Are the bears right? Is the pain till now just a prelude to the real crisis?
For three years now, since the great explosion of the great hi-tech bubble that sent the American and all other economies into a tizzy, a certain fundamental argument has been raging. It is between proponents of the bubble's-behind-us theory and the ones who claim the worst problems lie ahead.
Much more people opt for the sunnier scenario. Supporters of the "this has just been the warm-up act" tread softly, knowing how unpopular they are at cocktail parties.
The argument is easy to sum up. The optimisms claim the slowdown has been temporary in nature. It was affected by the stock bubble of the late 1990s, they propose, and exacerbated by the September 11, 2001 attacks on the U.S. This camp believes that policy steps such as lowering interest rates, reducing tax on labor and dividends, and stepping up government expenditure will do the trick of stimulating the economy.
This camp of romantics also notes the increasing productivity in America, the flexibility of its labor market, the technological advances and the underlying, competitive entrepreneurial spirit underlying the American economy.
Their conclusion is that the slowdown will pass, as have many others before. The rally will come, and within a few months, at that.
The soft-speaking, hard-hitting camp of pessimists claims otherwise. This is not a downturn in a natural business cycle, they say, that can be reversed by policy measures.
The problem is a structural one, they claim. American consumers, individuals and companies, have been living beyond their means for years, while constantly increasing their debt. Meanwhile, the productive sector has been losing its competitive edge against countries with significantly lower labor costs. Moreover, the bubble era generated vast overcapacity.
The pessimists agree that productivity may have improved (if it isn't a statistical mirage), but relegate it to secondary importance.
They conclude that the U.S. and the entire industrialized world can expect a protracted, painful depression that will only end after sweeping change in the economic balance of power. The U.S. and greenback will lose their economic hegemony, to put it baldly.
Policy steps cannot help as they cannot address the fundamental problems. At best they ease symptoms, but in fact they will only exacerbate the crisis due the day the palliatives run out.
That is the argument, in a nutshell. For the sake of fairness, let me know that the author is in the pessimist camp, which believes the main slowdown is ahead of us. Secondly, it should be said that the argument has not been obviated by the facts in the field yet.
Neither party can yet claim, "I told you so." The Internet bubble is fact; there was an argument, but it's over. This one isn't over yet.
On the one hand, despite all the aggressive steps taken, there are no real signs of sweeping recovery. Expectations for the rally "in the second half" keep getting put off from year to year, point out the pessimists.
Yet the crisis and sharp slowdown haven't arrived either, rebut the optimists.
Lacking clear-cut evidence, the argument persists. Naturally enough, each party takes advantage of whatever crumbs of evidence support their view, and this has been going on for three years now.
Yet last month's crash in the American bond market would seem to powerfully tip the scales towards the bears.
Two explanations have been proffered by the steep slide in U.S. T-bill prices, and commensurate climb in yields. One is that the bond market has changed its mind from a few months ago and "smells" a recovery in the offing, hence the increase in yields. That sounds optimistic, as the sinking yields a month ago emanated terror of deflation. Hence the increase in yields emanates the opposite message, one of rally.
The alternative explanation is that the huge government deficit, shooting far beyond preliminary estimates, together with the vast government fundraising drive, induced bondholders to understand that there's a ton of bonds in the pipeline. And when supply increases, prices drop (and yields rise).
That would be the negative view, as it does not portend an economic rally around the corner, it simply reflects the depth of the government's deficit. The result of that will be higher long-term rates for the very entities expected to extract the economy from recession ¿ consumers taking out mortgages and consuming, and companies raising debt for investment.
The theory under test is the bears' claim that the slide to a deeper recession has been averted, so far, by the temporary expedient of refinancing mortgages.
Low interest rates and rising housing prices generated a wave of refinancing, which brought homeowners cash that was largely spent on consumption. But that cannot last forever, say the bears, and when the process is over, the slowdown will be back in full force.
There is nothing like climbing long-term interest rates to depress the process of refinancing. And it is happening. Requests for refinancing have dropped steeply in the last two weeks, but it's too early to call it a new trend, or just a hiatus in the flood of borrowing, which could resume soon ¿ at higher rates of interest.
If the rise in long-term rates, which has the greatest influence over consumption capacity by individuals and investments by firms, really does result from a structural problem (the government deficit and debt burden of companies and individuals), as the bears postulate, then within months we should see a ripple effect spreading to the housing market and consumption.
The bears have been claiming for ages that low interest rates are no more than a palliative, serving to ease the pain. If the underlying disease is ignored and the painkiller taken away, the result should be pain.
Tracking long-term interest rates
The conclusion is that we must keep close track of long-term interest rates, and see whether they continue to rise.
A central pillar, not the only one but certainly an important one, of the bears' theory will be tested in the months to come. It will take more than weeks, as is the nature of plodding economic processes. But if bond yields are still rising by year-end, we will know whether the process of refinancing mortgages really was of critical ¿ but temporary ¿ weight in economic development; or if the economy really is rallying.