This week’s Thoughts from the Frontline e-letter by John Mauldin features a condensed version of a letter by Dr Gary Shilling, where he looks at the risk of another recession in the U.S.

You can gain access to read the entire letter from John’s web site by simply adding your email address to his mailing list (it’s free). John’s letter goes out every week to about 1.5 million subscribers, and his letters are always a pleasure to read both for their human side and the no-nonsense analysis.


Although investor views of the economy have reversed in the last five months, the reality probably hasn’t. The good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s and in the early 1980s among U.S. consumers. That leverage propelled the dot com stock bubble in the late 1990s and then the housing bubble. But now those two sectors are being forced to delever and in the process are transferring their debts to governments and central banks.

This deleveraging will probably take a decade or more – and that’s the good news. The ground to cover is so great that if it were traversed in a year or two, major economies would experience depressions worse than in the 1930s. This deleveraging and other forces will result in slow economic growth and probably deflation for many years. And as Japan has shown, these are difficult conditions to offset with monetary and fiscal policies.

The deleveragings of the global financial sector and U.S. consumer arena are substantial and ongoing. Household debt is down $374 billion since the second quarter of 2008. The credit card and other revolving components as well as the non-revolving piece that includes auto and student loans are both declining. Total business debt is down, as witnessed by falling commercial and industrial loans.

Meanwhile, federal debt has exploded from $5.8 trillion on Sept. 30, 2008 to $8.8 trillion in late August. Many worry about the inflationary implications of this surge, but the reality is that public debt has simply replaced private debt. The federal deficit has leaped as consumers and business retrenched, which curtailed federal tax revenues, while fiscal stimulus, aimed at replacing private sector weakness, has mushroomed.

Four Cylinders

As discussed in our May 2010 Insight, in the typical post-World War II economic recovery, four cylinders fire to push the economic vehicle out of the recessionary mud and back out on to the highway of economic growth. At present, only one – the ending of inventory liquidation – is generating significant power. The other three – employment gains, consumer spending growth and a revival in residential construction – are sputtering at best.

The letter then goes through each of the four cylinders, explains why the inventory cycle positive effect is coming to an end, and why the cylinders of employment, consumer spending and housing show no prospect of firing. It then goes on to discuss what, if anything, the Fed can do to goose any of the four cylinders into action. In my post Can Food Prices Rise During Deflation I referred to Joseph Stiglitz’s summary of the Fed’s QE efforts as “pushing on a string”. Dr. Shilling’s letter contains a discussion of the “pushing on a string” effect as well:

Pushing On A String

Conventional monetary ease is now impotent with the federal funds rate close to zero , the money multiplier collapsed and banks sitting on hoards of cash (Chart 12) and over $1 trillion in excess reserves. Sure, large banks report to the Fed that they are easing lending standards for small business, but after the intervening financial crisis, many fewer potential borrowers are deemed creditworthy than in the loose lending days. Furthermore, the small business trade group, the National Federation of Independent Business, reports that 91% of small business owners have had their credit needs met or business is so slow that they don’t want to borrow. The Fed is pushing on the proverbial string.

The Fed also worries about deflation, which means that even zero interest rates are positive in real terms, as has been the case for years in deflationary Japan. Also, deflation encourages buyers to wait for still-lower prices in a self-feeding cycle, as is seen in Japan and as we have discussed often in conjunction with our forecast of 2% to 3% per year chronic deflation. In it s post- August 10 meeting statement, the Fed said that “measures of underlying inflation,” already low, “have trended lower” lately and are “likely to be subdued for some time.” James Bullard, President of the Federal Reserve Bank of St. Louis, recently warned of the risks of deflation.

Deflation is a scary phenomenon, but we can’t resist noting that the Fed as well as many other forecasters are moving in the direction of our forecast. In contrast, an April 6 Wall Street Journal piece by Peter Eavis stated unequivocally, “No one in their right mind would bet on inflation remaining substantially below 4% for the next 10 years.” Maybe we better have our head examined.

The letter is long but well worth reading. The conclusion is that the US is set up for another recession with a chance of over 50%, and that as with past recessions, it will likely take some shock to trigger its onset. The Fed, in Dr. Shilling’s opinion, is in a deflation-fighting posture and will not tighten in any way to cause the shock itself. However…

If the Fed is highly unlikely to shock slow growth into recession, what could? This brings us back to the series of seemingly isolated events that are occurring on the deleveraging road, such as further financial woes in Europe, a crisis in commercial real estate, a nosedive in the Chinese economy and a slow motion train wreck in Japan. They are all possibilities – as are other shocks here or abroad that we don’t foresee. Maybe the exhausting of federal stimulus will be enough to trigger an economic downturn. Keep your eyes peeled, however, because it won’t take much disruption to push the fragile global economy back into decline.

Further financial woes in Europe and a crisis in commercial real estate are pretty much a given. Keep your eyes peeled, indeed.