Thursday, July 16, 2009

The Black Swan Myth

I've been seeing more and more people comment that we're in a black swan situation. The phrase black swan "refers to high-impact, hard-to-predict, and rare events beyond the realm of normal expectations". However, this phrase does not adequately describe the current recession. Below I will explain why.

First, a bit of history. One of the primary causes of the great depression was a series of bank failures from the years 1929-1933. In effect, there were three waves that greatly contracted credit and the money supply. As a result, the US economy contracted at a sharp rate leading to high unemployment.

That scenario appeared to be a strong possibility in September of last year when Lehman Brothers collapsed. In addition, on September 15, 2009 there was a "tremendous draw down" of money market funds. See this video starting about 2:00 minutes in.

These facts were the primary reason there was such a rush to move TARP through Congress. In retrospect TARP is a prime reason why -- despite the tremendous financial strain over the last 18-24 months -- there have been a relatively small amount of bank failures.

The point of the above information is this: there was no financial meltdown. As a result one of the primary reasons that led to the Great Depression did not happen thereby lowering the possibility of a second Depression.

In addition, the Congress passed the stimulus package which is just now starting to hit the economy:

Not so fast, say the plan's authors. Larry Summers, director of the National Economic Council, says the stimulus already has contributed to the economy's recent stabilization. And Summers insists unemployment might already have hit 10% if the president hadn't acted. "I think the stimulus is just about on track, progressing about as we expected," he tells USA TODAY.

As of July 3, the administration says, about $217 billion of the stimulus is being felt throughout the economy. That breaks down into: $43 billion in payroll tax relief plus $174.9 billion the government has committed to contracts.

In Boulder, Colo., Blake Jones, president of Namaste Solar, says the stimulus saved about 15 jobs at his small manufacturer. A $3 billion Treasury Department program converted an existing tax credit for solar investments to a direct payment, prompting commercial customers who no longer could benefit from a tax credit to go ahead with projects.

"The outlook was very bleak. ... Now we're anticipating not losing business, but we may continue growing," Jones said.

While critics complain that the stimulus has been slow out of the gate, Summers says the administration always planned for the stimulus to work over a two-year period. So far, the modest economic boost from the government coffers has been overwhelmed by other developments. Oil prices have risen from roughly $35 a barrel in February to just under $60 today, draining more than $165 billion from the economy on an annual basis. Partly in response, the July reading of consumers' expectations for the future took its biggest dive since October.

And let's not forget the Federal Reserve also dropped interest rates to -- well -- 0% after adjusting for inflation.

Simply put, there has been strong policy response to the crisis. While there is disagreement about various parts of the packages the point is Washington has not sat on their hands -- they have acted. And these actions have prevented a complete collapse and or meltdown of not only the US financial system but the economy. As a result, we're now in the middle of a severe recession not a black swan situation.

If the economy had continued in free fall along multiple indicators the black swan argument would have merit. But the economy has in fact started to stabilize (albeit at low levels). Consider these charts:

Auto sales have levels off, as have

retail sales and

real personal consumption expenditures.

On the employment front, today we learned that initial unemployment claims are still coming down (as is the 4-week moving average)

Simply there are multiple signs things are stabilizing albeit at low levels.

If the freefall had continued after the above mentioned policy actions, then the "black swan" arguments would be appropriate. But not in light of the information above. While things certainly are not great right now the evidence is the worst is behind us.