Markets and the mistake of 1937

DXY sank last night as debt ceiling worries mount:

AUD was up against USD and EUR:

But down against EMs as risk poured on:

Gold firmed and is nudging break out:

Brent was hosed:

Base metals were mixed but the anti-USD play still looks strong:

Big miners were firm:

EM stocks too:

High yield is still soft:

US yields fell:

And European:

Stocks were soft:

In short, the commodity pain trade rolls on as US doubts linger. Ray Dalio stoked them:

I believe that a) most realities happen over and over again in slightly different forms, b) good principles are effective ways of dealing with one’s realities, and c) politics will probably play a greater role in affecting markets than we have experienced any time before in our lifetimes but in a manner that is broadly similar to 1937.

I’m essentially an economic mechanic who focuses on how reality works by studying the cause:effect relations and how they played out in history to help me bet on what’s likely to occur. For reasons previously explained in “Populism…” it seems to me that we are now economically and socially divided and burdened in ways that are broadly analogous to 1937. During such times conflicts (both internal and external) increase, populism emerges, democracies are threatened and wars can occur. I can’t say how bad this time around will get. I’m watching how conflict is being handled as a guide, and I’m not encouraged.

History has shown that democracies are healthy when the principles that bind people are stronger than those that divide them, when the rule of law governs disputes, and when compromises are made for the good of the whole — and that democracies are threatened when the principles that divide people are more strongly held than those that bind them and when divided people are more inclined to fight than work to resolve their differences. Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation.

Average numbers hide the depths of the divisions. For example, by looking at average figures, one might conclude that the United States economy is doing just fine, yet when one looks at the numbers that comprise those averages, it’s clear that some are doing extraordinarily well and others are doing terribly, with gaps in wealth and income being the greatest since the 1930s.

Largely as a function of these economic differences and differences in the principles that people believe most deeply in, we are seeing large and increasingly firm political differences, which are apparent only by looking below the averages. For example, Donald Trump’s approval rating of 35% is a result of 79% support among Republicans and 7% among Democrats (Gallop). Of those who approve of President Donald Trump, 61% say they can’t think of anything Trump could do that would make them disapprove of his job as President, and 57% who disapprove of Trump say they are never going to change their minds on the President’s job performance (Monmouth). Similarly 40% of those polled (PRRI) would favor Donald Trump’s impeachment, which consists of 72% of Democrats and 7% of Republicans, and most of them won’t change their minds.

In other words, the majority of Americans appear to be strongly and intransigently in disagreement about our leadership and the direction of our country. They appear more inclined to fight for what they believe than to try to figure out how to get beyond their disagreements to work productively based on shared principles.

So, where does that leave us?

While I see no important economic risks on the horizon, I am concerned about growing internal and external conflict leading to impaired government efficiency (e.g. inabilities to pass legislation and set policies) and other conflicts.

I of course hope that the principles that bind us together are stronger than the ones that divide us. I believe that this is a time when it is especially important for us a) to be explicit about what our principles are in order to be clear about what we agree and disagree on, b) to practice the art of thoughtful disagreement, and c) to respect our ways of getting past our disagreements so we can start rowing in the same direction. I believe that how well this is done will have a greater effect on the economy, markets and our overall well-being than classic monetary and fiscal policies, so I continue to closely watch how conflict is handled while tactically reducing our risk to it not being handled well.

The political worry de jour is the US debt ceiling but is it a real concern? I doubt it. Here’s VOX:

Back in 2011, the federal government’s statutory debt ceiling, an obsolete vestige of World War I-era public finance, was successfully transformed by House Republicans from a cheap partisan talking point into a sharp-edged spear used to extract policy concessions. The result of their efforts was a brush with national economic calamity, followed by the imposition of a severe fiscal austerity regime that caused a few years’ worth of slow-burn economic pain.

Having faced the abyss, both parties backed away from it in subsequent rounds of negotiation. The changed partisan dynamics in Washington since Donald Trump’s election should have made the debt ceiling increase scheduled for this fall relatively straightforward — Republicans could just do it and move on.

Except it turns out that nothing in the age of Trump is exactly straightforward. The administration spent months offering no clarity on whether it even wanted a simple increase in the debt ceiling. That emboldened the right flank of congressional Republicans, who don’t want to raise the ceiling without also cutting federal spending in the process.

Freedom Caucus members have no real leverage to force legislative changes, but if they won’t vote for what’s known as a “clean” debt ceiling increase — one that is not attached to spending cuts or any other bills — that puts some leverage in the hands of congressional Democrats, whose votes GOP leaders will be counting on to get an increase done.

Democratic leaders, meanwhile, have been hesitant to engage in the kind of irresponsible brinksmanship that they condemned Republicans for six years ago. But backbenchers in safe seats are feeling restive, and with the next item on the Trump legislative agenda being a large tax cut, it strikes many Democrats as perverse to be bailing out Republicans on providing additional borrowing authority — authority that Treasury says will be needed next month.

…Back on May 24, testifying before the House Ways and Means Committee, Treasury Secretary Steve Mnuchin played the customary role of the Treasury secretary in this drama and told Congress that it should raise the debt ceiling.

“I urge you,” he said, “to raise the debt limit before you leave for the summer.”

It didn’t happen, in part because Trump’s own Office of Management and Budget director wasn’t in agreement with Mnuchin on the desirability of a clean increase. OMB Chief Mick Mulvaney finally got on board late last week, but by then Congress was already on its way out the door, with Republicans licking their wounds from the health care fight. But the president himself has been silent on the issue, and backbench House conservatives don’t seem interested in a clean increase.

“A clean debt ceiling hike is like having a credit card and saying, ‘I’ve reached my limit; I’m just going to change the limit higher without changing any of my spending habits,’” Tom Cole (R-OK) told Morning Joe on Tuesday. “That’s a tough sell to Republicans.”

This is, in reality, a pretty terrible analogy on all fronts. But outside conservative groups like Heritage Action are mobilizing to oppose a debt ceiling increase. For a while now, FreedomWorks has been pushing legislation that would explicitly authorize the Treasury to transform a debt ceiling breach into something more like a conventional government shutdown.

The result is that any debt ceiling bill is going to need Democratic votes to pass the House — potentially giving Democrats some leverage, if they want to use it.

Most Democrats on Capitol Hill seem content to lay low, not say much until the last possible minute, watch Republicans fight among themselves, and then deliver the necessary votes for a debt ceiling increase when the time comes. Nobody in the Democratic caucus genuinely wants to see a debt ceiling breach, and the party came down so hard against GOP brinksmanship in 2011 that there is a heavy stigma against engaging in a new round of it. Simply playing the issue to embarrass Republican leaders is good enough for most Democrats.

But there are some rumblings of discontent with this position.

One line of argument has to do with the looming debate over “tax reform” — which, with Mitch McConnell saying he’s looking to move a partisan bill with 50 votes, will almost certainly amount to a debt-increasing tax cut for corporations and affluent families.

Back in early June, Democratic leaders — including Nancy Pelosi and Chuck Schumer — hinted that they would try to link the debt ceiling issue to a demand that tax reform not increase the deficit. But then about a week later, Pelosi backed off that stance, and Schumer seems disinclined to pick a fight either. But Dick Durbin (D-IL) still seemed interested in attempting some kind of linkage last week, and for Democrats eager to make some base-pleasing gestures of “resistance” by taking a stand against a compromise with the unpopular Trump administration, last-minute qualms could seem tempting.

A somewhat more wonk-friendly approach, endorsed by Brian Schatz (D-HI), would be for Democrats to insist on abolishing the debt ceiling altogether, rather than lifting it.

The substantive benefit would be to remove the threat of politically induced default forever. Politically, Democrats would ensure that Obama-era brinksmanship tactics wouldn’t simply return when Trump is out of the White House.

For now, though, Democratic leaders simply say that Republicans — especially House Republicans — need to make the first move and introduce legislation. Most likely they will do so shortly after recess, and mostly likely when they do, enough Democrats will come along to pass the bill. But so far, that’s all speculation. None of the work has actually been done. And there’s precious little time left in which to do it.

Democrats are unlikely to block it. There’s no political upside in doing so. Moreover, if that passes OK it’s on to tax reform and if a clean sweep of Republicans can’t get that happening then the Right will only have proven that it is completely incapable of governing.

That’s not to say that Dalio is wrong. He’s right. But the 1937 analogy remains more important in a different respect, from Paul Krugman in 2010:

Earlier this week, the Federal Reserve Bank of New York published a blog post about the “mistake of 1937,” the premature fiscal and monetary pullback that aborted an ongoing economic recovery and prolonged the Great Depression. As Gauti Eggertsson, the post’s author (with whom I have done research) points out, economic conditions today — with output growing, some prices rising, but unemployment still very high — bear a strong resemblance to those in 1936-37. So are modern policy makers going to make the same mistake?

Mr. Eggertsson says no, that economists now know better. But I disagree. In fact, in important ways we have already repeated the mistake of 1937. Call it the mistake of 2010: a “pivot” away from jobs to other concerns, whose wrongheadedness has been highlighted by recent economic data.

…By the beginning of 2010, it was already obvious that these concerns had been justified. Yet somehow an overwhelming consensus emerged among policy makers and pundits that nothing more should be done to create jobs, that, on the contrary, there should be a turn toward fiscal austerity.

This consensus was fed by scare stories about an imminent loss of market confidence in U.S. debt. Every uptick in interest rates was interpreted as a sign that the “bond vigilantes” were on the attack, and this interpretation was often reported as a fact, not as a dubious hypothesis.

For example, in March 2010, The Wall Street Journal published an article titled “Debt Fears Send Rates Up,” reporting that long-term U.S. interest rates had risen and asserting — without offering any evidence — that this rise, to about 3.9 percent, reflected concerns about the budget deficit. In reality, it probably reflected several months of decent jobs numbers, which temporarily raised optimism about recovery.

But never mind. Somehow it became conventional wisdom that the deficit, not unemployment, was Public Enemy No. 1 — a conventional wisdom both reflected in and reinforced by a dramatic shift in news coverage away from unemployment and toward deficit concerns. Job creation effectively dropped off the agenda.

So, here we are, in the middle of 2011. How are things going?

Well, the bond vigilantes continue to exist only in the deficit hawks’ imagination. Long-term interest rates have fluctuated with optimism or pessimism about the economy; a recent spate of bad news has sent them down to about 3 percent, not far from historic lows.

And the news has, indeed, been bad. As the stimulus has faded out, so have hopes of strong economic recovery. Yes, there has been some job creation — but at a pace barely keeping up with population growth. The percentage of American adults with jobs, which plunged between 2007 and 2009, has barely budged since then. And the latest numbers suggest that even this modest, inadequate job growth is sputtering out.

So, as I said, we have already repeated a version of the mistake of 1937, withdrawing fiscal support much too early and perpetuating high unemployment.

Yet worse things may soon happen.

On the fiscal side, Republicans are demanding immediate spending cuts as the price of raising the debt limit and avoiding a U.S. default. If this blackmail succeeds, it will put a further drag on an already weak economy.

Meanwhile, a loud chorus is demanding that the Fed and its counterparts abroad raise interest rates to head off an alleged inflationary threat. As the New York Fed article points out, the rise in consumer price inflation over the past few months — which is already showing signs of tailing off — reflected temporary factors, and underlying inflation remains low. And smart economists like Mr. Eggerstsson understand this. But the European Central Bank is already raising rates, and the Fed is under pressure to do the same. Further attempts to help the economy expand seem out of the question.

The Fed remains the key issue for markets. It still insists it is data driven and inflation will give it no cover for further tightening until next year meaning markets have room to pursue risk.

2019 still looks more of worry to me.

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