Recession Is Here

As I have written previously on this blog, it is becoming clear that the current market dislocation is not a tail event, but rather a serious systemic crisis that is likely a precursor to a 30's style depression. The stock market -- its almost 20% drop last week notwithstanding -- will retest 2002 lows during the ongoing secular bear before embarking on its next secular bull, which I believe will be no sooner than 2014. I realize this is a somewhat extraordinary claim, but I have very good motivation for suggesting it. In this article I want to look at one important statistic supporting that thesis, which I think the investing community does not fully appreciate. As always, please don't trade securities on my advice. I have made it no secret since I started writing this blog that I have been trading in and out of my short stock and long gold positions, but what I offer is an Austrian analysis of the financial markets, and not an investment advisory.

Manufacturing And Jobs

Disclaimer out of the way, let's dive in. The most telling statistic of the last couple of weeks has been the ISM manufacturing index, which came in at 43.5 for September. The ISM PMI is a diffusion index with a reading below 50 indicating contraction. Investopedia explains that

[the] PMI is a very important sentiment reading, not only for manufacturing, but also the economy as a whole. Although U.S. manufacturing is not the huge component of total gross domestic product (GDP) that it once was, this industry is still where recessions tend to begin and end. For this reason, the PMI is very closely watched, setting the tone for the upcoming month and other indicator releases.

There are two important points that investopedia makes. First, the one I more or less agree with, is that recessions begin with manufacturing. This is because when central banks expand the money supply and maintain interest rates below what Wicksell termed the neutral rate, they create false signals of time preference, thus encouraging more roundabout to more direct methods of production. This elongation of the production structure creates a diversion of real wealth towards malinvestments that are first realized as such higher in the production structure and are thus liquidated first when a tight money stance finally takes effect. In a free market economy, the interest rate equates consumer time preference with capital efficiency and is thus nothing more than the marginal efficiency of capital. When the central bank artificially lowers the interest rate, it fools entrepreneurs into expanding the production structure out of sync with consumer time preferences. Because this expansion occurs in the higher stages of production, the contraction must begin at the same place.

An easy way to visualize this process is to think in terms of Hayekian triangles. The central banks manipulation of the interest rate alters the characteristic of the triangle to both elongate the time dimension, as well as reduce savings and increase consumption, something that is completely impossible without an unnatural expansion of money or credit. By this means, the central bank creates distortions in the pricing mechanisms of the market, the most important one being the price of time. Sadly Keynes' grossly underhanded mischaracterization of Say's law -- perhaps his greatest contribution to the retardation of economic thought -- has influenced generations of economists to believe that consumption and not savings are at the root of economic growth. As I have argued elsewhere, this is false for the reason that growth occurs through capital accumulation and hard work. If there really was an easy way to grow the economy and create wealth, governments in all their meddling through the years should have accidentally stumbled upon it by now. Quite unsurprisingly, they have not. Unfortunately, it is this flawed logic in the Keynesian framework that brings us the fallacies of GDP, helicopter drops, wars and natural disasters being expansionary, and deficit spending.

Returning to investopedia, the point I disagree with is that manufacturing is less relevant than consumption because it is not a large part of GDP. That manufacturing is not a large component of GDP is true; that it is less relevant is false. The fact is that GDP measures economic output and not economic growth. Economic growth, as the classical economists and Austrians have written, occurs through the natural extension of the production structure through capital accumulation. This can happen only if consumers willingly forgo consumption today so as to build up their capital stock and create the potential for increased future production. A simple example would be Robinson Crusoe taking a day off from fishing and building a fishing net, thus going hungry for the day, but creating the ability for him to catch more fish with the same amount of labor in the future. Without giving up something today so as to build infrastructure, research and develop new processes and methods, or invent new technology, one cannot expect to increase real wealth in the future. I.e., one cannot expect to grow the economy.

It is at this point that I should interject my line of thought briefly to remind the reader that real wealth is tangible physical goods. Money is not wealth; it is a claim on wealth. Nobody trades dollars to satisfy an ultimate want. We trade dollars in the expectation of trading them again in the future for something we desire. Thus, when the money supply is expanded and entrepreneurs can get their hands on money more readily, they believe it is because there is an increase in real savings to support the availability of credit. But this is not true. However, it is not realized immediately because capital investment takes time. Entrepreneurs expand the production structure, which is narrowest at the point of consumption and expands as you move towards the higher stages of production. It is this phenomenon that ensures that recession always begin and end with manufacturing.

To sum up, manufacturing is by far the largest sector of the economy, and the most important in determining growth. If manufacturing is ailing then the economy is in a recession, regardless of how consumption is faring. Manufacturing has been in trouble for some time now, consistent with my thesis that the US has been in recession for most of the year. This may never get reflected in the official government statistics, which is not really a big concern since I don't trust those numbers anyway. The government can say the economy is growing all they want, but that does not make it reality.

In addition to the ISM index, we find that non farm payrolls declined 159,000 in September. The unemployment rate held steady at 6.1%. I think even these numbers may be painting a rosier picture than is actually reality as the surveys have flaws in their design that one must consider before drawing any conclusions. It is not my wish to exhume the dead horse only to beat it to death again, so I provide the link if the reader is interested.

I hope the reader has found my analysis useful. I realize I have raced through this somewhat quickly, but you will find many links on my blog explaining these concepts more carefully.

Scope And Severity

This discussion on the causes of the crisis notwithstanding, the important question to consider is the scope and severity of the recession. I believe that the central bank is out of bubbles to blow. Since 1971 the money supply has increased at a staggering rate, causing tremendous structural damage to the economy as a whole. The 2000-02 recession should have been the cathartic cleansing of the previous malinvestments, but in response to the markets hang over from the aforementioned money supply binge, the central bank blew an even bigger bubble in housing that has fatally damaged the production structure and shifted a lot of manufacturing overseas, creating a services based economy supported by debt and the illusion of wealth. Until Americans cut back on their expenditure, lifestyles, and most certainly debt accumulation, there cannot be a re-alignment of the production structure or the availability of savings necessary to effect that.

Since last summer when we saw the beginnings of the credit crisis, the talking heads have told us that this "subprime" event will be contained, that it will not spread, and that our benevelont masters in Washington are always vigilant to save us from unbridled free markets (as if such a thing has even existed in the last 100 years). I did not believe them then and I do not now. I predicted commercial real estate, auto loans, credit card debt, and unsecured loans of all forms, would be next. I predicted that the various liquidity measures, such as the TAF, TSLF, and PDCF would fail because the problem was solvency, not liquidity. I predicted that they would be forced to nationalize Fannie and Freddie. I predicted the stock market was heading lower and precious metals would rise. All of these predictions were predicated on one thing only, which is that, try as they may, the Fed and Congress cannot change economic laws. They are bound by them just as they are bound by the law of gravity.

Unfortunately, this means that we are still only at the beginning of what promises to be a deep and painful recession. If the Fed and congress continue to meddle, they will only prolong and worsen it. Consider that between 2002 and 2007 alone, the central bank expanded the money supply by more than in the entire history of the United States. This is madness! And now Bernanke, as a result of a conveniently under reported aspect of the TARP, has the ability to pay interest on deposits at the Fed. I cannot stress how important this is. The whole debate around $700bn in a bailout is a complete red herring. It was nothing more than jawboning to soothe an inflamed market. The real action, as always, happens when no one is looking. He correctly sees the immense deflationary potential in the fiat money system and intends to inflate his way out of it, but this will backfire or have undesirable consequences, just like every other attempt he has made. Should he succeed, the end result will be what is colorfully known as stagflation. Should he fail, it could be a complete loss of faith in fiat money system and all the attending ills that would bring. I truly hope he succeeds.

The Bailout Reader

This is going to be a short post. With the markets blowing up everywhere I am working pretty long hours so I don't have much more time than to point out... the bailout reader, care of mises.org. The Austrians really did see this coming. Not just that, they predicted it would be the inevitable outcome of the Fed's actions, and clearly elucidated why. Something I have been talking about on my blog as well. If you have any interest in understanding the state of affairs today, I highly recommend starting with the articles linked above. In addition, if your interest is economics per se, the Mises Institute has plenty of resources on its website. If your interest is more towards the markets, as is mine, try this reading list.

It's really funny how the Austrian theory of the business cycle still gets almost no air time even though it is the most logical explanation of the events that have transpired, and really always has been. Did you know that Mises was one of the few people who predicted the great depression in response to the credit bubble of the 20's? The Austrians again predicted the housing and credit crisis we see today and the Pollyanna's conveniently ignore them. Well, as an Austrian, I respect their right to their (erroneous) opinions. However, dear reader, if you have any interest in successfully navigating what I expect to be a worsening financial landscape, I would highly recommend you familiarize yourself with Austrian theory and what it predicts going forward.

My Vindication?

Since I started writing this blog I have made some fairly radical claims. Now that some time has passed, I thought it would be nice to reexamine them and see if I have been correct on any.

1. Stock market is headed lower; gold and precious metals are headed up; muni's, commercial real estate, credit card debt, auto loans, etc will be the next to blow up (here). I absolutely still stand by this.
   
2. Fannie Mae and Freddie Mac will be nationalized (here).
   
3. The TAF, TSLF, PDCF will fail because the issue is solvency, not liquidity (here).
   
4. Lehman is insolvent (here). I actually didn't mention on this blog, but I thought Morgan and Merril were in equally bad, if not worse, shape.
5. The US is in a recession that started Jan 2008 (here). I still stand by this.
   
6. The stimulus package is a red herring and will exacerbate the recession (here).
7. Housing has plenty more to go (need to find the article, will add link soon).
   
8. The US is in a secular bull market that will last until 2016 (here).
9. Investment demand for gold will take result in significant price appreciation (here).
10. The dollar will collapse.
    

That last one I have actually not written about here because I was yet unsure whether to expect a deflationary debt bubble collapse, or an inflationary endgame. There is too much structural damage to the economy to avoid one or the other; the only questions is which will play out. The Feds recent action leads me to believe they prefer the latter. Seems to me like they are seriously considering destroying the dollar in order to pave way for the amero. However, I do not want to comment further on that as I would like to avoid politics if possible. Going forward I expect Bernanke to devise novel and ingenious manners in which to inflate the money supply as the last thing he seems to want is a repeat of Japan. If that is the case, this may be a good time to pick up some gold.

India Is Not Immune

I am currently on vacation in India (explaining the lack of activity on this blog) and I thought it might be interesting to talk about the Indian markets for a change. In the last few years the Indian market had a pretty phenomenal run, barring a few corrective spells, and was sitting pretty at 21,000 at the beginning of 2008. Since then it has shed over 40% and, as of this writing, is hovering around the 14,000 range with PE's in the 10-15 range. I suspect that the recent gain is a dead cat bounce and India has quite a bit more of downside potential as the global credit crisis continues to unfold. It may be a few months yet, but as foreign institutions continue to feel the pinch at home and attempt to shore up capital, India and other emerging markets will suffer from institutional withdrawals. Further, despite what appears to be stellar growth, I am not convinced the economy is on sound footing. This is largely due to the political system as well as the Keynesian ideology that seems to be firmly in charge at the central bank (The Reserve Bank of India).

The Blame Game

From my understanding of the Indian markets, the recent drop has been largely due to foreign institutional selling. Due to the credit crisis many foreign institutions have been withdrawing large amounts of capital to shore up their balance sheets at home. Insurance companies and retail investors in India seem to be unwilling (or unable) to pick up the slack. In short, if the credit crisis worsens towards the end of the year, as I suspect it will, then further institutional selling could mean further downside for the Indian markets, as well as other emerging markets.

Although foreign institutional investors (FII's) may have been the catalyst for the drop, I do not believe that they have caused a market dislocation. The Indian markets had become extremely overextended in recent years largely as a result of the Reserve Bank of India's (RBI) monetary policy. Valuations were extremely high at the peak and continue to be moderately expensive given current earnings estimates. Should estimates prove unrealistic, as I very well suspect they might, valuations are still looking quite on the high side.

Returning to the RBI and its monetary policy, the money supply in India has been growing at a staggering rate of 30% over the last few years. It has slowed to around 20% in the last year. Of course, official "inflation" figures are around 11% growth in the price index y-o-y. I remind the reader that inflation is NOT rising prices, but rather money supply growth. Therefore, true inflation in India is upward of 20%. That most people don't realize this is the only reason India cannot be considered to be in a hyperinflation, although the money supply growth certainly suggests so. Also, keep in mind that monetary policy always works with a lag, so India could actually see a drop in the official inflation rate as money supply growth has been slowing in the last couple of years.

ABCT Applied

Beyond this theoretical discussion of what inflation is and isn't, I have yet to argue why I believe the economy is not on sound footing. Inflation by itself can be harmless. Think back a few hundred years to when gold was money. Gold was continuously being dug out of the earth and added to the money supply (inflation by definition) but the effect was largely benign as the extraction and processing of gold required significant effort and created an economic good. Contrasting that with today where the central bank can type in a few 1's and 0's and create money, or banks can lend out deposits that do not belong to them (fractional reserve banking) and we have an entirely different kind of inflation altogether. This latter kind is undesirable because it creates distortions to the market process that result in malinvestments and bubbles. An example will illustrate:

Just like the US, the property market in India has been hit pretty hard. I am not sure of exact percentage rises and drops, but the residential market especially has taken a beating. When the RBI began pumping the money supply it facilitated the redirection of wealth. Investors and entrepreneurs used these redirected resources based on faulty price signals -- again created by the RBI -- to ramp up their investments. For a while it appears as though the economy is growing rapidly and the stock market begins to rise. Investors thus far on the sidelines are tempted to make an entrance, as are speculators who ussually avail themselves of further credit creation by the RBI and retail banks. Prices are bid up further.

Now, many of the residential developers in India, who had thus far been privately held companies with sound investment strategies based on sound forecasting of demand, suddenly realize that there is a sucker born every minute and decide to IPO at the clearly inflated valuations. Of course, a conservative company with low leverage and realistic organic growth prospects will not command excess valuations so the developers begin to take on any and every project, regardless of economy viability, only so they could book the assets and show increased future earnings potential, thus justifying the excess valuations. As a result, there is a rapid increase in residential developments, most exemplified by the high-tech cities such as Bangalore and Hyderabad. Whether these new development will be well recieved by the market is not a priority; the only priority is to show future earnings potential in order to command high valuations. The net result is a residential bubble, resulting in oversupply that eventually must burst, and it has.

Conclusion

This little story -- true, mind you -- is typical of the results of "bad" inflation. The RBI, through its irresponsible monetary policy, set in motion a housing bubble that appeared sound initially, but was eventually realized to be illusory and based on faulty signals. I believe the same is true for India as a whole. The highly highly irresponsible monetary policy has created bubbles everywhere in the Indian economy. Apparently, India is not immune to Keynesian ideology, and it is to her own detriment. Even worse, however, is the political system. Bad monetary policy in of itself can only cause so much trouble. The real trouble is caused by the government. The comparison is often made between India and China -- both having gained independence around the same time -- that China is quite comfortably ahead in terms of economic growth and infrastructure development. This puzzles the Indian intellectual classes to no end, but is really no puzzle, just simple economics. I am hoping to elaborate in my next post.

Theodore Forstmann Interview

There was a great interview with Theodore Forstmann in the WSJ a couple of days ago. He highlights some points I have made on this blog recently about the true causes of the credit crisis and what to expect going forward. The article begins:

Mr. Forstmann's argument about the present crisis starts with the money supply. After Sept. 11, 2001, the Federal Reserve pumped so much money into the financial system that it distorted the incentives and the decision making of everyone in finance.

100% agreed! See my earlier article on this. In fact, this observation is the crux of the Austrian theory of the business cycles. Interest rates are essentially the price of time. Like any other price, they contain information and work in concert with other market prices. An artificial lowering of the interest rate not only skews incentives it greatly hampers the decision making process by providing a false signal. It creates the illusion of false social time preference. The articles doesn't put it in these terms, but I think Forstmann would agree.

Distorting the market price mechanism always has unpredictable consequences that the economist must carefully consider. This was Herny Hazlitts excellent lesson. Take for example the ethanol boondoggle that is causing problems in functionally and geographically distinct areas of the economy due to faulty price information that renders rational economic calculation impossible. This is just the damage caused by ethanol subsidies. The price of ethanol is only one small element of the economic organism. Compare that to interest rates which are the single most important price in the economy. I ask you, dear reader, shouldn't we be scrutinizing the actions of the Fed more closely? Whether the intent was malicous or not, doesn't it make sense to understand the huge market distortions of the past decade so we can avoid making the same mistake in the future? Shostak has an excellent analysis here.

The article continues:

"They could not find enough appropriate uses for the money," Mr. Forstmann says. "That's why my little bank story for the kids is a fun way to put it. The money just kept coming and coming and coming and coming. What are you going to do with it? IBM only needs so much. The guy who can really pay his mortgage only needs so much." So you start thinking about new ways to lend the money, which inevitably means riskier ways.

Again, 100% agreed! I have said this earlier as well. The root cause of the credit crisis in not the financial innovations and the originate-to-distribute model, but rather the Fed which encouraged all these activities with its lose money policy. Certainly I don't mean to excuse reckless behavior, but let as also acknowledge the complicity and role of the Fed in the matter. This seems to be something most mainstream economists and commentators are unwilling to do.

Continuing, the piece of the puzzle everyone sees and blames is of course this:

Combine this with loan syndication and securitization, and the result is a nasty brew. Securitization and syndication allow the banks to take the loans off their books and replenish their capital. They then use this capital to make new loans, which they securitize or syndicate and sell to the hedge funds, which buy them with the money they borrowed from the banks. For a time, everyone makes money.

This is a great description of the skewed incentives in the originate-to-distribute model. Another commentator who has done a great job putting the pieces together is Steve Moyer. I particularly liked this article.

What To Expect

The problem, according to Mr. Forstmann, is that it's far from over. "I think we're in about the second inning of this." One reason is that the proliferation of new financial instruments has left the system more closely intertwined than ever.

I have discussed this earlier as well. There are also the lending channel effects, described here, and evidenced here, that one must consider. Not to mention the recession and the effect that will have.

At this point I am probably sounding like a broken record to anyone who has read my previous articles so I will stop. Suffice to say that I think we are yet to see the meat of the credit crisis, which is likely to happen towards the end of the year. It will mean pain for many banks, but will be a great opportunity for well positioned investors.

Links

Did the Fed cause the housing bubble? by Robert Murphy
Frank Shostak on Hymen Minsky's view on bubbles.

Trade Recommendations

In a previous post on trade recommendations, I laid out my views on the markets long term. At the time, I did not recommend any particular trades because I was uncertain about the near term. Although I did catch the counter trend rally from the March lows to the May highs, and the subsequent decline since then, I certainly cannot take credit for calling either the bottom or the top. Most of the trades I made were based on the recommendation of others. The reason for my post today is because I have realized that what I can offer the reader is not market timing, but rather fundamental analysis of the macroeconomy. Although I do trade for my own account, I am reluctant to make trade recommendations on this blog. Sorry, but I believe me, you are better off getting your trading ideas from the sources I linked to above.

Market Fundamentals

So what do the fundamentals look like? Well, it is clear that the US is in a recession. I have been saying for a while that I believe January 2008 was the start. See here for my rationale. The more interesting question for me is whether the recession will be inflationary or deflationary. But first, let us clear up some confusions about what inflation is.

Inflation is nothing more or less than money supply growth. The classical economists knew this. However, in recent decades, inflation has come to mean a general rise in prices. I am not being overly pedantic when I take issue with this redefinition. That you start calling a chair a table, does not change the essence of the chair. People will continue to sit on it and use it for "chair" like activities. A rose by any other name does smell as sweet. The question we are faced with, then, is identifying the essence of "inflation". I have argued elsewhere that inflation is money supply growth and that "generally rising prices" is caused by inflation and other factors. Once we understand that inflation is not rising and falling prices, we can begin to understand what lies ahead for the US and world economies.

One important consequence of an accurate understanding of inflation is that we can separate inflation from economic growth. Rising money supply is inflation and a falling money supply is deflation. An expanding economy is growth, while a contracting economy is a recession. Thus, there is nothing inherently inflationary or deflationary about economic growth or recessions, and concepts such as stagflation are perfectly understandable. In fact, stagflation is a likely consequence of monetary policy that artificially lowers the interest rate below the so called neutral rate through the printing of money. Similarly, a deflationary recession is a likely consequence of monetary policy that artificially lowers the interest rate through the expansion of fiduciary media instead of printing cash. A very unlikely consequence of either is inflationary growth. The big question today, is which of the two recessionary scenarios will evolve. The arguments on both sides are certainly compelling. I need to do a little more research before I take a position myself.

It would appear odd that a recession can be inflationary or deflationary, but growth is always inflationary. The reason for this is because of the nature of the monetary system today. Under a fiat regime with 100% reserve ratios, all monetary pumping is inflationary because it occurs through actually printing more dollars. However, because of fractional reserve banking built on top of, not fiat, but debt based money, recessions today can be deflationary because money supply growth occurs more through expanding fiduciary media than the monetary base. That is, money in the broader sense grows while money in the narrow sense can remain unchanged or grow only slightly. That this has happened in the last few years is the prime reason for the immense deflationary potential in the economy today. Just to throw out a few numbers, fiduciary media stands at approximately $2.5 trillion, while bank reserves are a paltry $40 billion. In addition, sweeps ($765 billion) and retail money funds ($1078 billion) have no concept of reserves. Cash in circulation is around $800 billion.

Of course, the only healthy monetary system is a commodity standard (preferably gold or silver, but many other commodities have been used in history). Under a commodity standard with 100% reserve ratios growth is neither inflationary or deflationary, which is highly desirable since it is in accord with the social time preference and avoids the boom-bust cycle. I fully recognize how bizarre this claim sounds to anyone from the Keynesian tradition. I sincerely hope you give the article linked above an objective read.

[EDIT: Re-reading this section, I realize I haven't done a very good job explaining these concepts. I wrote it in some haste. I am hoping to do a much longer post shortly on which recessionary scenario I expect will unfold and why. I will describe the mechanisms at play carefully then.]

Conclusion

A US recession is fait accompli. Whether inflationary or deflationary is yet to be decided. Depending on the latter versus the former, the actions one should take to protect their wealth and/or profit will differ. An inflationary recession will be hugely bullish for precious metals and commodities. Bonds will suffer and equities will suffer in terms of valuations. A deflationary recession will sink all ships, except bonds. In both cases, I feel like relative value plays on asset classes (metals/stocks, metals/bonds) should preserve their relationships.

PS

I took profits today on my index shorts and precious metals holdings. It looks like the market is setting up for another counter trend rally. At the very least, I think we will be presented with better shorting opportunities going forward. Interestingly, gold seems to be shaping up for a giant short squeeze.

May Unemployment And Beyond

When the May unemployment numbers came out a few weeks ago, I didn't have a chance to look at them very closely. Admittedly I still have not, but I wanted to put down a few thoughts consistent with the theme of this blog. I have been saying for a while now that I believe the US is in a recession. Ignoring the arguments about the unreliability of the data, I believe that even the official government data is clearly showing it.

1. Just as a start, consider the unemployment rate that jumped to 5.5% from 5.0%, the largest monthly rise since 1986. Although the change is alarming, in an absolute sense, the rate of 5.5% is still within the 4-6% safe range of Phillips curve adherents. Of course, this is only the headline number that ignores "discouraged workers", etc. Whether adding those back in results in a more accurate rate I refrain from commenting on, but only point out that that broader definition of unemployment is quite a bit higher.
   
   
2. Far more interesting in the report is that the economy is bleeding goods producing jobs, including construction and manufacturing. This should raise a red flag for anyone approaching the issue from the Austrian perspective. We know from the Austrian theory of the business cycle that job losses in the higher stages of production are indicative that malinvestments are being liquidated. This is because the credit driven boom that shifted resources towards more roundabout methods of production is finally being realized as illusory and based upon a false signal -- artificially low interest rates. The true time preference asserts itself by attempting to bring the production structure into sync. This entails a competition between various stages of production, with the lower stages (generally services) benefiting at the expense of the higher stages (generally manufacturing).
   
   The official report shows this clearly. Construction and manufacturing lost 34,000 and 26,000 jobs respectively, while services gained 8,000. Even within services, those further removed from the consumer, professional and business services, lost 39,000, while those closer to the consumer gained. Government gained 17,000. Please keep in mind that manufacturing and construction are generally higher paying jobs while services are generally lower paying jobs.
   
   Most interesting is that the loss in manufacturing happened depsite the weakness in the dollar that one would imagine should work to correct the manufacturing imbalances from previously. There is evidence that this process is underway with increased investment in the US on account of the dollar weakness. However, that investment is latent growth that will not contribute to the economy for a little while hence. In the meanwhile, the retrenchment will continue. The good news is that if investment genuinily picks up, the economy will recover from the recession sooner than I expected.
   

Birth/Death Model

In addition to the jobs numbers listed above, one should note that the birth/death model again played an interesting role. To remind the reader, the birth/death model is an ARIMA model of small business births and deaths. It is intended to correct for drawbacks in the payroll survey related to logistical issues with small businesses. As any time series analysis, it is backward looking and will project out trends into the future, missing important turning points. Even the BLS states this clearly:

The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process.

For the month of May, the birth/death model added 217,000 jobs, including 42,000 in construction and 9,000 in manufacturing. This seems at odds with other data that is showing construction and manufacturing declining. As I have said before, I believe this is because the model is projecting out previous trends and missing the turning point. Recall that in April, the model added 267,000 jobs. Recent revisions have removed 8,000 jobs from April and 9,000 from May. These revisions may not be enough; I expect more to come.

Further, one cannot simply subtract the 217,000 jobs of the birth/death model from the headline number of -49,000 because the latter is seasonally adjusted while the former is not. From the BLS:

Note that the net birth/death figures are not seasonally adjusted, and are applied to the not seasonally adjusted monthly employment estimates to derive the final CES employment estimates.

The only way to get accurate numbers is to wait for the final revisions, or start the analysis from raw data.

Looking Forward

Historically, the birth/death model has major revisions in the months of January and July. January is a much bigger month because most of the previous years excesses are wiped clean. However, July does have its fair share as well. The numbers for the coming July will be very important in understanding where in the economic cycle the model thinks we are. Of course, the impact on the headline number of a negative estimate is not clear due to seasonal adjustments.

In terms of unemployment, with many layoffs expected in the future, including Citigroup, Continental Airlines, and GM, we can expect unemployment to rise, perfectly consistent with the recession we are in. Most of the new jobs losses may not immediately show up in the headline numbers because of the methodological definitions, but that does not mean they are not impacting the economy.

Tho other good indicator of unemployment is temporary employment. I must thank John Mauldin for this observation. He notes that if the workload is shrinking then one first lays off temporary workers or simply does not hire them. Temporary employment is down 5.7% y-o-y. It is also showing continued weakness month on month. Consistent with my predictions of the start of the recession, John Mauldin has also weighed in on the matter with essentially the same time frame: January 2008. It would appear that the unemployment data is confirming our predictions.