A Warning from Air Freight

Boeing had a great 2011: orders for cargo airplanes rose to a record high. Altogether 79 planes were ordered. However, it looks now like 2012 will turn out quite differently.

As Bloomberg reports, international air cargo shipments are slumping noticeably:

„The world’s largest maker of cargo aircraft hadn’t logged a new freighter deal in 2012 through May 29, a dry spell that matches the worst start to a year for such purchases since 2009. Boeing’s tally in the same period in 2011 was 13 cargo planes whose catalog prices totaled $3.75 billion.

Freighter demand is wilting along with global air shipments as China’s economy cools and Europe’s debt crisis deepens. Those pressures on cargo carriers are erasing any chance for Chicago- based Boeing to approach 2011’s freighter deals, said Ken Herbert, a Wedbush Securities analyst in San Francisco.

“I’m not expecting a very good year,” Herbert said in an interview. “Freight traffic is still bouncing along the bottom and slow to come back.”

International air-cargo shipments fell 2.5 percent worldwide through April, even as industrywide capacity grew 1.8 percent, the International Air Transport Association trade group said yesterday. Europe’s cargo traffic slid 4.6 percent, while the Asia-Pacific region declined 4.4 percent.“

(emphasis added)

The steep decline in shipments to Europe won't surprise anyone, but what about Asia? Here we think we see two major causes at work. For one thing, the  lagged effects of the tightening measures undertaken by China's monetary authority in the course of 2010-2011 are still percolating through China's previously overheated economy. China's planners wanted to get both 'price inflation' (this is to say, rising consumer prices) under control, as well as the burgeoning real estate bubble. However, as they will no doubt find out in due course, once you prick such a balloon, it becomes very difficult to put Humpty-Dumpty back together again.

While the central bank has adopted a few easing measures this year by lowering reserve requirements, these must be put into context: as foreign exchange accumulation has slowed and is in fact in danger of reversing, the central bank does not need to sequester as many yuan as previously. China manipulates its exchange rate, and the only way of averting run-away money supply growth in the face of huge foreign exchange inflows is to 'sterilize' them via raising reserve requirements. In other words, the easing measures are not really providing much easing. Rather they reflect the decreasing need for sterilization now that inflows have ground to a halt.

The other cause is of course the continuing banking and sovereign debt crisis in the euro area. In Europe banks provide far more credit relative to economic output than in the US. The main reason for this is that the corporate bond market is much smaller. However, European banks are also very big international players. At the height of the credit expansion, they provided some $1.6 trillion in credit to Asian customers. We have no recent data on this particular aspect of their business, but since they are all busy shrinking their balance sheets in the face of enormous funding problems, it is safe to infer that they have curtailed their lending to Asia, just as they have curtailed their lending to commodity trading houses.

All of this leads us to conclude that a synchronized global recession is likely to happen. This means that the 'decoupling' theory propagated by stock market bulls will once again – as it always does – fall flat on its face. In 2007-2008 the favored 'decoupling ' theme was that the so-called 'BRICs' (Brazil, Russia, India, China) would somehow be able to skirt the US recession following the bursting of the housing bubble. Today the favored decoupling theory states that the US economy will be able to expand all on its own, regardless of the gathering storm in Europe and China.

We believe that this is wishful thinking. The global economy is much too interdependent to allow any large economy to sidestep a worsening contraction in the other major economies. All that separates them is the precise timing.

What Makes 2012 Different

1. The Potential for Bigger Losses

The main differences between 2012 and 2008 are the following: for one thing, instead of investment banks being at the center of the credit crisis, we have this time entire nations and their banking systems at the center of the crisis. Arguably, the current crisis is worse because of this: there is a much greater probability of wide-spread 'contagion' and the putative losses could easily dwarf those of the 2008 crisis. 

While we think that e.g. IIF chief Charles Dallara is a fear-monger who exaggerates on purpose in the interest of his lobby, we would not dismiss his estimates regarding the possible losses on a Greek exit from the euro area out of hand. Clearly the losses could be quite staggering, not to mention that a legal and administrative nightmare of unprecedented proportions would be set into motion. That however is just Greece, an economy so small that it amounts to less than 2.5% of the euro area's total output.

If Spain keels over – a prospect that looks ever more likely – then the problem  would be multiplied. We don't know at this point how the eurocracy hopes to stem the bleeding, or what plans it might come up with to kick the can down the road one more time. What we do know for certain is that the surplus countries have a vision of the way forward that is diametrically opposed to that of the profligate debtors that now find themselves in the soup.

This makes it extremely difficult to come to unanimous decisions that enjoy credibility with the markets. As our good friend Dr. Jim walker of Asianomics recently remarked: “If there were an easy way out, they'd have stumbled over it already”. They haven't stumbled over it because there simply is no easy way out. It is certain that the current method of kicking the can down the road from one crisis eruption to the next won't work forever.

The markets however continue to believe that there is some magic bullet that only waits for Germany's placet so it can be deployed. If only the Germans would acquiesce to euro-bond issuance. If only they were getting out of the way and let the ECB print wagon-loads of money in 'QE' fashion the way the Fed did.

However, no such magic bullet exists. If these interventionist measures were deployed – leaving aside the fact that they would actually be illegal under the current dispensation, i.e., the European treaties and the ECB's statutes – they would only invite the profligate to continue with their ways and let the Germans pay for it all. The 'tragedy of the commons' of the monetary union, as Philipp Bagus has so aptly described the situation, would then be perfect. In the end, the house of cards would come tumbling down anyway, only in an even bigger crash and with no survivors.

So the situation appears nigh intractable. Unfortunately, there have been very few attempts at genuine economic reform in the euro area, the type of reform that would create a glimmer of hope that growth and competitiveness could be restored in the debtor countries. Some, like e.g. Portugal, have proven more adept at introducing reform than the others, but overall the pace of reform is somewhere between glacial (Italy and Spain) and non-existent (Greece). In the meantime, their TARGET-2 liabilities keep climbing into the blue yonder. It is an unsustainable construct and therefore it won't be sustained.

2. Money Supply Growth

However, there is also another difference between 2008 and today that attracts comparatively little attention, but is probably quite important.

It concerns money supply growth, more specifically, US money supply growth. Prior to the crisis in 2008, money supply growth all over the world had been slowing down for several years and in fact had slowed to a crawl in 2007/8. This year, money supply growth is very slow in the rest of the world, but remains quite brisk in the US.

Via Michael Pollaro: growth of money TMS and official 'broad' money supply measures in four major currency blocs. In 2008, true money supply growth was very slow all over the world just prior to the crash. This time, US money supply growth stands out – it remains brisk – click chart for better reolution.

As can be seen, the ECB's attempts to get credit flowing again with its LTRO's have failed. The Fed has been far more successful in this regard, as 'QE' not only managed to raise excess bank reserves, but enough of it 'bled through' to the real economy to keep the true money supply growing at or above 10% annualized for what are now 43 months in a row.

Quarterly annualized growth of ECB credit of 48.7% translated into only 2.2%  of quarterly annualized growth in money TMS. Fed credit has actually shrunk by 7.1% annualized over the past quarter, and yet, broad money TMS-2 still managed to grow by 10.7% annualized over the same span.

However: this rate of growth represent a notable slowdown from the 14% year-on-year growth rate as of April. Unless the Fed opens the spigot again with 'QE3', the probability of US money supply growth slowing down and joining its brethren in the rest of the world will be great. In that case, we would expect stock markets and commodity markets to fall considerably further. In fact, it may already be too late to do anything about that: as a friend recently remarked to us, one can think of the stock markets of Spain and Greece as the 'canaries in the coal mine', just as certain market sectors like the housing stocks were in 2007/8 (these stocks had been collapsing since 2006 already).

In 2008, most central banks still thought that the biggest danger was 'inflation' (increase in CPI) as the oil price soared into its summer highs. This was the main reason for their reluctance to open the spigot wide, a reluctance that was only thrown overboard once asset prices collapsed.

This time there are no inflation concerns on the part of the monetary bureaucracy, but the central bankers are probably reluctant to add to the pumping they have already instituted on the grounds that their balance sheets are extremely bloated and there is a gale of criticism blowing into their faces for what they have done thus far.

Nonetheless, it appears that the Fed is preparing to 'do something', as can be gleaned from a recent speech delivered by Boston Fed president Eric Rosengren, one of the noted 'doves' at the Fed (he has however no FOMC vote this year). A few excepts:

“Boston Federal Reserve Bank President Eric Rosengren said Wednesday that U.S. monetary policy “needs to be more stimulative” than it is now and that “more aggressive” easing actions will be necessary if a European shock or some other downside side risk materializes.

Rosengren, who will return to the voting ranks of the Fed’s policymaking Federal Open Market Committee next year, made clear he is not satisfied with the degree of stimulus being provided by the FOMC’s current policy stance, even though that body has called it “highly accommodative.”

He argued that the economy is growing too slowly and is likely to continue growing too slowly to reduce unemployment significantly and that joblessness is primarily “cyclical” — due to insufficient demand – not “structural” in nature.

Rosengren seemed to be suggesting that the FOMC should take further easing steps at its June 19-20 meeting and that it should be prepared to do even more if the European debt crisis, the U.S. “fiscal cliff” or some other shock worsens an already unsatisfactory outlook.

Even assuming that Europe and the United States “muddle through” their fiscal problems, he forecast growth of just 2.3% this year, with unemployment staying at 8.1% and inflation running below the Fed’s 2% target.

“Given the poor current conditions and my forecast for continued weakness — and the evidence that suggests the problem is one of aggregate demand rather than structural unemployment — I believe monetary policy needs to be more stimulative if we hope to meet both elements of the dual mandate in a reasonable time frame,” he said.

“And should some of the downside risks that I have emphasized materialize, such as a significant disruption from abroad, more aggressive actions would certainly be warranted,” he added in remarks prepared for delivery to the Worcester, Massachusetts Regional Research Bureau.

[...]

“I believe further monetary policy accommodation is both appropriate and necessary,” he continued.

[...]

Noting that employment is “nowhere its previous peak,” even allowing for unusually weak construction and government labor conditions, Rosengren said he is “especially concerned about the ongoing weakness there.”

Some Fed officials contend that much of the high unemployment is structural in nature — a result of such things as “mismatches” between business needs and the skills of available workers. But Rosengren, siding with Fed Chairman Ben Bernanke and other top policymakers, contended that “most of the problem is in a lack of aggregate demand.”

(emphasis added)

Like all good Keynesians, Rosengren believes that the problems can be solved if we somehow manage to 'consume ourselves back to prosperity'. Spending, not production, is the chief problem in this view. Production is assumed to take care of itself, if only sufficient 'aggregate demand' were to surface. This is based on a very unsophisticated view of the economy as a kind of circular flow system (one person's spending is another person's income and so forth) – the complex capital structure and its inter-temporal coordination is ignored entirely. This is a bit like saying that someone with half a flask of water lost in the middle of the Sahara can improve his chances of survival by drinking as much of his remaining water as possible.  Someone will then, as if by magic, provide more of it, seeing that the demand for water has evidently increased.

In reality, an increase in consumption would make the economy even more imbalanced than it already is due to the Fed's ministrations hitherto. Below we show a chart we have shown in the past, plus a variation of it. In the first chart, we divide the production of business equipment through the production of consumer goods. The second chart shows the production of durable materials divided by production of non-durable consumer goods. The message from both charts is the same: ultra-low administered interest rates have drawn factors of production away from the lower order goods production stages to the higher order ones. The probability that fresh malinvestments have been added to the previously existing ones is very high, as the national savings rate has decline precipitously at the same time. What we see below is a production structure that is beginning to tie up more consumer goods than it releases. This is not sustainable and will invite another bust sooner or later – if the Fed stops with its pumping, then it will be sooner.

The ratio of spending on business equipment production to consumer goods production - click chart for better reolution.

The ratio of durable materials production to non-durable consumer goods production - click chart for better reolution.

Production of higher order goods needs to be funded. It is not money that funds it – money merely serves as a medium of exchange and money prices serve as a tool of economic calculation. Imagine an island with only ten workers assigned to various tasks. If nine of the ten workers were busy building a new boat that it takes half a year to build, the stock of saved consumer goods is however so small that it could sustain their lives only for two months, then the one remaining worker would have to produce enough food to see not only himself, but also the boat builders through for the remaining four months. It is a good bet that he wouldn't manage to do so – eventually, the building of the boat would have to be abandoned and the workers would have to return to food production until a sufficiently large stock of saved food has been built up to enable finishing construction of the boat.

The entire US economy is in a roughly analogous situation now – and the reason for this is that the low interest rates the Fed has instituted make the pool of savings appear much larger than it really is.

The savings rate is once again declining. Rosengren thinks if people were to spend even more, this would heal the economy. More likely is that it would serve to consume even more scarce capital - click chart for better reolution.

To be sure, the market economy – in spite of being hampered by countless regulations and onerous taxation – is extremely flexible and capable of producing wealth even under the most challenging circumstances. Consider that in the old Soviet Union, the 2% of the arable land that were privately owned produced practically all of the fresh fruit and vegetables that were available in the country. While long queues were forming at state-owned shops that distributed food produced by state-owned agricultural enterprises, with consumers often finding out after queuing for hours that what they wanted was actually not on offer, the markets where privately grown agricultural produce was sold had enough to satisfy everyone who was able to pay.

This fact is what allows our policymakers to 'kick the can down the road' so often. Even while they do everything to put obstacles in the way of recovery by interventions designed to avert the pain of the readjustment that the end of the bubble has made necessary, the private sector adapts and continues to produce wealth. However, this does not mean that the interventions have no effect. They have once again produced a highly unbalanced economy. The central bank will surely be able to delay the denouement if it prints even more money, but that will only make the eventual downturn all the worse. The central bank can not create one iota of wealth – its ministrations merely serve to redistribute wealth from later to earlier receivers of new money, as well as distorting relative prices in the economy and thereby upsetting economic calculation. It is not possible for a central authority to successfully 'plan' the economy, even if such an authority had more tools at its disposal than the relatively blunt ones in possession of the Fed.

Addendum:  John Hussman's Weekly Missive

We would like to point readers to John Hussman's weekly column, which this week neatly summarizes the problems faced by the euro area.

A few excerpts:

On Bankia:

“Spain is providing these funds not as part of any restructuring, but by purchasing newly issued stock of the unrestructured, insolvent bank. While this will give Spain nearly 90% ownership of Bankia, the bailout effectively gives the people of Spain nearly worthless stock in an insolvent entity, putting them behind Bankia's bondholders. In the likely event that Bankia fails, is nationalized, and is then restructured, the 23.5 billion euros of public funds will vanish as worthless stock, and in the process of restructuring, the bondholders of Bankia will recover 23.5 billion euros more than they otherwise would have. In short, by putting off the receivership and restructuring of Bankia, Spain is simply enriching the bank's bondholders at the expense of its citizens, who are already being squeezed by budget austerity. This is particularly troubling given that it further expands Spain's national debt at a time that Spanish yields are reflecting rising default premiums and regional governments are reporting significant strains.

On a lighter note, among the collateral put up by Bankia last year in return for ECB loans was the Portugese soccer player Cristiano Ronaldo, whose recruitment by Real Madrid was financed by Bankia. I wonder if Mario Draghi can play goalie.

[...]

On Eurobonds:

“With respect to Eurobonds, investors should understand that what is really being proposed is a system where all European countries share the collective credit risk of European member countries, allowing each country to issue debt on that collective credit standing, but leaving the more fiscally responsible ones – Germany and a handful of other European states – actually obligated to make good on the debt.

This is like 9 broke guys walking up to Warren Buffett and proposing that they all get together so each of them can issue "Warrenbonds." About 90% of the group would agree on the wisdom of that idea, and Warren would be criticized as a "holdout" to the success of the plan. You'd have 9 guys issuing press releases on their "general agreement" about the concept, and in his weaker moments, Buffett might even offer to "study" the proposal. But Buffett would never agree unless he could impose spending austerity and nearly complete authority over the budgets of those 9 guys. None of them would be willing to give up that much sovereignty, so the idea would never get off the ground. Without major steps toward fiscal union involving a substantial loss of national sovereignty, the same is true for Eurobonds.

Over the weekend, Jean Claude Trichet, the former ECB head, proposed a system to save the Euro, whereby European politicians could declare a sovereign country bankrupt and take over its fiscal policy. He also proposed a system whereby the Eurozone could produce its own domestic energy by placing a giant hamster on a wheel the size of the Eiffel Tower.

[…]

On the hopes of investors:

“Ultimately, what investors really want is for the debt of various countries to be wiped away by the ECB simply printing money to retire that debt, or by having Germany and stronger Euro-area members to make endless transfers to peripheral European countries. The whole system rides on this willingness to transfer fiscal resources, or to allow money printing (with no revenue to stronger members from that money printing) in order to finance heavily indebted members. The reason the recent elections in Greece and France matter is that they send a signal from the public to European governments: the people are unwilling to make any more "austerity bargains" that put the public behind bank and government bondholders. So Germany is now being asked to continue its transfers without any end in sight.”

(emphasis added)

This echoes many of the things we have been saying in recent weeks. The entire column is well worth reading, we recommend it highly.

Charts by: Michael Pollaro, St. Louis Fed

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