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The Big Contraction

Look Out Below!

by MIKE WHITNEY

The slowdown has begun. The economy has started to sputter and unemployment claims have tipped 400,000 for the last seven weeks. That means new investment is too weak to lower the jobless rate which is presently stuck at 9 percent. Manufacturing–which had been the one bright-spot in the recovery– has also started to retreat with some areas in the country now contracting. Housing, of course, continues its downward trek putting more pressure on bank balance sheets and plunging more homeowners into negative equity.

The likelihood of another credit expansion in this environment is next-to-none. Total private sector debt is still at a historic high at 270% of GDP which augurs years of digging out and painful deleveraging. Analysts have already started slicing their estimates for 2nd Quarter GDP which will be considerably lower than their original predictions. With the economy dead-in-the-water, the IPOs, the Mergers & Acquisitions, and the stock buybacks and all the other ways of amplifying leverage will slow putting a dent in quarterly earnings and pushing down stock prices. Here’s a clip from the Wall Street Journal:

“After a disappointing first quarter, economists largely predicted the U.S. recovery would ramp back up as short-term disruptions such as higher gas prices, bad weather and supply problems in Japan subsided.

But there’s little indication that’s happening. Manufacturing is cooling, the housing market is struggling and consumers are keeping a close eye on spending, meaning the U.S. economy might be on a slower path to full health than expected.

“It’s very hard to generate a rapid recovery when rapid recoveries are historically driven by housing and the consumer,” said Nigel Gault, an economist at IHS Global Insight. He expects an annualized, inflation-adjusted growth rate of less than 3% in coming quarters?better than the first-quarter’s 1.8% rate, but too slow to make a meaningful dent in unemployment.” (“Economists Downgrade Prospects for Growth”, Wall Street Journal)

The Fed has tried to revive the economy by buying government bonds (QE2) which helped to boost equities prices. Unfortunately, the program sent gas and food prices higher too, which has only deepened the distress for consumers forcing them to cut their discretionary spending even more. While retail sales improved significantly in the latter months of the program, a closer look at the data shows that most of the money went for food and fuel. So, basically, QE2 was a “wash”. Now businesses are left with bulging inventories and fewer customers because demand is weakening. This is from the New York Times:

“An economy that is growing this slowly will not add jobs quickly. For the next couple of months, employment growth could slow from about 230,000 recently to something like 150,000 jobs a month, only slightly faster than normal population growth. That is certainly not fast enough to make a big dent in the still huge number of unemployed people.

Are any policy makers paying attention?…

The most sensible response for Washington would be to begin thinking more seriously about taking out an insurance policy on the recovery. The Fed could stop worrying so much about inflation, which remains historically low, and look at how else it might encourage spending. As Mr. Bernanke has said before, the Fed “retains considerable power” to lift growth.

The White House and Congress, meanwhile, could begin talking about extending last year’s temporary extension of business tax credits, household tax cuts and jobless benefits beyond Dec. 31. It would be easy enough to pair such an extension with longer-term deficit reduction.” (“The Economy Is Wavering. Does Washington Notice?”, New York Times)

This is more than just a “rough patch”. The economy is stalling and needs help, but consumers and households are not in a position to take on more debt, and every recovery since the end of WW2 has seen an increase in debt-fueled consumption. So, where will the spending come from this time? That’s the mystery. The early signs of “green shoots” were produced by fiscal stimulus from increased government spending. But now that the deficit hawks are in control of congress, the budget will be pared and the economy will remain sluggish. If government spending is cut, unemployment will rise, the output gap will widen, and GDP will fizzle. Contractionary policies do not lead to growth or prosperity. Just look at England.

Most of the Inflationistas have returned to their bunkers sensing that deflationary pressures are building and the signs of Depression have reemerged. Stocks appear to be on the brink of a major correction. Here’s what economist Nouriel Roubini told Bloomberg News on Friday:

“The world economy is losing strength halfway through the year as high oil prices and fallout from Japan’s natural disaster and Europe’s debt woes take their toll…. Until two weeks ago I’d say markets were shrugging off all these concerns, saying they don’t matter because they were believing the global economic recovery was on track. But I think right now we’re on the tipping point of a market correction….

With slow global economic growth, they’re going to surprise on the downside. We’re going to see the beginning of a correction that’s going to increase volatility and that’s going to increase risk aversion.” (“Roubini Sees Stock-Correction ‘Tipping Point’”, Bloomberg)

With short-term interest rates stuck at zero and QE2 winding down by the end of June, the Fed appears to be out of bullets. At the same time, government (at all levels) is trimming spending and laying off workers.

When spending slows, the economy contracts. It’s that simple. Without emergency stimulus, commodities will fall hard and stocks will follow. Look out below.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com