The Sucker Rally

I am too busy now to produce a detailed analysis of the latest U.S. economic data. Suffice to say that all of them except the Chicago PMI, but inluding the Beige book, durable goods orders, corporate profits, new and existing home sales, construction spending, consumer confidence, personal income and spending and jobless claim support my prediction that this quarter will experience negative real growth at least on a terms of trade adjusted basis and probably on a volume basis too.

Meanwhile, I recommend Nouriel Roubini's interesting analysis of the stock rally of the last few days, which he calls "a sucker rally".

European Inflation Getting Worse

The inflation problem is getting worse and worse in the euro area. This is illustrated first of all by the fact that M3 growth accelerated from an already high 11.3% in September to a new all time high of 12.3% in October.

Moreover, consumer price inflation rose from 2.6% in October to 3.0% in November, according to Eurostat's preliminary "flash" estimate.

Yet despite this surge in both monetary and price inflation, the ECB betrays its legal obligation to hold M3 growth at 4.5% and consumer price inflation below 2% by failing to raise interest rates and by offering "emergency loans" to failed investors.

Meanwhile, monetary crank Sarkozy tries a light version of Mugabe's inflation fighting tactic of government price controls, by pressuring retailers -using unspecified threats- to cut prices. This tactic failed miserably for Mugabe and is likely to fail for Sarkozy as well. In order to obtain lower prices you must rein in money supply growth and/or pass supply-boosting spending- and tax cuts.

Accelerate the Appreciation?

Nicholas Sarkozy has visited China where he reportedly secured deals worth €20 billion for French firms. Fairly impressive, if it is really true that the visit really caused them.

Anyway though, he also spoke on the issue of the Chinese currency and told Chinese leaders that they should allow the yuan to strengthen and that doing so would be in China's best interest as well. Here I for once agree with Sarkozy on a monetary issue, but I can't resist the temptation to point out an error in his statement when he said:

"This means that, for its own sake as well, China needs to accelerate the appreciation of the yuan against the euro."

Accelerate the appreciation? Make that decelerate, stop and preferably reverse the depreciation of the yuan against the euro. While the yuan has appreciated against the U.S. dollar, so has almost all other currencies, and most -including the euro- have in fact appreciated faster against the U.S. dollar than the yuan. That means that the yuan has depreciated against the euro. The euro has risen from 10.2 yuan in June to 11 yuan today. This is of course one of the reason why the Chinese current account surplus have continued to rise despite the steady appreciation of the yuan against the U.S. dollar.

Arbitrage Opportunity

Arbitrage is usually defined as an opportunity to make a profit that requires no initial net investment -no negative cash flow- and that presents no risk for the arbitrageur. Such opportunities regularly arise, although they are usually short-lived.

More lasting discrepancies are opportunities which do not fully satisfy the technical definition of arbitrage, since they are either not 100% certain or because they require some initial investments.

One of the more fascinating cases of profit opportunities which may not be 100% certain but are nevertheless fairly certain and which requires no initial net investments are in the U.S. bond market.

Whether you look at the latest 20 years or 5 years, the historical average for U.S. consumer price inflation has been 3%, and currently inflation likely stands at more than 4%. Yet the spread between the regular nominal U.S. treasury note and the treasury inflation protected securities of similar maturity is just 2.3% for the 5-year note. While that is up somewhat since the Fed's September rate cut, it is still irrationally low.

So, in other words, even as Helicopter Bernanke has rapidly accelerated the pace of inflating and shown his willingness to in effect throw the dollar to the wolves, the U.S. bond market is pricing in a significant decline in inflation in the coming years!

While that scenario may not be impossible, it certainly appears highly unlikely that inflation would fall under the current circumstances, and fall to less than 2.3%. It is much more likely that inflation will instead rise and stay at a level higher than 3% over the next 5 years.

So, here is a almost risk free arbitrage strategy that requires no initial net investment: first you sell short the nominal treasury notes. Then you use the proceeds from that to buy inflation protected treasury securities of the same maturity. Then you hold this position and watch the interest income to you come in at larger sums than the sums you have to pay to compensate the owner of the treasury notes you sold short. And as you've made no initial net investment, you won't face any exchange rate risk (except in the sense that the falling dollar will limit your gains, but it can't inflict direct losses on you).

Denmark to Join EMU?

After the centre-right Danish government was re-elected with the support of nationalist Danish People's Party, it is now proposing a new referendum on having Denmark adopt the euro as currency.

If the alternative is for Denmark to keep its current currency policy of pegging the Danish krone to the euro, then certainly it makes sense to go all the way and adopt the euro. Denmark's monetary policy is already determined by the ECB and both exchange rates and interest rates follow the euro area so the only difference would be that transaction costs would be eliminated.

The Danish People's Party which opposes the move argues that as Denmark's economy is strong there is no reason for this move. But aside from the fact that Denmark's economy actually isn't that strong with economic growth being among the lowest in Europe, there is no theoretical basis for believing the current peg is superior to joining the euro outright. Or does the Danish People's Party believe that extra transaction costs are good for the economy?

Only if the alternative to joining the euro is adopting floating exchange rates could a case be made against it under the condition that with a floating exchange rate one would pursue a significantly sounder monetary policy than the ECB. In that case it is possible that the reduced distortions from inflation would outweighs the loss from reduced trade that the existence of separate currencies. If however independent monetary policy would be less sound, as sound or only slightly sounder, then a monetary union is superior.

Yet with its current policy of having a peg to the euro, this potential argument against joining the monetary union is inapplicable. Although the peg reduces some of the negative aspects of having a separate currency, it also makes the potential argument for it inapplicable. We are therefore left with only negative aspects -although again these negative aspects are smaller than with a floating exchange rate- of having a separate currency.

Some in Sweden speculate that if Denmark adopts the euro, then that would make it harder for Sweden to stay out. Actually, the effect would be very small for Sweden. Because of the peg, exchange rate movements would be the same if Denmark adopted the euro as they are now. The only economic difference would be that the euro's international status would be slightly higher and that the transaction cost argument would be somewhat stronger as a euro entry for Sweden would then eliminate transaction costs with Denmark as well as the current euro area countries, instead of just the current euro area countries. But that would be a very small difference. The main difference would be that the psychological appeal of euro entry would strengthen if Denmark joined.

The economic case for Sweden joining euro used to be strong with both the trade factor and economic soundness factor arguing for it. Yet with the Riksbank becoming a lot more hawkish and the ECB becoming more dovish in recent months, the economic soundness argument is no longer valid as an argument for joining the euro. To the extent it is applicable, it is an argument against it.

Jim Rogers-Master of Investments

As a follow-up on the previous post, I would like to point out just to some examples regarding why Jim Rogers is a master investor whose opinion should deserves to be noted. Not only did he for example achieve abnormal returns in the Quantum fund he managed with George Soros and predict the beginning of the commodity price boom in 1998. He has recently made real big gains selling U.S. financial stocks short.

In the Bloomberg interview from November 2 where he characterized Ben Bernanke as "a nut" for his inflationary ways, he also told the interviewer that he is selling short shares of Citigroup, America's largest bank, and Fannie Mae, America's largest mortgage lender. For those of you who don't know, selling short means borrowing shares from someone, selling those shares and then buying the shares back at a later point. If share prices fall, then this strategy will make you money.

Since that day, Citigroup shares have fallen from about $40 to $31, giving short sellers like Rogers a 20% return in less than 3 weeks. Assuming he actually made the short sell a few days before the interview, the return would have been more like 25%.

But that's nothing compared to the gains Rogers have made from selling short shares of Fannie Mae. That stock has plummeted by roughly 50% since the interview, giving Rogers a equally sized gain. And that's in less than three weeks.

This is not to say that Rogers is always right. But he is almost always right, and that is why I feel comfortable about the fact that I am on almost all investment issues in agreement with him.

The Future of the Commodity Price Boom

A review of star investor Jim Rogers book Hot Commodities written by me has been published as a Mises Daily Article. Read it here.

Sarkozy's Thatcher Moment

I have been bashing Sarkozy quite a lot here, mostly for his monetary policy statements. However, I have also said that despite his statist leanings on monetary policy and some other issues, he was still a lesser evil compared to the other candidate in the presidential election, Segolene Royal. And so, he does in fact push for some positive reforms.

One of these reforms are the plans to reduce the overly generous pension benefits of many government employees, that allows them to retire with full benefits after working 37.5 years, a period which Sarkozy wants to increase to 40 years. This will help reduce France's all too high level of government spending and increase the supply of labor.

Of course, the reform is too modest and affects too few people to have a really dramatic positive effect on the French economy. But now that it like previous reforms pursued by Chirac is being challenged by strikes organized by the unions, it is vital for France that Sarkozy does not surrender, like Chrirac did on several occasions. If these modest reforms cannot be implemented then of course, anything more radical or just equally radical will be ruled out in the future too.

So, Sarkozy now faces a choice. Either he like Chirac,and Edward Heath in Britain in the mid-1970s surrenders surrenders to the strikers and dooms France to continued stagnation. Or he decides to play tough and demand unconditional surrender from the strikers, like Margaret Thatcher did in the early 1980s. That would not only mean that the modest improvements now proposed will be implemented, but more importantly it will also help clear the way for further free market reforms.

Well, I'll Be Damned.

The one thing I regarded as really certain didn't come true this week. The Big Picture blog now reports that earnings of the large corporations listed on the S&P 500 fell 27.8% from a year ago. Operating earnings fell too, although somewhat less, 8.5%.

What is remarkable about this is not the fact that earnings fell, that have happened often in the past and certainly wasn't anything I thought wouldn't happen again. No what was remarkable is that this was lower, indeed much lower, than was expected in official estimates in the beginning of the quarter. At the time, earnings was estimated to have fallen just a few tenths of a percent. But instead of outperforming estimates as they have always done during the more than 10 years that I've followed these numbers, for once they underperformed-and underperformed very significantly.

The reason for this extremely rare underperformance was a few extraordinary events, such as General Motor's $39 billion tax charge and the massive write downs by several financial companies. This is however not to suggest that that number is somehow the objective indicator of corporate performance. So-called operating earnings, excluding one-time events such as tax charges, are virtually always higher than overall earnings as almost all "extraordinary items" have a negative effect on earnings. While "true" earnings didn't decline as much as 27.8%, it arguably declined more than 8.5%.

Official estimates, which except for this quarter have always been too low just before the earning season but too high the months before, still imagine earnings will rise 5.9% for the fourth quarter. While lower than the 9.9% estimate a month ago and 7.6% number a week ago, that is still far too high. Particularly given the likelihood of more write downs, the actual number is more likely to be close to zero or even negative.

Given how this includes a significant boost to earnings of multinationals from the weak dollar, such a weak number certainly is indicative of a recession.

Review of the Week

Because of the infrequent posting earlier in the week, I will now list and briefly comment a few news that I find worthy of comment, besides the items already commented -the essay contest and the issue of asset price targeting-:

-Economic statistics from America were mostly bearish, consistent with a recession. Most notably, industrial production fell 0.5% from the previous month in October. The decline was broad-based, with utilities, mining and manufacturing all declining. The weakness in mining is particularly interesting given the elevated commodity prices. Mining is actually only up 0.4% from a year ago. This indicates that at least in America, there are supply-restraints, which is bullish for metal prices, some of which have fallen recently due to fears of the implications of a recession.

Retail sales were up 0.2% in nominal terms, but as the CPI were up 0.3% this implies a decline in real retail sales. This decline is likely to accelarate sharply in November, as the sharp increase in oil prices will then finally show up as a sharp increase in gasoline prices. Also consistent with this pattern is a rise in initial jobless claims.

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The Economist finally figure out in this week's cover story (see also their leader) that a recession is inevitable, and is in fact already likely a fact, and even if it isn't, it certainly will be in coming months.

The Economist thus figure this out before most of their competitors. However, a certain insightful observer figured this out 7 months ago.

-The Economist also has a story about why the effects of rising oil prices have been less stagflationary than in the 1970s. It points to falling oil consumption relative to GDP in the G7 and argues that is the explanation. It also concludes that the impact might be bigger in coming months in particularly America as the rise in oil prices are no longer counteracted fast income growth.

Their explanation is not incorrect, but rather incomplete. One reason oil has fallen relative to the economy is the decline in inflation-adjusted prices since the early 1980s. Now that this is reversing, oil will rise in importance.

Also, the story overlooks how much of the supposedly less stagflationary environment is due to the change in how inflation is calculated. Since the early 1980s, inflation measures around the world, but particularly in America, have been adjusted in various ways to lower the inflation rate, by introducing adjustments meant to account for supposed quality improvements and substitution. Whatever your opinion of the validity of these changes, it remains the case that comparing the 1970s to now is a case of comparing apple to pears. An apple to apple comparison that involves either applying the methodology of the 1970s to current data or applying current methodology to the data of the 1970s would show that the economy has not become as much less stagflationary in relative terms than in the 1970s as statistics show.

-Leftist economist Joseph Stiglitz offers a nearly Austrian explanation of the housing bubble, pointing out that Greenspan are to blame for the housing bubble by increasing "liquidity" too much.

-Euro area inflation rose to 2.6% in October from 2.1% in September and 1.6% in October 2006, just as the initial estimate indicated. Interestingly, it is not "merely" food and energy prices.
"Core" inflation is also up, to 1.9%, up from 1.8% in September and 1.5% in October 2006. This makes the ECB:s refusal to raise interest rates increasingly incompatible with even the appearance of committment to its formal objective of holding inflation below 2%.

-Swedish unemployment statistics has finally been harmonized with the rest of the world and now includes students who would like to work, but are unable to find a job and so instead studies. This raises the unemployment rate by 1.5%:points, to roughly 5.6%. Unemployment has fallen significantly during the latest year due to the Swedish government's reductions in the income tax and unemployment benefits, so the unemployment rate was a lot higher during the previous Social Democratic government's era both compared to now and compared to the numbers published at the time.

-Due to a sharp decline in U.S. bond yields, they are now lower even in nominal terms than Swedish bond yields. 10-year U.S. bonds yield 4.15% versus 4.24% in Sweden, the 2-year yield is 4.07% in Sweden versus 3.33% in the U.S.

Given the higher inflation in America and the far more hawkish stance of the Riksbank compared to the Fed, Swedish bonds provide much higher value than in America, where the real yield is negative. Considering this and considering the fact that Sweden still has a large current account surplus while America has a large current account deficit -albeit shrinking, but not dramatically-, the Swedish krona looks highly undervalued compared to the U.S. dollar.

Targeting Asset Price Bubbles

Paul De Grawe at the Vox EU blog points out that consumer price inflation isn't the only peril, and that asset price bubbles are worrisome too. Which is good, although the picture he gives of central banks somehow being independent of this is misleading, as central banks even though they may not have undertaken active steps to create it -although they sometimes do that too, the Fed's action in 2001-04 was a good example of this- they are still responsible by preventing interest rates from rising when speculative demand from credit rises.

He also points out that the various arguments that various Fed officials, such as Alan Greenspan, Ben Bernanke and Frederic Mishkin, have used against preventing asset price bubbles, or more correctly abstaining from accomodating them, is nonsensical.

First that it is impossible to detect asset price bubbles, since detecting them assume that Fed officials are smarter than the markets as the markets if they realized it was a bubble would have already ended the bubble. But as De Grawe points out, it should be obvious that double digit credit growth combined with double digit asset price increase is a sign of a bubble. And here I could add that it is often the case that it is rational for investors to participate in something they know is a bubble if the bubble seem likely to get bigger still, and if they know central banks will bail them out and limit their losses if they sell too late.

The second argument is that it is somehow impossible to burst asset price bubbles. Which makes even less sense as it is in fact the case that monetary policy has a stronger effect on asset prices than consumer prices. Try raising the Fed funds rate from 4.5% to 6.5% at the next meeting and have Congress institute a law preventing it from being reduced in the coming 24 months. I think we can be certain that stock prices would fall far more than consumer prices on that news, particularly in the short term.

Japanese Yen, Swiss Franc Winners of the Week

From Doug Noland's always interesting weekly creditbubble bulletin on Prudent Bear, we can read that the two strongest currencies of the week was the Japanese yen, up 3.4% against the U.S. dollar, and the Swiss franc, up 2.8%. A well-deserved increase as these two currencies had been unfairly pounded by the carry trade due to their low nominal interest rates. Yet if you take into account the fact that price inflation and expectations of price inflation is much lower there than elsewhere, then real interest rates there are much higher than in the U.S. and the Euro area, particularly with regards to long term bond yields.

The Japanese yen and the Swiss franc were two of the currencies I a week ago pointed to as particularly undervalues, the two other being the Swedish krona and the Chinese yuan -they too rose on the week although less than the yen and the Swiss franc. What makes the yen and the Swiss franc so particularly interesting is the fact that money supply growth is so particularly low in these countries.

Broad money supply growth in Japan was just 1.9%, and the narrow M1 measure had in fact 0.0% growth.
Broad money supply growth in Switzerland was even lower, at 0.9%, and M1 actually shrinking.

Compare this to the double digit money supply growth in the U.S. and Euro area and most other economies, and it is clear why the yen and the Swiss franc should be considered relatively sound currencies.

Fed Losing It?

The unofficial intention of the Fed's recent rate cuts was clearly to prop up the stock market and create another bubble there, whose stimulative effect would counteract the negative effects of the bursted housing bubble. This was the trick they pulled of back in 2001, only with the roles of stocks and housing reversed as the strong housing sector counteracted the negative effects of the bursted tech stock bubble.

That is how it has to work in order for monetary inflation to succeed in boosting real output. Asset prices, or more correctly, the type of real investments they represent must be boosted so as to enable higher investments without lower real consumption.

At first it seemed to work, with stock prices ignoring all the bad news about earnings and just kept rising and rose to new all-time highs in October, at least with regards to the S&P 500 and the Dow.

But lately, a barrage of bad news about earnings, with banks reporting almost every day new multi billion dollars losses related to the subprime sector, with GM taking a $36 billion tax charge and with even many non-financial companies reporting deteriorating earnings prospects, despite the boost from the weak dollar from such companies, have induced sell-off after sell-off, and now stocks are in fact lower than before the Fed's September 18 rate cut.

Of course, it can be argued that in the absence of the rate cuts, stock would have been even lower. But nevertheless, it is clear that stock values are simply not rising the way they are needed to in other to counteract the effect of the housing bust.

The really lasting effects of the rate cuts instead simply seem to be a weaker dollar and sharply increasing commodity prices, both of which are likely to fuel consumer price inflation. So, it seems that in this case, monetary expansion will simply not boost output even in the short-term but will simply raise consumer price inflation.

While a weaker dollar will of course help reduce the U.S. trade deficit -or at least the non-petroleum deficit-, which we already see in recent trade statistics, this apparent growth boosting effect is counteracted by the reduction in domestic purchasing power. Particularly in November we are likely to see a sharp reduction in real incomes and with the decline in consumer confidence, this certainly implies a decline in real consumer spending.

I therefore expect real consumer spending to fall for the first time since 1991 during this quarter. Real GDP is also likely to fall, marking the beginning of the recession, at least in terms of trade adjusted terms, but probably also in volume terms.

Ron Paul-Campaigning For Gold

Lew Rockwell tells of perhaps the greatest benefit of the Ron Paul campaign-how he by making the negative effects of the Federal Reserve's policies has spread the awareness of the need for a return to the gold standard.

"Ron has made an issue, and a huge one, out of the Federal Reserve and its destructivism and business cycles. Last month, 2,000 University of Michigan students cheered his calls for sound money by chanting "Gold, Gold, Gold." And last night, as he was walking through National Airport, a man with a British accent approached him. "Congratulations on making monetary policy a live issue," he said. "I never thought it could be done. I'm an economist at the IMF," he added, "And I also agree with you about this: the IMF should be abolished!""

Here is also Ron blasting Bernanke again for his destructive policies at a congressional hearing

Investing in Commodities

I have long argued for commodities as an investment object, a recommendation that have certainly been vindicated by the commodity price rally. Some may think it is too late to invest in commodities now, but I don't think so. The fundamental factors driving the commodity price rally remains in place.

The factor I have been highlighting most on this blog is the Fed's monetary policy , which has helped push up commodity prices for a number of reasons, not least as it lowers the U.S. dollars foreign exchange value, but also as money supply increases will raise the most flexible prices to a disproportionate extent. And that factor will continue to push up particularly the U.S. dollar value of commodities as mad "Helicopter Ben" continues his inflationary policies.

Moreover, in his new book, Hot Commodities-How Anyone Can Invest Profitably in the World’s Best Market investment super star Jim Rogers lays out a number of non-monetary reasons for believing in a continued commodity price rally for several more year. I won't elaborate on these arguments here and now, and will instead do so in a full review of the book which will soon be published. For now, suffice to say that capacity growth in commodity extraction is trailing growth in demand from particularly countries like China and India, and will likely continue to do so for a few more years.

Meanwhile, I see that even some Swedish news outlets start to offer read detailing practical how-to tips on how to invest in commodities.

Catching On Slow, Larry?

We're still waiting for that gold weakness that Larry Kudlow predicted after the Fed's 50 basis point cut in September. When I first asked the rhetorical question of when that gold weakness will come, gold was at $787. Now it stands at $841. That is 16% higher than before the rate cut, and 25% higher than before the Fed's discount rate cut in August.

Meanwhile, oil has risen over $98, the euro is up to $1.47 and the pound to $2.10, while the dollar is down to 6.27 versus the Swedish krona. If the petroleum inventory report today from the EIA shows continued declines in inventories, oil could easily reach $100 today.

Commodity prices is increasing so fast, and the dollars exchange rate against other currencies dropping so fast, we are close to what one might characterize as a run on the dollar. Bernanke's actions leaves no doubt that he will inflate as much as it takes to bail out failed Wall Street investors, and that will in effect be paid for by holders of dollars, so anyone holding dollars is a sucker who volunteers to pay for Bernanke's bailout. As more and more people realize this the dollar's collapse will continue.

Some correction might come given how dramatic the fall in the dollar has been, but Bernanke's determination to debase the dollar and the growing realization means that the trend will remain for a falling dollar, and that any such correction will likely be short-lived.

Someone who is not catching on is Larry Kudlow himself. He asks "what's it all mean?" in a recent blog post, refering to the rally in gold and oil.

He mentions the obvious explanation, inflation, but dismisses it by pointing to rising stock prices and low bond yields. Yet that just shows how clueless he is. There is no reason for stock prices to fall on the basis of inflation, indeed they should in fact rise from it as the nominal value of earnings and fixed assets rise. They should only react negatively to the extent that this provokes the Fed to tighten monetary policy. And with Bernanke as Fed chairman, that won't happen. And bond yields will also only rise with inflation to the extent this increases expectations that the Fed will raise short-term interest rates in the future, as bond yields should roughly mirror expected future short-term interest rates.

If you adhere to false theories of how the economy works, as Larry does, you will have trouble understanding economic trends.

U.S. Dollar Flight Continuing

More and more people are bearish on the U.S. dollar. I have of course long recommended people to stay away from it, and so have many other people, including Jim Rogers, one of the world's most successful investors. He put the matter well in his recent Financial Times interview when explaining why he is selling all his U.S. assets:

"The U.S. dollar is a terribly flawed currency...I don't want to own a currency which is being debased that way. The central bank of America has said that it will print as much money as it need to drive down the value of the currency...it doesn't take a genius to figure out that this is a currency that will be going down for some time to come. The head of the central bank has been printing money since he got there for two years ago. He is printing money very rapidly now, especially since this summer. This is a man who spent his whole career studying the printing of money, now America has given him the printing presses. I don't want to be in a currency like that. He[Bernanke]'s gonna print money until he runs out of trees. I don't wanna own U.S. dollars in an environment like that. I don't know why anybody would."

Now, even models start to reject the U.S. dollar too. Gisele Bündchen, a Brazilian model of German ancestry, has now said she will no longer accept payments in U.S. dollars and instead wants to be paid in euros.

Personally, I don't think euros is the best alternative given how bad the ECB have been doing in recent months. Gold would be the best, but among paper currencies, swiss francs, swedish kronor, chinese yuan and japanese yen are the most attractive currencies to receive payments in as they are either the most undervalued and/or the least debased.

U.S. Economic Numbers Much Weaker Than They Seem

The last few days we have seen reports about the U.S. economy which at first glance have appeared strong-or at least not weak enough to indicate recession. Yet if you look more closely they really are much weaker than they appear-

1. The GDP report which published GDP growth of 3.9% in the American way of expressing growth. Even setting aside the good reasons for believing the GDP price deflators underestimate inflation -and so overestimate real growth- it is still far less impressing than it would seem. First of all, GDP numbers are generally revised down. 2004 GDP growth was for example first published as 4.4%. Now after having been revised down three times in the annual revisions of 2005, 2006 and 2007-it is estimated to be 3.6%. Secondly, the domestic price deflator rose 1.6% versus the 0.8% increase for the GDP deflator (If you're not sure why estimating real income gains on the basis of the prices you pay rather than the prices you receive see here). The likely revision and terms of trade factors together thus indicate a real number 1.6% lower than the headline figure, leaving us with 2.3% in growth.

Moreover, some of the growth was related to increased government demand for goods and services (note this does not include transfer payments like social security or welfare) which rose from 19.4% of GDP to 19.5%-the highest since early 1993.Adjusting for that, private sector growth were more like 1.8%. That is not a recession, but is far from the boom numbers the headline numbers suggest.

Of course, it was not to be expected that the third quarter would be the first of the recession. But it seems increasingly likely that the fourth quarter will have negative growth, as the two reports analyzed below-and many other indicators- suggest.

2.The ISM Manufacturing report fell back to 50.9 in October from 52 in September. That indicates weak growth, but not a contraction. However, this headline number is calculated by weighing together different sub-components, such as new orders, production, employment and prices paid. Guess which sub-component had the highest value and which increased significantly in October? Well, if regular readers remember how many times I've been mentioning stagflation, they should be able to guess that it is the prices paid index. And if they guessed that, they guessed right, as the prices paid index rose from 59 to 63. Excluding that, the overall index would be below the 50 level which is the level which is the border line between expansion and contraction.

3. The employment report were widely interpreted as indicating a strong job market. The main basis for this claim is that the number that financial journalists always focus on, the increase in payrolls in the payroll survey was a full 166,000.

However, first of all, with the mere 0.2% increase in nominal wages, it seems almost certain that real wages fell significantly given the surge in food and energy prices.

Moreover, there are good reasons to believe that this job growth number is extremely misleading and that job growth was in fact negative. The household survey for example indicated a 250,000 job loss.

The payroll survey is widely considered more reliable than the household survey. This is however only to some extent true with regards to monthly changes which have been somewhat erratic in the household survey. However, there are good reasons to believe that the household survey better reflects trend movements in employment. During the housing bubble, employment growth according to the payroll survey was suspiciously
low, with employment increasing by a mere 4.2 million or 3.2% in the four years between December 2001 and December 2005. And the initially reported number was actually even lower than that as the payroll survey growth for that period has been upwardly revised several times.

The household survey's increase of 6.8 million or 5% looks a lot more reasonable.

Now the tables are turned, with the 12 month increase in the household survey being 0.5% versus 1.3% in the payroll survey.

The reason why the household survey is more reliable in tracking trend changes in employment, while the payroll survey tend to underestimate growth during booms and overestimate in during downturns is that the household survey automatically tracks changes in for example in employment of illegal immigrants and start-ups of new businesses or business deaths. The payroll survey is useless in covering either. In order to account for employment in new businesses, the Bureau of Labor Statistics has a "birth-death" model of new businesses. The trouble with that is that it is being applied without any consideration of cyclical fluctuations. The result is that most of the payroll survey growth is now a result of the assumption of new businesses being created, whereas during the housing bubble only a small part of payroll survey growth was a result of this. The absurdity of this is most apparent in the construction sector, where the Bureau of Labor Statistics would have us believe that 164,000 more jobs were created in new businesses than lost through bankruptcies in the last seven months, despite the housing bust.

The payroll survey is thus simply not credible as an indicator of cyclical fluctuations. And if we look at the household survey the bottom line is that employment was 133,000 or 0.1% lower in October than in June. This implies a direct contraction in the labor market.