Thoughts From The Frontline

Time to Bring Out the Howitzers

It is now common to use the term bazooka when referring the actions of governments and central banks as they try to avert a credit crisis. And this week we saw a coordinated effort by central banks to use their bazookas to head off another 2008-style credit disaster. The market reacted as if the crisis is now over and we can get on to the next bull run. Yet, we will see that it wasn't enough. Something more along the lines of a howitzer is needed (keeping with our WW2-era military arsenal theme). And of course I need to briefly comment on today's employment numbers. There is enough to keep us occupied for more than a few pages, so let's jump right in. (Note: this letter may print long, as there are a lot of charts.)

Employment Up But Not Enough

The headline number is that 120,000 new jobs were created in November, in line with estimates. That total is the sum of 140,000 jobs from the private sector coupled with the now usual loss of 20,000 jobs in the government sector. But when we look at the details, things are not as upbeat.

First, the good news: the US economy is continuing to grow. As I have said for quite some time, the US should not fall into a recession unless it is pushed by something from beyond our shores, which, sadly, I expect (details below). However, we are nowhere near the typical recovery pattern. By this time into a recovery we are usually making new highs on the employment front. As everyone knows, we are millions of jobs from that level.

And my friend Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business, sends us these headlines today from his own survey:




The net change in employment per firm wasn't much different from zero, but it did have a plus sign in front of it for the first time in nearly half a year. On average, owners reported increasing employment an average of 0.12 workers per firm. Seasonally adjusted, 14 percent of the owners added an average of 3 workers per firm over the past few months, and 12 percent reduced employment an average of 2.9 workers per firm. The remaining 74 percent of owners made no net change in employment (47 percent hired or tried to hire and 35 percent reported few or no qualified applicants for positions, both figures up 4 points).

The percentage of owners cutting jobs has returned to "normal" levels (even in a great job market, over 300,000 file initial claims for unemployment, i.e., they are fired or laid off). And the percentage of owners adding workers (creating jobs) continued to trend up. Reports of new job creation should pick up a bit in the coming months.

(I spent last Sunday with Bill, and we outlined our new book on creating jobs and employment. Our goal is to finish it in record time and have it out next spring.)

120,000 jobs is not quite enough to keep up with the growth in the population. Along with positive revisions to previous months, we have now averaged about 114,000 a month for the last 6 months. But then why did the headline unemployment number fall to 8.6%?
That is a very large drop for one month. The simple answer is that the number of people looking for a job fell by 315,000. And the number of people counted as not in the labor force (a different measure) swelled by 487,000 to a record 86.5 million.

Again, for new readers, you are not counted as unemployed if you have not looked for a job in the last four weeks. Let's look at a chart from the St. Louis Fed database that shows the number of citizens not in the labor force. What we see is a rise from 77 million in 2007 to 86.5 million today. Part of that can be explained by population growth, but it would be less than half of the increase of almost 10 million people not considered to be in the labor force.

If we looked at a chart of those counted as being in the labor force, we would see that it is roughly where it was back in 2007, yet there has been working-age population growth of at least (my guess) 5 million. And the next chart shows the number of people that are actually employed, private or government, full- or part-time. What we see is that the number of people working is about where it was 8 years ago.

That is not a pretty chart. What all that means is that unemployment would be closer to 11-12% if we went back to the labor force of just a few years ago and adjusted for population.

Let me quickly note, too, that if we went back to the unemployment measurement basis of a few decades ago, the numbers would be closer to what I suggest above. Counting unemployment the way it is currently done allows whoever is in charge to publish numbers that look better than they are in reality on the street. I expect Republicans to point this out in the next election cycle, although if they get into office they will have to live with that analysis when it comes back to haunt them in four years. Because as the next chart shows (from my friend Lance Roberts of Streettalk Advisors in Houston), we need job growth of about 400,000 jobs a month to get back to the long-term trend by 2020. This shows the employment-to-population ratio, which has dropped by 6% since 2000, falling precipitously since the beginning of the recession. We have never had such strong employment growth, and are unlikely to get it as we reduce government spending, which we must do.

This shows above all else why the #1 issue for the coming elections will be jobs. The US economy is looking more and more European all the time in terms of unemployment numbers. If the course is not changed, it will make any real recovery back to what we think of us "normal" for the US highly problematic.

Let's quickly look at a few other problems in this employment report. The work week was unchanged at 34.3 hours (and was down 0.2 hours in manufacturing). Aggregate hours were up just 0.1%. Average hourly earnings were off 0.1%, leaving the three-month average at -0.1%. For the year, hourly earnings were up just 1.8%. When the Great Recession began, they were rising at a 3.4% annual rate.
Aggregate payrolls were up just 0.1% for the past month. The decline in unemployment was concentrated among the shorter durations, with almost all of it among those jobless for 14 weeks or less. Those unemployed for 99 weeks or more rose 143,000 to 2.0 million, very close to an all-time high. The mean duration of unemployment rose to 40.9 weeks, a record. (Hat tip The Liscio Report.)
This does not bode well for consumer spending. Any growth of late has come from a reduced savings rate, as income is barely keeping up with inflation; and if you look at the inflation we "feel" in healthcare, food, and energy, then the average consumer is losing ground. This also means any recovery is only one external shock away from slipping back into recession.
Finally, the "quality" of the new jobs is not what we would like. More and more people are taking lower-paying jobs. We saw 105,000 jobs in retail, temporary, and food services out of the total of 120,000. Many of these are seasonal and will fall off in the next quarter. (Let me hasten to add that I am not being derogatory of food-service jobs. They are important and are hard work. I have two kids who are employed in the food-service world, and most of my kids, and your humble analyst, have been employed in various food-service jobs at one time or another. Without those jobs some of my kids might be moving back home! So, the next time you're out, leave a bigger tip than normal if it's deserved. Your wait person is someone's kid!)
The World Slips into Recession
How fragile is the recovery? The rest of the developed world is either in recession or soon will be.

This next chart is from friend Prieur du Plessis of Plexus Asset Management in South Africa. Notice that every major region is slipping into contraction except the US. (

Now, let's look at more details, provided by SISR (sadly, I lost the email of the person who provided this, so I can't credit him). It shows that outside of the US and Canada, the rest of the developed world is watching their PMI (manufacturing production) numbers go into contraction. Of the emerging world, only India and South Africa are growing. Notice that the contraction in both Germany and France is getting worse month by month.

Source: Markit Economics, SISR

How long can the US resist a global slowdown? My answer would be, for longer than you might think, absent the potential shock coming from Europe. But the above data does set the stage for the rest of the letter.
Central Bankers of the World, Unite!
Now, a few quick observations. This was truly a global effort by the central banks of the world (the US, Europe, Japan, Switzerland, Canada, and China). But then, what else did you expect them to do? Their main tool is to provide liquidity, and that is what they promised. They lowered the cost of coming to the "window" and certainly lowered the "shame" factor in doing so. Going to the central bank could be seen as a sign of weakness and, at higher rates, banks might be reluctant to do so. At the new rate it is reasonably economical, and the central banks have signaled it is more than OK.

Second, this effort also included China, which cut its bank reserve requirements by 0.5%. David Kotok pointed out to me something unusual about this. Normally, China makes it moves with a number ending in "7," like 27 or 47, as 7 is good luck. For those paying attention, this was China's way of saying "We are part of the team," rather than acting on their own, as they usually do. Now, it makes sense that if you include Canada in the "club" you should include China.

The stock markets of the world went into an ecstatic frenzy, capping off a very positive week. But I would remind my enthusiastic friends of a few things. Let's look at what really happened. We just recovered from a very over-sold condition and are still down almost 7% from this summer.

And this has happened before. Let's rewind the clock to October of 2008, deep in the credit crisis. This is a report from Jim Lehrer of PBS:

"JIM LEHRER: World stock markets staged a comeback today. They did so as key governments moved to support troubled banks. On Wall Street, the Dow Jones industrial average scored its largest point gain ever, soaring 936 points to close above 9,387. The Nasdaq was up more than 194 points to close at 1,844. Overseas, stock indexes rose 8 percent in Britain, 11 percent in France and Germany. Markets across Asia also shot higher, including a gain of 10 percent in Hong Kong.

News of European efforts to end the banking and credit crisis helped ignite the rally. On Sunday, nations that use the euro agreed on coordinated steps. Today, Britain was first to act. It was followed by Germany, France, Spain, Portugal, Austria, and the Netherlands."

The good news is that this week's action may (and I emphasize may) help stave off a true bank credit crisis on the order of 2008. That is, if the central banks of the various European countries follow through (more on that below). The real problem was best summed up this week by Mervyn King, the governor of the Bank of England, speaking at the press conference to launch his Financial Stability Report.

"Many European governments are seeing the price of their bonds fall, undermining banks' balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks' balance sheets further. This spiral is characteristic of a systemic crisis.

"Tackling the symptoms of the crisis without resolving the underlying causes, by measures such as providing liquidity to banks or sovereigns offers only short-term relief. Ultimately, governments will have to confront the underlying causes... The problems in the euro area are part of the wider imbalances in the world economy. The end result of such imbalances is a refusal by the private sector to continue financing deficits, as the ability of borrowers to repay is called into question.

"The crisis in the euro area is one of solvency and not liquidity. And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected. Only the governments directly involved can find a way out of the crisis..." (Hat tip, Simon Hunt.)
Time to Bring Out the Howitzers
If the problem were one of liquidity, then this week's action would be enough. But the problem is solvency. The majority of European banks are insolvent. They own too much debt of sovereign countries that are going to have to reduce their debts. There is a growing number of analysts who are realizing that even Italy may have to reduce its debt burden. I have highlighted the problems faced by Belgium. And how about Spain, and Portugal?
What this action does is give the ECB the dollars it will need to loan to the various national central banks, so they can loan to their insolvent banks. Will they bail them out, or nationalize them? The answer depends on the country and its voters. But absent recapitalizing their banks, there will be a credit crisis that will affect the whole world.
The amount of debt that will have to be written off and the loan portfolios reduced, as well as new capital raised, is daunting. As I have noted previously, the need is for around €3 trillion.
Writing off so much debt in the midst of a recession, coupled with austerity moves, will be massively deflationary for the eurozone. But Merkel and the German Bundesbankers have made it clear that they will not be part of any "printing press" action that is not coupled with serious commitments for balanced budgets. Even in the face of a recession.

Which makes it quite strange that the ECB has been tightening in terms of money supply the past year. Notice in the graph below that M1, M2 and M3 are all in negative territory. (Chart from the London Telegraph.)

The ECB under Trichet was apparently fighting inflation. He raised rates and let his inner Bundesbanker take control. Maybe with the rate cut and the new head of the ECB, Mario Draghi, we can see signs that the ECB may in fact act to ease. This is from my friend Dennis Gartman, writing this morning:

"Turning to the ECB, the new President, Mr. Draghi, has obviously taken on the most difficult of jobs and we've no choice but to admire him for the audacity necessary to take on a role such as his especially at a time such as this. Yesterday, Mr. Draghi made a statement that we find tectonic-plating-shifting-like in nature when he said firstly that the Downside risks to the economic outlook have increased.'

"They have indeed, and we've no problem with what he said for that is indeed the truth. Then, however, the plates shifted when he said, noting that the ECB's mandate, that price stability is to be maintainedin both directions.' In other words, the ECB's mandate forces the authorities to be concerned about deflationary risks as well as those inflationary.

"Did you hear the plates shifting? You should have for they have indeed shifted. Draghi's warning was that the authorities are just as concerned about deflation as inflation and that monetary expansion is to be considered just as has monetary contraction.

"So we are now or shall soon be faced with a monetary and political union that is manifestly different than that which the original united nations had signed up for AND we have a central bank intent upon fighting deflation as strongly as it has fought inflation. These are the attributes of a regime intent upon weakening, not strengthening, its currency in order to strengthen the economy and to save the union if at all possible."
The coordinated central bank action will make dollars available to the ECB, which will in turn loan them to the national central banks, which presumably will loan them to their in-country banks, taking lower-quality collateral than the ECB (which under the rules they are allowed to do). Given the deflationary pressures that are the natural result of a recession and deleveraging/default, they can print a lot of money without igniting too much inflation. But I agree with Dennis; I just don't see how they can do so without seeing the valuation of the euro fall rather smartly.
Merkel and Sarkozy have told us they will meet Monday and announce a plan on December 9, when the full eurozone meets. Forget bazookas, this needs the equivalent of a howitzer. They are seemingly intent upon rewriting the treaty, which is the only way that the Germans will go along with any major ECB action. But by my reckoning, a few hundred billion, or even a trillion, is not major action, at least not on the level of what will be needed.
The price for German acquiescence will be a loss of sovereignty and the ability to run deficits of any real size for any appreciable length of time for the countries of Europe. Will the peripheral countries go along? Heck, forget them; will Finland go along? This situation has been coming along since the foundation of the eurozone. The early founders acknowledged that a tighter fiscal union would eventually be necessary if the euro experiment were to survive. And eventually is now. As in this month. Time is running out if they want to forestall a credit crisis that would be worse than 2008.
The world is watching, as what happens in Europe will affect us all, in every part of the globe. It could easily tip the US into recession, and it will only be worse for the emerging markets. For Europe, the Endgame is now. We can only hope they come up with a plan that avoids disorderly defaults and a crisis far graver than 2008. They have no good choices, only difficult ones and disastrous ones. Let us hope they choose wisely.
(And for my fellow Americans, note that we will face the same consequences if we do not get our own house in order, and very soon. This is more than an academic observation.)
It is time to hit the send button so the translator in Hong Kong can get started. In theory, no more really late nights on Friday for me. But this letter has been more than long enough. Have a great week.
Your wondering how we Muddle Through analyst,
John Mauldin

December 2, 2011 8:19 pm

Eurozone’s darkest hour is just before dawn

By Tony Barber

Two fine old traditions are returning to life in the European Union: the late-night summit and the last-minute deal. Only one detail is different. These days EU leaders haggle not in glamorous settings such as Nice, Rhodes and Seville but in the Justus Lipsius building, a featureless hulk in Brussels filled with hundreds of meeting rooms and 24km of corridors.

Next Friday’s summit is predictably being billed as the best opportunity to save the euro since – well, since the last summit on October 26-27. Listen to Olli Rehn, the EU’s monetary affairs commissioner. Like many Finns, he is mild-mannered and gives the impression of being in total control of his emotions. But on Wednesday he said: “We are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union.”

The crucial words are “complete and conclude”. Taken at face value, they raise expectations that the EU will find a definitive solution to the sovereign debt and financial sector crisis. But on Friday Angela Merkel, Germany’s chancellor, said her centre-right government was still of the view that the crisiscannot be solved in one fell swoop overnight”.

What, then, is it realistic to expect from next week’s summit? Roll back the years to May 1998 and you will get an idea of how EU leaders bargain, bully and bluster their way to a deal. At stake 13 years ago was the nomination of the European Central Bank’s first president.

Germany was keen on Wim Duisenberg of the Netherlands, an orthodox central banker trusted by the Bundesbank. But Jacques Chirac, France’s then president, was having none of it. Seething with suspicion that other EU politicians and central bankers had conspired to pick Mr Duisenberg without properly consulting France, he pushed the candidacy of Jean-Claude Trichet, the French central bank chief.

After much hot-tempered negotiation, EU leaders struck the deal in the early hours of the morning. Mr Duisenberg would serve half of his eight-year term and then retire on grounds of old age, handing over to Mr Trichet. Seasoned summiteers joked that the ECB’s first president would be “Jean-Claude Trichenberg”.

The May 1998 summit offers two lessons. One is that compromise is the essence of EU dealmaking. It can hardly be otherwise in a union of 27 states that have only partly pooled their sovereignty.
Consider how the euro got its name. The French at first wanted to stick with the ecu, the EU’s monetary unit in the 1990s. But the Germans grumbled that the word reminded them of a Bavarian beer called Eku. Eventually everyone raised a glass to the euro.

The second lesson is that EU compromises often take a shape that few predict before the summits. Do not be surprised if this happens on December 9 in Brussels. After all, when EU finance ministers met one Sunday evening in May 2010 to respond to a rapidly intensifying emergency in sovereign debt markets, no one quite knew what they were going to come up with. The final deal involved a quid pro quo: the EU and the International Monetary Fund would set up a €750bn safety net for stricken eurozone governments, and the ECB would buy sovereign debt on the secondary market.

This time something similar is in the air. Germany, France and the other 15 eurozone states will solemnly promise perpetual fiscal discipline. This will involve stricter procedures for debt and deficit sinners and may one day form part of a rewritten EU treaty. Meanwhile, vulnerable countries such as Italynow back in favour after the professorial Mario Monti replaced the mercurial Silvio Berlusconi as prime minister – will pledge themselves to rigorous measures to control debts and deficits in the short term.

In return, the ECB will take prompt action to protect the banking system and governments threatened with rout in the bond markets. It is also highly likely that the IMF will chip in. Emerging powers with large current account surpluses such as Brazil, China and Russia may increase their IMF contributions, a step that would permit the fund to boost its assistance to Europe.

But the IMF’s probable involvement provides one reason not to expect a comprehensive solution to the crisis from Friday’s summit. The Brazilians, Chinese and Russians are not minded to give Europe a free lunch. They want more influence at the IMF. This will mean reforming the quota system that determines the voting powers of IMF member states. It will take time to sort out.

Whether there is enough time left to rescue the euro is uncertain. But most of the world has a strong interest in saving a project that defines Europe’s commitment to closer integration. Even the UK, rarely enthusiastic about the euro, knows it. The Conservative-Liberal Democrat coalition government this week extended its austerity programme beyond the next general election, due in 2015, and acknowledged that a eurozone collapse would expose the British economy to grave danger.

Sharon Bowles, the UK politician who chairs the European Parliament’s Economic and Monetary Affairs committee, framed the issue on Friday in the starkest terms. “We are potentially facing the demise of the euro by Christmas and, if that happens, it will wreck our economy,” she said.

Arguably, the real question is not what EU leaders may or may not decide on Friday. It is what may happen in financial markets. A big bank failure, a run on deposits, a bond market strikeany of these events could shatter the eurozone. EU summits once provided ingenious fixes to difficult problems. But this time a summit is unlikely to be enough.
The writer is the FT’s Europe editor
Copyright The Financial Times Limited 2011.