Worst economic policy decision of the year

When it comes to misguided economic policies, Argentina wins the prize more often than not.

Today the government of Argentina announced a two-month price freeze on all products sold at the nation's largest supermarkets, representing about 70% of the Argentine market. It is apparently a voluntary freeze, worked out in a joint accord between the supermarket chains and the government. On its face, this is a blatant attempt to cool the inflationary fires that are slowly consuming the Argentine economy, and it comes on the heels of the IMF chastising Argentina for manipulating its inflation statistics. Now, not only does Argentina manipulate its inflation statistics, it also manipulates its prices.

It won't work, of course, and is only likely to make things worse. It won't take consumers long to figure out that they have two months to stock up on things before prices resume their rise. And that will almost surely lead to shortages and more consumer anxiety and more efforts to stockpile goods with a long shelf life. Thus will begin in earnest the decline in the demand to hold pesos, and their more rapid circulation, which in turn will result in more inflation. Will the politicians never learn?

It's deja vu all over again.

The chart above shows the allegedly manipulated CPI statistics. Note how year over year inflation has been suspiciously flat around 10% per year since early 2007, when the government puts its own man in charge of the statistics office. For the past 36 months, year over year inflation has been almost exactly 10% every single month—something that is nearly impossible in the real world.

The chart above almost surely does not show manipulated data for currency in circulation. For the past 36 months currency in circulation has grown almost 40% per year. It is virtually impossible for currency to grow 40% a year at the same time inflation is only 10% per year. The M2 measure of Argentina's money supply is also growing at breakneck speed, averaging about 32% a year for the past three years. The growth of currency and M2 points strongly to inflation being 25-30% per year, as most independent economists suggest it is.

Inflation in Argentina is not the result of rising supermarket prices, it is the result of a rapid expansion of the Argentine money supply. Argentina is literally "printing money" to pay its bills, even as the central bank's monetary reserves have fallen by almost 20% in the past two years. This will end in tears, in shortages, in more government repression, in more capital flight, and eventually in another big devaluation.

The official exchange rate for the peso is currently 5 per dollar, but the "blue" rate (i.e., the black market rate) has dropped to 8 per dollar, suggesting a potential devaluation of almost 40% is lurking in the wings.

Advice to tourists headed to Argentina: take plenty of $100 dollar bills with you. You'll need to figure out how to exchange your dollars for pesos at the blue rate (something the government is trying hard to discourage), but you have a huge incentive to do so, since otherwise if you use an ATM or your credit card while in the country you will be buying pesos at the official rate.

Jobs and manufacturing point to continued growth

In my estimation, the market continues to underestimate the health of the U.S. economy. To be sure, this recovery still ranks as the worst in modern times. The unemployment rate remains very high. The labor force participation rate remains very low. The number of people working today is still 3 million less than at the peak in early 2008. It's no secret that the economy should be doing a whole lot better. However, the most important thing is what is happening on the margin. The bad news is that the rate of improvement has been disappointing; the good news is that the economy continues to add jobs at a decent pace, and there is no sign of any deterioration. The market is braced for a recession, but there is no sign of a recession; the economy continues to grow, albeit at a disappointingly slow pace.

For the past two years, the private sector has been adding jobs at a 2% pace: about 190K per month on average. That's the same pace as during the 2004-2006 period. According to this chart we are growing just as fast today as we were when the economy was reasonably healthy about 8 years ago. The difference, of course, is that given the depth of the recession we should have been growing much faster.

Both employment surveys show that the private sector of the economy has added a little over 6 million jobs in the past three years. At this pace, jobs will reach a new high within a few years. That will still leave many millions of people unemployed, so it's nothing to cheer. But things are nevertheless improving, not deteriorating. That's critically important, since the markets and the Fed are worrying that the economy is clinging to growth by the skin of its teeth. It's not. It's doing much better than that. Economies are not like airplanes: they don't have a "stall speed." Economies don't collapse if they grow too slowly, they just keep growing slowly.

The January ISM manufacturing report was a good deal stronger than expected (53.1 vs. 50.7). As the above chart suggests, it is reasonable to think that the economy is growing at a 2-3% pace given the health of the manufacturing sector. Things could be a lot better, but they are not getting worse.

As the above chart shows, manufacturing conditions in both the U.S. and the Eurozone are improving on the margin. To be sure, although the survey suggests that Eurozone manufacturing is still shrinking, the pace of deterioration has slowed. On the margin, the outlook is improving both here and in Europe.

Even in Japan the outlook is improving. The Nikkei 225 is up almost 30% since mid-November, thanks to declining deflation risk courtesy of a weaker yen. As the second chart above shows, the January manufacturing surveys in Japan, like in the Eurozone, show a reduction in the rate of deterioration.

It's never smart to let the perfect be the enemy of the good. The economy should be doing better, but it is improving, and that is a far cry from being at risk of recession. Things are likely to continue to improve, albeit slowly.

Markets (and the Fed and most other central banks) are too worried about how things should be better, when they should be encouraged that the outlook is slowly improving.

Avoiding recession is all that matters

When yields on risk-free assets are close to zero, it only makes sense to hold those assets if you need liquidity and/or are highly concerned about the potential for losses in other assets, most of which are yielding substantially more. From a macro perspective, the fact that significant assets are being held with virtually a zero yield can be interpreted as a sign that the market is very worried about a recession, since that is the one event most likely to create widespread losses in risky assets. 

This has been the case for most of the past 4 years (during which time the yield on 3-mo. T-bills has averaged about 0.1%), yet the economy has avoided a recession and the returns on almost all alternative assets have been astounding. The returns on cash have actually been negative in real terms, since inflation has averaged 2.2% a year over the past four years. Cash, the risk-free asset, has produced an annual loss of purchasing power of over 2% for four years running. The S&P 500 index, on the other hand, has produced annualized total returns of 16.8% for four years running.

With almost $7 trillion sitting in bank savings deposits earning practically nothing, and with tens of trillions invested in risk-free assets around the world, there are therefore many millions of people and investors who need a recession to justify their current asset allocation.

Are there any signs of a budding recession? None that I can see in the recent data.

Weekly unemployment claims are volatile around this time of the year since the seasonal adjustment factors can be large. The 4-week average of claims, which eliminates a good deal of this volatility, is now at a post-recession low. No sign here of any recession or even an economic slowdown, to judge by this relatively fresh and sensitive indicator of conditions in the jobs market.

No sign here either of a recession, to judge by the Challenger tally of announced corporate layoffs. There is no sign of any unusual downsizing.

Meanwhile, it's almost certain that a housing market recovery is well underway. As the above chart shows, the stocks of major home builders are up over 100% in the past 16 months, and they are up 270% since their recession low. Housing starts are up 77% since the beginning of 2011. 

The zero growth reported for the fourth quarter of last year was the result of a downsizing of defense spending and a slowdown in inventory accumulation. Reduced government spending is not necessarily a bad thing, since it frees up resources for the private sector. Inventory investment is quite likely to bounce back, having been depressed in recent months by the uncertainty of the "fiscal cliff" which has since been resolved.

All of this is being repeated on a global scale. The value of global equities has more than doubled since their early-2009 low. $25 trillion has been earned by the holders of those equities, compared to a loss on the purchasing power of the tens of trillions that was held in cash over the same period.

Investors are notorious for following the money rather than anticipating where the money will be made, and $25 trillion in gains ought to be enough to get a lot of people's attention. We may finally be at the point where the private sector stops trying to deleverage and begins to releverage; when investors stop taking money out of equity funds in order to add to bond funds; and when investors try to reduce their cash balances in favor of riskier assets. The Fed and all other major central banks have been trying very hard to make this happen, and it would be foolish to think they won't be successful. By keeping interest rates on risk-free assets extremely low, the Fed is trying to destroy the demand for those assets, and trying to encourage money to find its way into other more riskier asset classes. The money can't actually  leave cash, but the attempt by the private sector to reduce its cash exposure (and/or increase its borrowings) in favor of equities or real estate could unleash a powerful change in relative asset prices. Ultimately, the yield on cash will rise significantly, while the yield on other assets will decline as their prices rise.

All it takes for this to happen is to simply avoid a recession.