With recent declines in oil and commodity prices and bond yields (30 year Treasury 4.75% on June 10, 4.21% today), people have now lost faith in the global economic recovery they had placed too much faith in a few weeks ago. Time to slow down and think a little. There never was a screaming recovery—it didn't go away. But the world is not ending either any many parts of the world (China) are growing nicely again. In America, the bond market is functioning again, banks are beginning to heal and eventually they will lend money to small businesses again. When that happens, and ordinary people calm down, both employment and GDP will grow again. This is not your father's recession. It did not start in the normal textbook way with a decline in spending. It will not end in the normal textbook way either. The downturn started with a freeze-up in the capital markets in June, 2007 when investors lost confidence in their ability to predict the cash flow and estimate the values of leveraged bank loans and mortgage-backed securities. It rumbled along for more than a year as primarily a capital market problem, with minor impact on output and employment until a series of tragic policy errors by the Federal Reserve, culminating in the failure of Lehman Brothers and the near-failure of a giant money market fund last August/September, produced widespread fear and a virtual run on the U.S. banking system.

Since that time, frightened individuals have hoarded cash. They have withdrawn more than $90 billion from their bank accounts to hold in the form of currency—$20 and $100 bills—to keep at home in a coffee can or under the mattress. That is approximately equal to the total reserves of the U.S. banking system when the virtual run on the bank began a year ago. You can see the most recent data on currency held by the public and keep track of the revised number every week with U.S. Financial data at the St. Louis Fed's website. The sudden shift to cash hoarding last September was the proximate reason the capital market virus leaped from the capital markets to the GDP accounts last fall and drove the economy into the worst recession since the 1930's.

Today's wholesale trade report for May in the above chart shows that inventories were actually in very good shape until last August. But inventories exploded when individuals shut off all spending and started hoarding cash in August/September. That spending shutdown and the resulting inventory explosion was the cause of the dramatic production cuts in October, November and December that drove GDP down at a 6.3% annual rate in the fourth quarter. This recession won't end until the fear subsides and people stop hoarding cash. There may be some signs that's beginning to happen. Although currency holdings at $852.6 billion are still $90 billion above a year ago they have stopped growing. May wholesale inventories fell 0.8% after falling 1.3% in April. Wholesale sales increased +0.2% in May (April was revised +0.4% as well). May sales of durable goods were down -0.2%; but nondurable goods sales increased +0.5%. You can see the full report by clicking here: WHOLESALE TRADE: SALES AND INVENTORIES, MAY 2009 . Of course, it's early and we shouldn't get too excited. Fear isn't going to disappear overnight and events like last weekend's cyber-attack on government websites don't help matters. But when fear does return to normal levels people will find themselves with $90 billion of currency they do not want to hold. Much of it will be re-deposited into their bank accounts, which will increase reserves by the same amount. The rest will be spent on groceries and iPods, which will increase consumer spending and reduce inventories back to normal levels. Both will contribute to an eventual recovery of GDP back to normal levels. I think we will see that happen before the end of this year.


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