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Baseline

In January happy days were here again. Q4 2010 GDP had come in at over 5.5. The dawn was breaking, life was going to be good according to the consensus. What happened? Another flock of black swans! GDP was revised down to under 4 for Q4 2010. Forecasters initially ignored it, but when Q1 2011 came in low, they reestablished their practice of forecasting the past. Our practice at Demand Side is to forecast the future.

In January (Link to the January podcast)

The blue chip forecasters are in the stratosphere compared to our assessment of the probable experience of the economy in 2011 and beyond.

Over the next three weeks, we will be updating our bi-annual, once every two years, view of GDP, net real GDP, employment, inflation and investment. Subsequently we hope to begin looking back at our calls and how they worked out, compared to our rivals.

Our short form for 2010 was the economy would continue to bounce along the bottom, with significant downside risks from European debt and banking problems and from domestic weakness in commercial real estate. We saw only modest manifestation of those risks in 2010.

The short form for our 2011 outlook is that those risks will be put in play in 2011, triggered by the traditional trigger, rising oil and commodity prices. 2011 will witness significant new disruption to the American and global economies, likely within the first eight months of the year. The potential for bubbles in emerging economies to burst is growing. And since the structural dilapidation of mega-banks and investment houses has not been repaired, only papered over, and the paper has all been used up, a new and severe crisis in the financial sector is a non-trivial possibility.

The key to the call is the trigger, rising oil prices.

In our view, we have returned to 2008, when political constraints and economic ignorance resulted in over-reliance on the Fed and a very poorly designed stimulus package under George W. Bush. The stimulus design had its advocates in the Democratic camp too, and might be most correctly laid at the feet of Larry Summers, who descended from Harvard with a mantra: Timely, Targeted and Temporary. Public infrastructure spending was deemed too slow a mechanism. The tax cut package cobbled together was weighted toward business, and although everyone appreciated the $400 or $800 bonus from the government, the economy did not respond.

Meanwhile a huge commodity bubble rose out of the ashes of the housing bust, as investors scrambled for returns and a hedge against the inflation that was assumed to be inevitable from aggressive Fed action. This commodity bubble has largely been ignored to this day. Yes, everyone remembers the $147 dollar oil, but do they associate it with a financial bubble? Mostly not.

Rising oil prices, combined with higher interest rates, have been the surest early warnings of impending recessions. This same trigger was operative in 2000. Oil prices and interest rates rose together in 1999, when then Maestro, now buffoon, Alan Greenspan raised short-term rates right into the explosion of oil prices. Demand Side listened to Warwick University’s Andrew Oswald, and joined him in predicting the recession of 2000. This was the collapse of the New Economy.

And the same two factors triggered the 2007 recession.

Interest rates are low in the current environment, but credit terms are tight and dropping real estate values means collateral is not as handy as it is in normal times.

Oil and broader commodity prices are the match that will start a new conflagration in 2011. In our view, the American economy is fundamentally weak and burdened with debt, public policy has chosen the madness of austerity, and the corruption of the financial sector is structural. That is, the economy will not be able to bear the shock. This is not your father’s economy.

Oil prices are the trigger for two reasons. One, a rise in oil and gasoline acts as a tax on consumers, constraining their purchases of other goods and services and weakening their confidence. Two, resource extraction industries, particularly oil production and distribution, are by far the worst producers of jobs. A dollar spent on gasoline or heating oil employs fewer workers than a dollar spent on any other activity. Thus, returns to oil up, returns to labor down, and labor produces demand when oil does not.

That was January. Subsequently in an unprecedented revision, the Bureau of Economic Analysis went back again and marked down Q1 2011 and Q4 2010. This after the consensus had taken their bows. And we’ve been recovery deniers since the recovery did not begin as advertised by the NBER. No wonder people get tired of us.

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