Steve Blitz Morning Notes

All the talk about comparing the current downturn with the Depression makes for scary bedtime reading. But as liquidity slowly returns to the capital markets and profits to financial institutions there is also now lots of chatter about green shoots and so my thoughts run to the 1980-82 recession (see chart). Actually that period was officially two recessions. The first ran from January 1980 to July 1980, the second ran from July 1981 to November 1982. That these were two recessions not one is exactly why I believe the comparison with the current downturn is valid.




The ferocity of the downturn in the first recession was created by credit controls. The second one was created by more traditional means – the Fed allowed the funds rate to get to 19% and the yield curve inverted a lot and stayed that way for some time. For the point of historical accuracy, the Fed did raise the funds rate during the first downturn and reversed quickly when everyone got scared at how fast the economy imploded.

One could say that that was an era of extraordinary inflation and that is not the case today. It’s not if you are only counting the price of good and services but it is if you decide to look at asset prices during the current decade.

At that time credit was deliberately collapsed by government fiat in order fight inflation (from a Time magazine article at the time) –

The Federal Reserve will tell banks and other lenders that, if they expand their lines of credit beyond the totals outstanding last week, they will incur a penalty: they will have to deposit a sum equal to 15% of the additional amount into a special reserve drawing no interest. How to stay within this requirement is entirely up to the lenders. They can refuse to extend additional credit to consumers, cancel the unused portion of existing credit lines, or go ahead and offer more credit, pay the penalty, and pass the cost along to the borrowers. "Secured" loans—those taken out to buy houses, cars, refrigerators and other appliances—will not be affected at all.

Also, the Federal Reserve will be empowered to extend its reserve requirements to banks that are not members of the Federal Reserve System; these banks hold 30% of all deposits. The effect will be to tighten the Fed's control of lendable funds throughout the economy. Fed Chairman Volcker will also undertake, in Carter's words, "a voluntary program, effective immediately, to restrain excessive growth in loans by larger banks." That sounds like more federal jawboning to get banks to stop making loans for unproductive purposes, such as financing mergers or speculative inventory increases.

The more things change…….

This time around the credit machine collapsed from the capital market imploding on itself. Regardless of how we got there, the reaction of real GDP growth is eerily similar and so is the reaction by the Fed and the President.

Once credit controls were lifted and monetary policy eased, the economy snapped back quite nicely. So it is perhaps a good percentage bet, based on returning liquidity and the math of quarterly data, that we get an upturn in the third quarter. And then?

In 1980-82, another recession took hold because Volcker was determined to squeeze inflation out of the economy. That recession brought about lots of comparisons to the Great Depression at the time and kicked off the hollowing out of this nations industrial core. You can look it up, but I will save it for another blog. In the end, at some real high costs, inflation was gone.

Do Obama, Geithner, and Bernanke have the political will to squeeze asset inflation out the economy by driving down the overall leverage in the economy. If they do, 2010 will witness a downturn just like what occurred in the 1980-82 recession. If they don’t, TIPS are cheap.