This isn’t a recovery. It’s an Obama Bubble

Last week the Dow Jones Industrial Average reached the symbolic 10,000 mark, capping a 50 per cent increase since March. Confetti fell in the New York Stock Exchange, and traders took to the streets of the Big Apple wearing ‘Dow 10,000’ baseball caps. Writing in the Wall Street Journal, economist Brian Wesbury says the rise in the financial markets like the Dow suggests ‘investors are confident the crisis has ended’, and is a sign that ‘the economic recovery is well underway’ (1).

The most common retort to those rejoicing the Dow milestone is to point out that it is in bad taste for Wall Street to celebrate while Main Street is still suffering. ‘There are no champagne corks being popped on Main Street’, says the New York Times (2). Quite rightly, the Times and others point out that unemployment remains at a high 9.8 per cent rate and the economy has not fully recovered.

But there is more going on than Wall Street’s detractors see. The Times says ‘the stock market usually recovers before the economy does’, but the latest rise in the stock market is more of an indication that the finance bubble is returning rather than a harbinger of broader economic recovery. And rather than blame greedy Wall Street types for starting the party before others have arrived, this reinflated bubble has been made in Washington, DC – led by liberal Democrats in the Obama administration, who many Wall Street critics praise for saving the economy from another Great Depression.

There is, in fact, something of a recovery happening. Retail sales, for example, have increased since the beginning of the year, after substantial declines last year. According to the National Associations of Business Economics, more than 80 per cent of economists believe the recovery has begun and anticipate growth of about three per cent in the second half of 2009 and for all of 2010 (3).

The fact that output is growing again is not that surprising. Any downturn leads to mechanisms which restore conditions for an upturn – companies cut costs, the weakest go bankrupt, inventories get depleted and eventually need to be restored – and these factors have been in play during this recession, which started in December 2007. In addition, the financial crisis led the US government to provide massive support in various ways, which was bound to have an effect on the output statistics. In monetary terms, the Federal Reserve lowered interest rates to nearly zero, and found new ways to provide liquidity. In fiscal terms, the Obama administration convinced Congress to pass a $787billion stimulus package, and has bailed out banks, insurers and other companies, among other actions.

The problem is, this government support seems to be a crutch rather than a ‘stimulus’ to private industry. In its recent report on the impact of the stimulus package, the Council of Economic Advisers writes: ‘There is broad agreement that the ARRA [American Recovery and Reinvestment Act] has added between two and three percentage points to baseline real GDP in the second quarter of 2009 and around three percentage points in the third quarter.’ (4) Recall that economists are predicting three per cent growth in the second half of 2009 – in which case, government spending via the stimulus package is accounting for all of that growth. Also, an analysis by the Economic Policy Institute found that the stimulus is saving or creating between 200,000 and 250,000 jobs a month. In other words, September’s bad 263,000 job losses would have been twice as bad if not for government spending (5).

The unemployment picture is bleak today, but, as many are quick to point out, it is a ‘lagging indicator’ and may only improve after other signs have turned positive. What is arguably a more disturbing symptom than unemployment is the lack of investment – the force that would create jobs in the future. In the second quarter of 2009, net private investment fell off the cliff to a nearly non-existent 0.1 per cent of the total economy (gross domestic product or GDP), the lowest level since modern records started in 1947. And although this figure includes residential (housing) investment which we know has been hit hard, all major categories are significantly lower, including structures, equipment and software (6).

Stock markets are said to be higher on the back of companies reporting better-than-expected profits. Yet share prices relative to earnings look frothy: the shares of the large companies listed in the S&P 500 index are trading at about 20 times earnings, compared to an average of 14 times over the past century. Moreover, these profits are mainly the result of cost-cutting, including cutting investment, rather than growing revenues. For example, minerals giant Alcoa reported $77million in profits, but slashed research and development (R&D) by $39million (36 per cent) at the same time. And there are few signs that companies are planning to invest anytime soon. As the Wall Street Journal reports: ‘Executives say they are hesitant to reinvest such profits into their businesses. With large portions of their factories, fleets and warehouses sitting idle, some say they probably won’t see reason to do so for a year or more.’ (7)

It is not for a lack of cash that companies are failing to invest; it is because profitable conditions do not exist. The biggest corporations have found it easier to borrow money than during the earlier credit squeezes, but those that have raised funds are not investing them. According to Dealogic, only six of the 100 largest US bond issues in 2009 gave investment, capital expenditure or R&D as the reason for obtaining additional money. Instead, companies are mainly seeking to shore up their balance sheets and possibly hoard to weather another downturn. Or, they plan to use the money for acquisitions – which are more likely to reduce rather than add to overall investment (8).

It is the lack of investment in the real economy that is behind the rise in the Dow and other financial markets. Liquidity created by the Federal Reserve and other money pumped into the economy by the government does not have profitable investment outlets. The cheaper money is instead flowing into stocks, bonds and commodities, pushing speculative gains higher and re-starting an asset bubble.

The results for JPMorgan Chase, which pushed the Dow over the 10,000 level, highlight how money is being made today. It is not from traditional lending: the banking giant’s consumer-related business has been poor, with credit cards losing $700million in the past three months, and retail banking barely breaking even. Instead, JPMorgan’s much-improved profits derived from investment banking and in particular from trading in stocks and bonds (9). Results for other big investment banks, like Goldman Sachs, have told a similar story.

And as investment banks’ profits increase, so will bankers’ bonuses: Goldman Sachs alone has set aside $5.3billion for its compensation, almost half of its revenues. As the Financial Times says, ‘Stay tuned for another swell of public outrage’ (10). Right on cue, Obama’s aides appeared on Sunday’s political TV programmes to denounce the bankers. Rahm Emmanuel, White House chief of staff, said Americans ‘have a right to be frustrated and angry’, while adviser David Axelrod called the bonuses ‘offensive’ (11).

Yet administration officials ought to look closer to home rather than blame Wall Street. Investment bankers are doing what they have always done: share out a high percentage of their profits. And where are those profits coming from? The government-inflated bubble. Zero interest rates and Federal Reserve money pumped into the economy have lifted stocks, and in turn the big banks have benefited. More specifically, the investment banks have been helped by Washington’s bailout moves in the sector: Troubled Asset Relief Program (TARP) direct support; covering losses from trading with insurance giant AIG; allowing investment banks like Goldman and Morgan Stanley to become holding companies, which then gave them access to inexpensive Federal Reserve funding and allowed them to issue bonds guaranteed by the Federal Deposit Insurance Corporation (FDIC) – a status traditionally reserved only for banks that provide general financial services (12).

Beyond the stock market, other areas suggest that the bubble is re-inflating. In a recent speech, White House economic adviser Lawrence Summers pointed to stabilisation in the housing market (13). New home sales are 58 per cent higher on an annual basis, and the S&P/Case Shiller index finds that home prices have risen in 15 of 20 cities in the past three months (14). But house prices are starting to rise in some regions again before they have been restored to historical (and more affordable) levels as a multiple of people’s incomes – again suggesting overvaluation. Furthermore, the housing sector is hardly out of the woods. The Center for Responsible Lending estimates that there will be 2.4million foreclosures in 2009, and projects that, for most states, foreclosures will more than triple to over eight million over the next four years (15).

In the same speech, Summers also cited signs of normalisation of credit flows, which had seized up at the onset of the crisis. But the main area where the thawing is occurring is in ‘securitisation’ – the packaging of loans for re-sale, and the site of the so-called ‘toxic assets’ that set off the credit crunch. JPMorgan, Citibank and others have, for the first time, made significant ‘write up’ gains on their leveraged loans and mortgage-backed assets. Again, government schemes – such as the Public-Private Partnership Investment Program (PPIP) and the Term Asset-Backed Securities Loan Facility (TALF) – are what have excited investors. However, these assets remain as ‘toxic’ as before. As the Financial Times reports: ‘Some of the debt market’s riskiest assets have found buyers, though many of the assets remain hard to value. Information is scarce about the likely performance of some mortgages, making predictions of cashflows and values difficult.’ (16) In other words, the investors still don’t have a clue, but since trading in these assets is rallying again, why not jump on the bandwagon?

In contrast to the busy action in toxic assets, overall credit levels, in particular for business purposes, remain subdued. On the one hand, banks are reluctant to lend to businesses because of ongoing losses, tighter underwriting standards and because they anticipate higher required capital reserves in the future. On the other hand, companies are not seeking loans, as they are not investing (17).

President Obama recognises that a true recovery has not arrived yet. In a recent speech he said: ‘Our goal is not just to rebound from this recession, but to start building an economy that works for all Americans; where everyone who’s looking for work can find a job – and not just a temporary job, but a permanent job that lasts from season to season; where our stock market isn’t only rising again but our businesses are hiring again.’ (18) He and his administration are no doubt hoping ‘green shoots’ will gradually emerge. They also know the economy will get another boost from the stimulus package, most of which has yet to come into play: as of the end of September, only 20 to 25 percent of the total $787billion had been spent or gone to people in the form of tax reductions (19).

But unless the underlying conditions for investment are restored, government money is likely just to pump up further the re-emerging bubbles. Even if the Obama administration recognises this trend, it is likely that lacklustre economic growth and high unemployment will render them reluctant to tighten monetary and fiscal conditions too much.

The unspoken issue at the root of Obama’s dilemma is that the economy’s engine – private non-financial industry – is not investing and innovating. And his response so far is part of the problem, not the solution.

Sean Collins is a writer based in New York.

Read on: spiked-issue Financial crisis.

(1) The economic recovery is well underway, Wall Street Journal, 12 October 2009

(2) Dow 10,000: Then and now, New York Times, 16 October 2009

(3) Summers outlines risks to recovery, Wall Street Journal, 13 October 2009

(4) Cited in The $800 billion deception, Slate, 12 October 2009

(5) Cited in The truth about jobs that no one wants to tell you, Huffington Post, 2 October 2009

(6) Cost cuts lift profits but hinder economy, Wall Street Journal, 14 October 2009

(7) Cost cuts lift profits but hinder economy, Wall Street Journal, 14 October 2009

(8) Too cash-strapped to brag, companies aren’t using borrowing to spend, Wall Street Journal, 13 October 2009

(9) JPMorgan profits lift Dow above 10,000, Financial Times, 15 October 2009

(10) ‘Public needs more bang for its buck’, Financial Times, 16 October 2009

(11) Obama aides go on TV to criticize Wall Street, New York Times, 19 October 2009

(12) ‘Bailout helps revive banks, and bonuses’, New York Times, 17 October 2009

(13) Summers outlines risks to recovery, Wall Street Journal, 13 October 2009

(14) Cited in The economic recovery is well underway, Wall Street Journal, 12 October 2009

(15) Cited in The stock market has never been this (intermediate-term) overbought, Hussman Funds – Weekly Market Comment, 19 October 2009

(16) US banks book gains from rally in toxic assets, Financial Times, 19 October 2009

(17) Credit in America: Slim pickings, no appetite, The Economist, 17 October 2009

(18) Obama’s remarks on the stimulus package, Fairfax County Parkway Extension, 14 October 2009, published by realclearpolitics.com

(19) Cited in The $800 billion deception, Slate, 12 October 2009