declare victory and withdraw. It’s devoutly to be hoped that the current administration doesn’t make the same mistake with Iran and North Korea that the previous one made with Iraq and Afghanistan.

Bush and Blair didn’t, and consequently made appalling errors of judgment.
It’s even more devoutly to be hoped that Britain’s current Prime Minister should behave more sensibly than his predecessor. The latter, of course, was a wrong ’un. That he got elected in the first place is regrettable, a serious indictment of Britain’s psephological perceptiveness (excusable only by reference to the difficult aftermath of the shambles that characterised Major’s time in office). That Blair got re-elected twice subsequently is not so easily explained away. It’s a stain with which the Brits will have to learn to live!

We’re still in a bull market. The best may yet be ahead.
Where should we be putting our money? Most asset classes will appreciate during the next nine months. Bonds will be buoyed by lower inflation and governmental determination to contain public spending. Expansive credit will provide the cherry that tops the icing. Equities, though, will fret about labour disputes and the possible negative impact on profits. It’s only as these fears are seen to be groundless that investors will become positive.

Only property may be dull in the next few quarters.
Property may be the spanner in the ointment. Commercial demand seems likely to be scaled back as private companies (and public authorities) downsize. And residential demand will be restrained by job losses and smaller pay deals. Outside London and its catchment area, therefore, despite surging quantities of liquidity, the property scene may be dull.

And only if the B-of-E messes up again will valuations generally be soft.
The threat to general valuations comes from the Central Bank. It’s only if the Old Lady should take it into her head to tighten money that prices would crash. Might she do so? Sadly, yes. She’s done so before—in 2007, for instance. The misanalysis then was shocking; let’s hope it won’t be again.

Nicolas Chamfort, Maximes et Penseés, no more, of course, is a General to be reckoned competent just because he has lots of soldiers!

We all wish we’d not made so many mistakes.
It’s not uncommon for stable doors to be closed after horses have bolted. It is, though, a procedure in which politicians and bureaucrats, famously lacking foresight, specialise. It was illustrated last week by the Bank of England’s Charles Bean.

Some of us, though, try to pretend we didn’t.
Speaking in Wyoming at the Annual Conference of the Kansas City Reserve Bank, he said that mortgage finance needed tighter regulation. It was possible that “direct constraints” on lending would be required. If housing bubbles were to be avoided in the future, there was some merit in setting caps on loan-to-value ratios.

Public sector grandees, most particularly.
If he’d said these things five years ago, he’d have deserved plaudits. And it’s possible that the policies he recommended, if implemented then, would have helped stabilise mortgage finance: limiting the frenzy on the upside and containing the depression on the downside. To say them now, though, merely draws attention to past errors of judgment.

Occasionally, that compounds the original error.
As a rule, the indulgence of 20-20 hindsight does no harm. But sometimes it leads to policies that are counterproductive. If, for instance, restrictions on mortgage finance were to be imposed in the near future, they’d be more likely to exacerbate the downturn than mitigate it.

The Bank’s current thinking on housing finance is worrying.
It makes no sense to apply the brakes when the vehicle’s already going too slowly. To do so risks stalling the engine. The good driver, the one avoiding the extremes of boom and bust, waits until the pace of activity requires action. He starts to close the throttle as the vehicle’s speed approaches normality, and to brake when it becomes excessive.

It risks turning disaster into cataclysm.
Is housing finance currently excessive? Of course not! It is hopelessly inadequate. House prices are falling and negative equity is increasing. In effect, first time buyers are already excluded from the market. Has the B-of-E not noticed? Is it so concerned with preventing future problems that it can’t see current ones?

The first step should be an acknowledgement of previous mistakes.
The commercial banks need no excuse to tighten their lending criteria. They’re making so much profit from risk-free “round-tripping” (borrowing from the B-of-E’s money-creating Department at one rate and lending to the Treasury’s spending Departments at a higher one) that they have little incentive to do anything worthwhile. This is the problem to which Charles Bean might profitably have turned his attention.

The second, a reversal of earlier policies.
He didn’t because it was the B-of-E that was largely responsible for creating the mess. It was the Bank that bailed out the RBS and HBOS delinquents. And it was the Bank that sustained them by the subsequent sequestration of taxpayer funds.

It’s best not to put the lunatics in charge of the asylum!
If there’s a message here for the rest of society, it’s that commercial banks oughtn’t to be run either by second-hand car salesmen or by half-baked academics. In reality banking isn’t complicated. It needs competence rather than charisma. We didn’t get it in the past; we may not in the future.

Asset values are rising, and’ll probably continue to do so.
The good news, and there’s not much of it, is that asset valuations as a whole are rising. Currently, the emphasis is on fixed interest securities. Later on, perhaps imminently, it’ll shift to ordinary shares. A conjunction of accommodative credit and resilient corporate profits will provide the motive force.

Blaise Pascal, Penseés—but, in economics, it is with high probability; and, in finance, with almost complete certainty.

The US is ahead of the curve: its GDP estimates are being lowered; those of others raised.
It’s rumoured that the official estimate of GDP in the US in the second quarter is shortly to be cut. Growth had previously been set at 2½% per annum. It might, it’s now being said, be lowered to just 1¾%. Some investors are worried; some, noting the exaggerated response of stock price indices to below-par economics data in recent weeks, are in panic mode.

Is that likely to undermine security valuations?
Is their anxiety justified? Probably not. Quarterly numbers are unreliable. It’s the trend that’s important, not the volatility. And the former was established several months ago. Activity in the US (indeed, in the world as a whole) is slowing. The deceleration is likely to continue for another twelve months or so. But whether it ends in recession, and whether equity and bond prices decline in consequence, are quite separate issues.

Pascal wouldn’t be sure. Nor should we be.
The relationship between asset valuations and economics activity is complicated. But it’s driven less by some factors than others. GDP is much less important than liquidity, profits or inflation. The former is relevant only if it affects the latter.

But bonds will probably extend their gains.
Will it? Yes, but often favourably rather than unfavourably! As economies subside, central bankers usually operate more accommodative monetary policies. And businesses invariably find it harder to raise prices. The conjunction of expansive credit and low inflation is unambiguously favourable for bonds. They virtually always perform well in periods in which economies are softening.

Equities might follow suit.
But equities are influenced also by corporate profits. How do they respond? It’s a two-way pull: they’re hurt by duller sales, but helped by moderating wages. Which is the more important? Often, the latter. If the economics debility should be protracted rather than ephemeral, wage negotiations take much of the strain. The employee’s bargaining position is undermined more than the employer’s. Profits hold up fairly well, and equity valuations, albeit hesitantly, rise.

Economies meanwhile will continue to soften.
Is that the prospect the world has before it now? Possibly so. The economics, it has to be admitted, aren’t looking good. The root cause of the anaemia seems to be consumer attitudes. People are choosing to save and not to spend.

Consumers seem to have lost the will to spend.
They feel insecure because their finances are stretched, and they respond by paying down debt. That causes activity to falter, unemployment to rise and insecurity to soar. It’s a vicious circle in which effect reinforces cause. And it’s one which the authorities are almost powerless to counteract.

It may be some time before they regain it.
It’s not recession that has to be feared, but depression. If a negative consumer psychology were to become ingrained in the States and Europe (as it already has in Japan), the problem would last a long time. Not until personal balance sheets had been returned to “normality” would personal spending do so as well.

Who’ll suffer more? Debtors or creditors?
It’s not only countries with sizeable consumer debt burdens that would be hurt. So also would those that had previously been exporting to them. All would suffer; the latter perhaps more than the former. In 1930, it was countries which had risen most in the prior decade that proved to be most susceptible to declines in the subsequent one.

Sometimes, ironically, the latter.
China may be particularly vulnerable, therefore. It is heavily dependent on exports. If they were to be hit for any reason (protectionism, for instance), the PRC would be devastated. Higher public spending wouldn’t square the circle, nor easier money. Japan’s experiences in somewhat similar circumstances in the last couple of decades are not encouraging.

And raw material suppliers? Are they set to climb ladders or descend snakes?
There’s also a cloud hanging over the commodity producers. The fact that the investment consensus is so positively disposed to them is a sizeable negative. They’ve enjoyed a superlative phase in the last couple of decades, but it’s resulted in strong currencies coupled with relatively high inflation. That’s no problem for them at the moment. But it would be in the context of significantly reduced demand for their exports in the future.

How vulnerable is Britain?
As a rule, countries like the UK come relatively unscathed through periods of persistent economics debility. Their economies specialise in areas in which value-added is high, but competition limited. Though real activity suffers, terms of trade don’t. They take a single whammy, not a double!

Arguably, less than most.
Perhaps significantly, sterling has been drifting up for several months. The pundits have been almost universally pessimistic, but the unit’s value nevertheless keeps edging ahead. Do traders know more than experts? Is water wet?

Economics data never present a completely uniform picture of developments. Even in the midst of devastating recessions, a significant proportion of published statistics (15% perhaps) will be upbeat. And, correspondingly, even in the eye of glorious booms, a similar proportion of releases will be dull.

It’s the averages that the analyst has to watch: they’re rarely misleading. And, in recent months, they’ve been saying that the world economy is losing momentum. Since late-spring, that’s been the message of almost two thirds of them; since mid-summer, almost three quarters.

The outlook for the UK is not good, therefore. Recession isn’t imminent, but it mightn’t be long delayed. At best, growth in the next couple of years can be expected to be anaemic; more likely, it’ll be negative late in 2011 and early in 2012.

Is there anything the authorities can do to restore equilibrium and reignite growth? Probably not. They’re unlikely to sanction a new surge in public spending, for instance. The one implemented in 2008 was manifestly a mistake: it made things worse, not better.

The Bank of England, on the other hand, will try to keep monetary conditions expansive: interest rates low and credit availability high. That’ll certainly help, but it’ll probably not be enough. It’s the commercial banks that are the problem.

They tend not to pass on the largesse to their customers. Though they borrow cheaply from the taxpayer, they lend expensively to the customer. Their focus is the executive’s bonus, not the economy’s vitality. They’re a drag on the economy!

The B-of-E made a huge mistake in 2008 when it acted (without Parliamentary authority) to save RBS and HBOS. The case for protecting depositors was one thing; that for bailing out incompetent managers, quite another. It would have been better to break up and sell off the failed banks. What was needed was more competition in financial services. What we got was less!

The securities markets provide the one bright spot in an otherwise gloomy scenario. At the moment, it’s bonds that are making the running. Investors have begun to appreciate that dull economics will keep inflation low and borrowing subdued. They know that the demand for fixed income paper will consequently rise, and the supply fall.

Later on, equities will take over. Corporate profits have exceeded expectations recently and will probably continue to do so. Why? Not because of higher sales, but lower costs—labour costs in particular. The process has further to go. Likewise the equity indices.

Known in England as the Law of Cussedness, it states that attempts to alter the equilibrium of a system are frustrated by changes in the dynamics of the system!

Fiscal policy doesn’t remedy economics ills.
Faced with an economics problem, politicians are inclined to implement fiscal solutions. Usually, their therapies fail; often, they make things worse. In the aftermath of the global financial crisis, for instance, the knee-jerk reaction of politicians in most countries was higher public spending. Was it effective? No. Economics debility may have been temporarily moderated, but it wasn’t remedied. The situation today is very grave; another setback is looming. And, rather significantly, countries that spent most then are suffering most now.

And its effect on social problems isn’t impressive either.
It’s not just in macro-economics areas that fiscal policies have failed to deliver. In micro-ones as well, they’ve been disappointing. American housing demonstrates the point. Congress was quick to recognise the frailty of the sector in 2008 and fast as well to try to help it. House buyers were awarded a tax credit if they purchased a new principal residence in the six months ending April 2010.

The US’s housing tax credit, for instance.
Sales in the relevant period were fairly high. Subsequently, they plunged. It looks as if the policy affected the timing of transactions more than the level. Those who were going to buy anyway benefited from the credit, but few others were persuaded to take the plunge. As a result, the boost to activity was low, but its cost (in lost taxes and extra administration) high.

Obama’s in a bind. And no BP to blame!
What is the administration to do now? Re-introduce the tax credit? Or try something else? The problem is complicated by the approach of congressional elections. Obama’s ratings are slipping steadily. Democrats look as if they’ll lose the House and, possibly, the Senate as well.

More reliance, therefore, on the Fed! None on commercial banks though.
What’s fairly certain is that interest rates will stay low and credit availability high. An occasional commentator worries about inflation, but he’s not taken seriously. A bigger worry is that excessive liquidity will cause parts of the financial community to misbehave again. Commercial banks are the prime candidates. They’ve escaped scrutiny thus far, but their favoured position may not last forever.

Europe’s housing sector is worse.
In Europe, the situation’s no better: housing in Spain and Ireland is especially troubled. Levels of employment are falling, wages per employee declining and interest rates rising. There’s no respite anywhere. If the euro is to be retained, it’ll be a decade before the imbalances are rectified.

Britain’s is slightly less bad.
Residential property in Britain, partly because of currency flexibility and partly because of rising population, is less fraught. But the country’s politics are looking messy. Cameron and Clegg aren’t winning the arguments, and the pain has hardly started. Conservatives are mildly suspicious of the coalition; LibDems hate it.

But its politics are worse.
The latter may well split. What would that do to Parliamentary arithmetic? Would it, in the next poll, give the Tories an absolute majority (as it did in the thirties)? Or would it return a Labour government? Markets, understandably, are worried.

Bonds are currently up and equities down.
Last week, equity indices crashed. Allegedly, the declines were a response to softening economics news. Is that so? Had investors expected reports of activity to be strong? Did they know nothing of the chronology of cycles? Of course not!

It’ll probably reverse.
The reality is that valuations are attractive. Profits are likely to hold up well, inflation to fall and interest rates to stay low (the predictions of the flat-earthers notwithstanding). Not a bad recipe!

Rene Descartes—in economics, as in politics, deception is the rule; understandably, therefore, confidence is low. 

Obama is worried. He should be.
There was more disappointing economics news from the US last week. It was reported that the labour market there had continued to deteriorate in the late summer and that the factory sector might be about to do so. Initial Unemployment Claims had risen again and the Philly Fed’s Survey of Manufacturing had fallen for the first time in a year.

The US economy has weakened a good deal.
Were these numbers, taken in the context of others published in the last couple of months, consistent with an economics recovery that was broadening and deepening? Hardly! It was much more likely that activity was in a decelerating phase.

There’ll probably be recession next year.
Growth at the beginning of 2010 had been rapid, but it’d moderated thereafter. Momentum was still satisfactory in the spring, but it had become pedestrian by the summer. How much farther would it go? Would activity stabilise at current levels or slip back into recession? And, if the latter, when? Investors were understandably nervous; politicians frantic.

It’s much the same in Japan and most of Europe.
It wasn’t only America’s economy that was displaying anaemic tendencies. Japan’s and most of Europe’s were worryingly soft as well. Just about everywhere, the consumer was disenchanted. He wanted to repair his balance sheet. Accordingly, he used such income as he got, not for spending, but for saving. While that was the case, expansive monetary policies notwithstanding, activity was likely to remain subdued.

And the PRC may be particularly vulnerable.
China may have a particularly acute problem in this respect. The credit stimulus implemented three years ago when the financial crisis first began was not an unqualified success. It boosted demand and output, but only temporarily, and at a sizeable cost.

Another Spain?
It looks as if house prices absorbed a disproportionate share of the funds. In the last twelve months, they’ve risen by 30% or more. That boosted consumer sentiment, but also rendered it vulnerable.

Property is the bugbear.
When the property boom ends, there’ll be collateral damage. If prices stabilise, consumer confidence will be hurt. If prices fall, it’ll be shattered. The consequences for an economy already teetering on the edge of inadequate growth may be dire.

It’s unlikely that . . .
What might Beijing do to lessen the danger? Not a lot. It could try to delay the denouement; it could keep money policies accommodative and property prices therefore strong. But such policies would risk intensifying the crash when eventually it occurred.

. . . embarrassment will be avoided.
Alternatively, it could try to offset consumer debility with export virtuosity. If the authorities could organise a devaluation, competitiveness might be enhanced and overseas sales raised. But the rest of the world would cry foul. And might retaliate with protectionism!

The choice is: now or later?
China, in short, looks as if it’s riding a tiger. Things look impressive enough currently, but less so prospectively. Any attempt to dismount could invoke disaster.

Britain looks less awful.
By comparison, Britain’s economy seems to be encouragingly boring; its politics similarly dreary. Six months ago, the consensus was extraordinarily pessimistic about both; these days, it’s only moderately so. GDP has quickened and the fiscal deficit diminished. Currency markets are impressed. Faute de mieux, sterling is now preferred to many other units.

But favourable perceptions won’t last.
Will the good news continue? In relative terms, it may; in absolute, it won’t. Britain’s not able to buck global trends. If there’s to be another setback, this country is bound to participate—but probably with a modest beta.

It’ll share the pain, albeit in a dampened form.
The UK has relatively low exposure to sectors in which competition is intense (manufacturing, for instance) and relatively high exposure to those in which it’s subdued (fund management, law, education etc). The characteristic helped Britain survive the thirties. It may do so again in the period ahead.

Politics will get worse.
Politics is another matter. The coalition has enjoyed a honeymoon thus far. But that may be about to change. Spending cuts are likely to wreak havoc amongst grassroots LibDems.

The coalition will become unpopular.
In the thirties, there was a somewhat similar situation. The support of the Labour and Liberal parties for the National Government was divisive. Arguably, it kept the former out of power for a protracted period, and hammered the final nails into the coffin of the latter.

Will Cameron hold things together? Unlikely.
But the Tories then had a Parliamentary majority. They needed the others only to share the blame. Will it be the same this time? Will opinion polls and by-elections see a swing to Cameron? Hmph!

Valuations may nevertheless rise.
Near term, investors are running for cover. But sentiment may shortly revive. Inflation will be low, credit easy and profits satisfactory. Equities and bonds will both appreciate.

Apologies to John Donne

Factory output in the States was stronger in mid-summer.
Industrial Production in the US in July perked up a little. Output was estimated to have risen by 1% in comparison with a modestly lowered June figure. The securities markets were encouraged by the news. So were the media. Both prematurely perhaps: the economy’s prospective profile was little changed.

Was that significant? Probably not.
The cyclical trough had occurred at the end of 2008. Since then, there’d been an anaemic recovery. It was due to peak in autumn 2011. In the meantime, the advance would probably continue, but at progressively slower rates. Annualised GDP growth might be in the region of 2% in the second half of 2010, 1% in the first half of 2011, and possibly negative thereafter.

There aren’t enough jobs.
The authorities hadn’t acknowledged that the best of the revival was over. But they were known to be worried. The labour market was their particular concern. At comparable stages in previous cycles, it used to be job creation that propelled the economy into top gear. Not this time, though.

And not enough borrowing.
Nor was personal debt providing its customary stimulus. Usually, half way between trough and peak, the consumer would have been an enthusiastic borrower; his banker an enthusiastic lender. This time, in reaction possibly to the mistakes each thought he’d made in the past, consumer debt was barely growing and mortgage debt declining.

US prospects are grim.
If the economy were indeed headed for another downturn, could the authorities do anything to ease the pain? Arguably, not! Monetary policy had been tried. Fiscal policy likewise. The one hadn’t helped; the other had made things worse.

Elsewhere as well.
It was not much different in the rest of the world. Japan’s second quarter GDP estimate was a huge disappointment. And China’s wasn’t much better. So much for decoupling!

What about Germany?
Was Germany the exception?
Was its surge in output in the spring to be taken at face value? Probably not! It was likely to have been a temporary blip consequent upon the euro’s recent depreciation. In the summer and autumn, there’d possibly be a reversal.

Best of a bad bunch!
Most of the rest of Europe, meanwhile, was in dire straits. Over regulated and under competitive, it was sinking fast—yields on Government debt under pressure again. There was uncertainty about the future of the EZ, and possibly that of the EU as well. Not a time to commit extra funds to the region, therefore.

The Australias and Brazils are also at risk.
Questions were being posed also about the viability of the commodity producing economies. In the last decade, their labour costs had risen very rapidly (partly because of generous pay deals, partly because of strong currencies). That’d been no problem so long as commodity prices stayed high. But what if they were to fall? The potential setback would be huge. High beta was a double-edged sword.

Share prices are the one (moderately) bright spot.
Interestingly, though economies are looking gloomy, equity markets are holding up well. Profits announcements have been encouraging: sales weak, but margins strong. It’s wages that have been taking the strain; unit labour costs falling relative to prices. The process is likely to intensify before it reverses. If so, valuations will continue to rise.

James Branch Cabell—there’s lots of the former in central banks; lots of the latter in the general public!

Nobody’s much good at economics forecasting.
Last week, the Bank of England scaled back its forecasts for Britain’s economy in 2010 and 2011. The revisions were long overdue. Activity in most parts of the world had been faltering in recent months. It wasn’t likely that Britain would buck the trend.

But some, the BOE for instance, are worse than others.
The surprise was not that the Bank cut its estimates, but that it cut them so little. It seemed to pay scant attention to problems in the US and EZ, none at all to those in China and Emerging Asia. It ignored the business cycle, and dismissed investors’ distrust of the credit markets.

Its optimism is unrealistic.
The Bank’s analysis was based solely on seventies-style liquidity considerations. Excess reserves in the banking system would stimulate private sector activity, it claimed. Borrowing and spending would both respond. So would inflation.

It pays no attention to recent developments.
But if that logic had been appropriate, we’d not have experienced the recession of 2008/09. What the Old Lady failed to appreciate was that the economics environment had changed. These days, it was characterised by excess supply, not excess demand. The one boosted activity; the other smothered it.

The European Bank is similarly challenged.
The ECB is as bad as the BOE, possibly worse. For a decade or more, its aggregate economics forecasts have been wildly optimistic. And the performance of the component parts (those of individual countries) have diverged, not converged. The latest data underline the point. Germany and the Netherlands seem to be able to live with the euro; not so half a dozen of the others. For the ECB to pretend otherwise is unhelpful; undermining its own credibility.

The Fed is the best. But it too has lost its way.
The Fed has the best forecasting track record of any of the central banks. But it too has been jolted by recent developments. There’ve been downwards revisions to GDP estimates and there’s been a sequence of soft labour market returns. Greenspan talks about a “pause” in the recovery, but it’s more likely to be the start of a (possibly protracted) slowdown.

The Asian counterparts also.
China and Japan likewise. Activity in both is slowing. And it’s occurring, not in consequence of monetary tightness, but despite monetary looseness. The central banks don’t know what to do. But they fear that, if the community’s response can’t be improved in the next eighteen months, there’ll be another recession, possibly another severe one.

Commercial banks are a negative.
The commercial banks will be no help in preventing the nightmare. Nor will the public spending departments of governments. Both, on the contrary, may do more harm than good.

And so are public spenders.
The banks, for instance, are a drag on activity, not a spur. Their balance sheets are still fragile and that’s made them reluctant to lend to businessmen. Where they can be persuaded to extend credit, they charge extortionate rates of interest. It’ll be a decade, possibly as much as a generation, before they become contributors to society.

Rightly or wrongly, there’s distrust of government debt.
Government spending is an even bigger negative. It’s a consumer of resources, not a creator of them. Transfers from the private sector to the public one nearly always result in a net loss to the community. And today, there’s an additional negative. Investors have become sceptical of the capacity of governments to repay debt. Accordingly, extra public spending is associated with systemically higher interest rates and universally lower creditworthiness!

Not all problems are immediately resolvable!
What are the authorities to do? Preferably, as little as possible. If they were to want to help rather than hinder, they’d cut public spending and taxation as well. They’d get rid of most regulators and nearly all quangos. But, if psychology were to turn decidedly negative, even this wouldn’t help.

Ironically, asset markets may fare well.
Interestingly, assets markets would probably come out of the chaos quite well. Fixed interest stocks would like the low inflation. And ordinary shares would benefit from heightened profits (unit labour costs falling faster than prices). Both trends have been apparent in the last year or so. Both will persist (possibly intensify) in the period ahead.

Robert Heinlein—but the credibility of the man proposing it is crucially dependent on the credibility of what he proposes.

Bernanke, like Greenspan earlier, keeps his forecasts under review.
The Federal Reserve Board may not be very good at forecasting the economy, but it’s excellent at monitoring it. As a result, its errors are quickly recognised and its projections sensibly amended. Credibility is rarely prejudiced, therefore.

They’re changed when necessary.
Other central banks are less accomplished. Many refuse to acknowledge misanalysis. As a result, their projections are unrealistic, and their authority low.

Last week, they were.
Last week, the Fed skilfully shifted position. It admitted that US job creation had been weak and that activity was faltering. The gap between current reality and earlier expectation was wide, and getting wider. Forecasts needed to be scaled back, and policy options reviewed.

That’s because activity, far from revving up, is stalling.
In the event, the forecasts were changed relatively little. The Fed seemed to be assuming that the slowdown that had occurred hitherto wouldn’t be reversed, but that it wouldn’t be extended either. Hmph! That was possible, but it was much more likely that things would continue to deteriorate.

Credit will remain accommodative.
Investors were more interested in the Fed’s discussion of future monetary policy. It was set to become more accommodative, it emerged. Quantitative easing would continue.

Will that remedy the debility? Maybe not!
The unstated presumption was that easier credit conditions were bound to help. Not so, of course. It depended on what had been causing the anaemia. If it hadn’t been penal interest rates or scare liquidity, there was no reason to expect the changes to be helpful.

People don’t want to spend; they prefer to save.
The Fed knew this. It knew that, to restore vitality, it had to identify the economy’s inhibitions, and remove them. But what if they were psychological? What if consumers and businessmen weren’t spending because they thought current problems were a consequence of excesses in the past? That was the nightmare. That spelt a replay of the thirties!

The nightmare of depression might become a reality!
Bernanke hasn’t yet talked openly about the issue of depression. He hasn’t wanted to exacerbate any deficiency of demand by scaring the general public. But it’s likely he’s mentioned it to the president.

Obama is scared.
It’s possibly that which has made Obama behave so erratically in recent weeks. The man had said he’d like to be another Roosevelt. Be careful what you wish for! You may get it.

Central banks in Europe seem unaware of the problem.
Elsewhere in the world, many central banks are in a state of denial. The ECB and the BOE, for instance. Their forecasts are hopelessly optimistic. They ignore the business cycle on the one hand and the consumer’s repudiation of debt on the other. The credibility of these organisations is already low, but it may go lower still.

Those in Asia only dimly conscious of it.
Japan’s central bank has begun to recognise its problems in recent weeks. China’s likewise. Both know their economies have become over-reliant on exports; that they’re consequently vulnerable to declines in demand in the EU and US. They hope, officially, that a quickening pace of domestic sales will provide an offset. Both know, realistically, it won’t.

Bonds understandably are soaring. Equities will follow.
Investors and politicians are worried. The former have less justification for their anxiety than the latter. Asset valuations will continue to rise. Currently, it’s bonds that are making the running. Shortly, it’ll be equities again.