John Hussman: Inside a ‘surface’ recovery

On the surface, the U.S. economy is gradually recovering

The following is an excerpt from the market commentary of John Hussman, president of the Hussman Investment Trust, for the week of Nov. 29, 2010. For more of his commentary, please visit Mr. Hussman’s archives.

“If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that’s why they are so bad, and that’s why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It’s mostly to decide to start to grow up and stop the mess.” — MIT Economist Rudiger Dornbusch, November 1998

On the surface, the U.S. economy is gradually recovering. Based on mean reversion to potential GDP (which generally occurs over a 4-year horizon absent an intervening recession), we would expect GDP growth over the coming 4-year period to average 3.8%, with average monthly employment growth of 200,000 jobs. This would be my “benchmark” expectation if the U.S. and international banking systems were “clean.” However, my concern is that the surface U.S. recovery is built over a foundation that is vulnerable to further strains. If our policy makers had made proper decisions over the past two years to clean up banks, restructure debt, and allow irresponsible lenders to take losses on bad loans, there is no doubt in my mind that we would be quickly on the course to a sustained recovery, regardless of the extent of the downturn we have experienced. Unfortunately, we have built our house on a ledge of ice.
Debt burdens have not been meaningfully reduced in the mortgage sector – they have only been extended. Home values are still well above their historical norm relative to incomes. Yet more than 20% of homeowners already have “negative equity” – mortgages that exceed the current prices of their homes. A few months ago, Deutsche Bank projected that the negative equity rate may rise to 48% in 2011. Yet even if we ignore the mortgages that have been “modified” by slapping delinquent payments onto the back of the obligation, one in seven U.S. homes is presently delinquent or in foreclosure. As much as we have done to make lenders whole, nothing apart from a major restructuring of mortgage obligations will ease the continuing vulnerability on the debtor side.
Meanwhile, the dependence of the banking system on short-term deposits is worse than it was prior to the crisis. The FDIC reports that time-deposits have declined for the 7th consecutive quarter, while the cost of funding assets has dropped below 1%, as banks rely on the shortest liabilities possible in order to earn higher interest spreads. So while the month-to-month progress of the economy has been somewhat encouraging, our policy makers have put us in the position of continually revisiting a can that they simply kicked down the road.
As we look ahead to the coming years, I believe that the best way to avoid major losses will be to remain mindful of the distinction between surface economic progress and latent (underlying) risks. As a starting point, we’ll look at the “benchmark” scenario – the potential growth in GDP and employment that we can expect in the absence of further economic shocks. Second I think it’s useful to review the observations that the late MIT economist Rudiger Dornbusch made in 1998, many of which are directly applicable to the present environment. Finally, we’ll review the current state of the economy and the financial markets.

Click here to read Mr. Hussman’s full article

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