Some signs are looking up, but there are still plenty of landmines in the economy.

It's high time I laid my cards on the table about 2011. So, here it is: I am cautiously optimistic about the US and global economy for 2011. Let me explain both pieces of the puzzle -- the cautious part and the optimistic part -- below. I'll start with the positive first.

Optimistic

Double dip recessions are not the norm; they are the exception. Why? Here's how I put it in September:

Recoveries by definition start from a point of diminished output because recessions are periods of diminishing output. So output in the initial period of any recovery is always lower. That's how the math works -- and also why I continue to stress that this is a technical recovery.

But, the important part to remember is how the business cycle works and how the recency effect creates self-reinforcing declines or recoveries in output.

Increases in income lead to increases in retail sales which lead to increases in output and inventories which lead to more jobs and thus a further increase in income. This is a virtuous circle that defines the upward path of a business cycle.

So, you really need to see powerful secular forces to overcome this self-reinforcing dynamic. Once a technical recovery begins, we should expect it to continue and blossom into a full-blown cyclical recovery. Obviously, I am talking about the medium-term, not the long-term here. But the point is that we have been in recovery for over one-and-a-half years in the US. Odds are that this will continue for some time to come (through 2011 at least).

I see the jobs picture as encouraging. Employment is lagging, as it has in the last two recoveries. So the recovery looks particularly weak. Moreover, there seems to be a skew toward the upper income strata. This makes the technical recovery appear even more sluggish. But clearly, the jobs picture is improving.

What are US jobless claims telling us about recovery? They are averaging about 410,000, down from almost 470,000 a year ago. And since employment is a lagging indicator, we should expect claims to drop even further as GDP has been growing.

Across the board, the economic indicators show a modest but improving economic picture: industrial production, capacity utilization, personal income, retail sales. And I expect this to continue through at least the first half of 2011, probably through the whole year.

Cautious

I am cautious about this outlook because I still believe the US is in a cyclical upturn within a larger depression. The concept that the structural problems of excessive household indebtedness and an over-reliance on financial services and housing can be solved by money printing and fiscal stimulus leaves me cold. My thesis is that these remedies mask problems only due to the cyclical upturn. If the recovery is not used to whittle the problem away, the next recession will be as bad or worse than the last.

That said, policy makers have done a pretty good job of avoiding egregious policy errors so far. I think that gives us enough oomph to get over the hump so the cyclical agents like inventories and cyclical hiring can do their magic. But, here are my lingering concerns.

1. Europe: the sovereign debt crisis refuses to go away. The European periphery is hurting but the crisis has infected the core via Belgium and Italy. I expect the crisis to get worse before decisive action is taken because that's how politicians usually respond. There are three options for the euro zone: monetisation, default, or break-up. The question is whether this -- in and of itself -- deals a fatal blow to recovery in Europe, infecting the global economy. If you had asked me this question early last year, I would have said yes. Today, one year more into a cyclical recovery, it is less clear.

2. US states and municipalities: Meredith Whitney has put this crisis front and center. My take is similar to the one on Europe: The question is whether this -- in and of itself -- deals a fatal blow to recovery in the US, infecting the global economy. Here, I have always felt that the budget issues would only become dire in a cyclical downturn as declining asset prices created public sector pension losses. In an upturn, tax revenue increases, as do accounting gains from asset prices. Costs for supporting the unemployed decrease. To the degree that there are budget problems, the situation is very pro-cyclical -- meaning you have what MBAs call a high degree of operating leverage on municipal and state income statements. Leverage works to magnify cyclical ups and downs. That means that, while I agree with Whitney's alarm on munis, I do not think this is a 2011 event.

3. Housing: House price declines have resumed in the UK and the US. They never stopped in Ireland and Spain. The housing double dip is in progress. Complicating matters, clearly, fraud was a big issue not only in the origination of mortgage loans in the US but also in packaging and foreclosure. There is a real possibility that a systemic legal problem develops on that front in 2011. I don't know how this problem will be resolved. At this point, I see it as the biggest near-term risk for the US in 2011.

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4. Currency Wars: a lot of good is done simply by having economic growth. It takes a lot of political heat off politicians. The currency wars are really a political event because they are caused by a lack of aggregate demand. When the pie shrinks, individual countries feel obliged to implement beggar-thy-neighbour policies to maintain their standards of living by taking a larger share of the pie. The developed economies have felt this ‘pie shrinkage' most acutely. So it is they who are driving the so-called currency wars forward. The emerging markets are merely reacting in kind. I say "First the rate reductions, then money printing, then the currency war, then the tariffs, then..." hopefully economic recovery. But, as with the other problems, unless recovery is used to solve the issue of external imbalances created by our jury-rigged monetary system, the so-called Bretton Woods II, then tensions will return worse than before when a recession hits. Only after a full-blown crisis will the underlying issues be addressed. So, wait for the next crisis for reform of the monetary system.

5. UPDATE: Added this paragraph -- Commodity price Inflation: There is a real threat to recovery from commodity price inflation. We have already begun to see signs of food price riots, food price controls and the like in emerging markets. Additionally, Brent crude is at 27-month highs, closing in on $100 a barrel. Just think back to 2008; this type of commodity price inflation was toxic and sowed the seeds of its own demand destruction.

Conclusions

I may write what I think this means for stocks or bonds in another post. But the quick data dump is that profit margins are cyclically high while P/E ratios are above their long-term levels. If firms staff up, we could see a modest rise in stocks due to an increase in aggregate demand, despite these two factors. Personally, I tend to like large cap value and I think that's the right call for this environment because, while I am optimistic, I am cautious. On bonds, I have been saying for four months that they showed a poor risk/reward skew at these levels. Moreover, duration changes are pretty large when yields are low. That means you can sustain heavy losses if yields tick up. There is no reason to be a hero by moving out the curve and getting long duration. Nor is there any reason to load up on risk, especially in munis and sovereign debt. That is still my view. But US sovereign debt is a lot more attractive today than it was four months ago.

On the economic front, I moved away from a multi-year recovery baseline because of the prospect of policy errors. We avoided those errors in 2010. With the technical recovery poised to become a full-blown cyclical recovery, I think it's time to move back to the multi-year recovery baseline. Let me repeat my oft quoted phrase about the secular leveraging in the developed economies:

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings. As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America's possession of the world's reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and over-consumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse, will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at -- only to resurface in 2007 and 2008 with their new tales of woe. Knowing this shapes the psychology of economic forecasting is why missing the turn is disastrous for one's career. Efforts to avoid missing the turn are also part of a very large pro-cyclical psychological force underpinning a cyclical bull market.

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Marc Faber: "Don't underestimate the power of printing money"

You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, "Don't underestimate the power of printing money." This quote has stuck with me as asset markets have soared in the intervening time. What Faber was alluding to was the fact that printing money works. It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what's happening in China. Are you telling me stimulus is not working? It most certainly is.

In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. It is doing just that.

But, remember, the developed world has a lot of problems to work through. The origins of the next crisis are already apparent -- and they have nothing to do with cyclical upturns and everything to do with a secular trend of rising indebtedness, now in both the public and private sectors in developed economies. If the developed economies use this cyclical upturn wisely to reduce household debt levels, to increase private sector savings, to clean up the balance sheets of weak banks, and to cautiously normalize fiscal and monetary policy, we will be in a much better position to counteract economic weakness when the next downturn hits.

Edward Harrison blogs at Creditwritedowns.com, where this  piece originally appeared.

Our colleague Edward Harrison of Credit Writedowns considers the definition of greed and what it means in the wake of the economic catastrophe.

In one of my latest posts I said "greed is not good." Quite frankly, I looked at this statement as self-evident in the wake of an economic catastrophe where greed was a defining element. Yet, a remarkable number of people commented in defense of greed; they seem to believe greed is a good thing. So, I would like to clarify a few things about greed in the context of the recent financial crisis and prudent regulation of the financial industry.

Greed is not good

Greed is defined as:

* A selfish and excessive desire for more of something (as money) than is needed (Merriam Webster)

* An excessive desire to acquire or possess more than what one needs or deserves, especially with respect to material wealth (Free Online Dictionary)

* The selfish desire for or pursuit of money, wealth, food, or other possessions, especially when this denies the same goods to others. It is generally considered a vice, and is one of the seven deadly sins in Catholicism. (People who do not view unconstrained acquisitiveness as a vice will generally use a word other than greed, which has strong negative connotations.) (The Free Dictionary)

* The obsession with accumulating material goods (Access-Jesus)

Do you notice the commonalities in all these definitions? Excessive, selfish, more than what one needs or deserves, unconstrained, obsessive. You can make the non-judgmental argument as I did that greed is neither good nor bad. But, in what twisted world view is any of this good? Greed is not ambition or hunger or drive. Greed is by definition excessive and unconstrained, and, thus, leads to unstable and suboptimal outcomes. Greed is not good.

This version of the definition was quite telling:

"Greed is something that can never be satisfied. Greed and slothfulness have similarities in definition. The greedy and slothful both crave material goods as well as they have no desire to work for or to exchange anything of value for the object of their desires. The slothful will not work even for basic necessities much less add value to the world around them. The greedy will use deception to acquire material goods. The greedy will lie and use false pretenses to acquired goods at the expense of others."

For more on this, see the Seven Deadly Sins. And just to make it clear, greed is antithetical to the core beliefs of all major religions in the Indo-European world. Why Americans who are ostensibly religious think ‘excessive wealth accumulation' is in keeping with the tenets of their faiths is beyond me.

Free market ideology is a religion

This is where the financial system comes into play. Back in 1987 when Oliver Stone made the movie "Wall Street," he intended Gordon Gekko to be an anti-hero emblematic of a period of excess. Yet, for some reason Gekko has since become a hero worthy of emulation amongst Wall Street's entrants. Why has this ‘greed is good' anti-hero become the man to emulate?

Let's go back to what Jared Diamond says about how kleptocracies maintain power:

"1. Disarm the populace, and arm the elite."

"2. Make the masses happy by redistributing much of the tribute received, in popular ways."

"3. Use the monopoly of force to promote happiness, by maintaining public order and curbing violence. This is potentially a big and underappreciated advantage of centralized societies over noncentralized ones."

"4. The remaining way for kleptocrats to gain public support is to construct an ideology or religion justifying kleptocracy."

Method number four, construct an ideology or religion justifying kleptocracy, should stand out for you. The religion, of course, is free market ideology. Now, I happen to believe quite fervently in the primacy of liberty and freedom over the the coercive power of the state. However, I see the free market as a means to an end not as an end unto itself.

In my post "Deregulation as crony capitalism" I said:

Obviously, if some always have more power and wealth than others, there is never a situation in which the economic playing field is level. Moreover, it is axiomatic that those with the means and access will always have greater influence over government than those without. So, in a very real sense, the socioeconomic elite of any advanced, stratified society will always have disproportionate control of the economic and political system.

By that, I meant that a society with a perfectly free market is a fiction which is used to justify the theft from those with less access and power by those with more. It is an ideology which has never had any real world manifestation in any stratified society in history. To believe that markets are or should be completely free is to de facto believe that those with greater access and wealth should be free to use this access and wealth to bend the system in their favor.

Trust but verify

Regulators are there much as police officers, sports referees or teachers on schoolyard playgrounds are: to make sure people follow the rules or suffer the consequences.

When I wrote the ‘Greed is not good' post, one reader responded that regulation was unnecessary; market discipline is the only regulation we need.

Is market discipline alone going to prevent mortgage finance companies from engaging in predatory lending? Is market discipline alone going to prevent mortgage originators from making bad loans, knowing they can offload the risk in the securitization market? Is market discipline alone going to prevent bank holding companies from retaining excessive leverage? No, it is not. The credible threat of the regulator is necessary.

"Speak softly and carry a big stick; you will go far."

So what about Lehman?

The Lehman decision was disastrous because it produced anarchy that resulted from the uncertainty of government action. I wrote a detailed post to this effect. When Lehman Brothers failed, I said the day after:

"Yesterday was a volatile day in the global financial markets. With the Nikkei down 5% and European bourses down 2% in overnight trading, we should understand that more volatility awaits us in the coming days and weeks.

As I survey this situation in serene tranquility away from market turmoil, I realize that I am very troubled by how the Lehman Brothers bankruptcy was handled. In my estimation, it was like putting the cart before the horse - allowing a financial institution to fail before you have worked out a mechanism of how to deal with that failure.

This one action will expose the global financial system to enormous additional risk.

Hank Paulson at the U.S. Treasury and Ben Bernanke at the U.S. Federal Reserve wanted to avoid the moral hazard of supporting the acquisition of a failed institution with government funds as it had done when JP Morgan Chase bought Bear Stearns. Therefore, Paulson and Bernanke were both fairly adamant about not offering any backstops for a Lehman Brothers takeover.

This is the principal reason both Bank of America and Barclays decided not to pursue a takeover of the firm. And this is also the reason Lehman Brothers failed. Had the U.S. government offered guarantees on Lehman's debt, Barclays or Bank of America would have bought Lehman Brothers. In fact, I reckon BofA would have preferred to buy Lehman Brothers over Merrill Lynch as the price tag was much lower.

Were Paulson and Bernanke correct? After some time to digest events, I must answer no. They were wrong."

They were wrong for three principal reasons:

1. The U.S. government has failed to provide a framework and process for dealing with failed institutions of this size and the impending wave of future bankruptcies it should expect.

2. Failure will lead to asset liquidation, depressing asset prices further and putting further pressure on the remaining solvent financial services firms to writedown asset values.

3. This will potentially result in a Great Depression-like chain of failures, credit contraction and asset liquidation.

Rather than learning from the Great Depression, we are likely to repeat it.

Why we need a framework and process

It is clear from the difficulties facing AIG and Washington Mutual right now that further large failures are likely to occur.

In the case of AIG, we are presented with a potential derivatives nightmare as this $1 trillion firm has its tentacles in all manner of Credit Default Swaps, Collateralized Debt Obligations and insurance products generally. AIG represents a much more ominous case of potential systemic risk than either Bear Stearns or Lehman Brothers.

Washington Mutual is a large bank with $300 billion in assets. It is very leveraged to Alt-A and pay-option mortgages. Unlike subprime mortgages, which have seen the maximum number of interest rate resets, the majority of these products are resetting to higher interest rates now and in the future. This means a significant number of defaults in the sector will occur and that Washington Mutual will be stressed by these events. That may create liquidity or capital concerns which would force WaMu into insolvency. Were WaMu to be declared insolvent, the FDIC would need to be bailed out as it does not have adequate funds to deal with the likes of Washington Mutual.

These two institutions are suffering even more as a result of the uncertainty that allowing Lehman Brothers to fail has created. Due to investor and counterparty jitters, AIG and WaMu are now more likely to fail than had Lehman Brothers been rescued. This fact and the systemic risk that AIG represents and the threat to the FDIC's adequacy that WaMu represents makes the need for a government bankruptcy framework and process more evident.

A too big to fail resolution process is needed

By and large this is exactly how things played out. AIG and WaMu both went bust and a Great Depression-like chain of events unfolded. Only due to herculean efforts and extreme government intervention was worse averted.

The problem with Lehman was not that Lehman was declared insolvent and put into bankruptcy, but rather that no adequate resolution process for the firm was in place to address this too-big-to-fail institution's collapse without precipitating a market panic.

When a systemically important institution faces collapse there are three potential avenues a resolution can take:

1. Anarchy. Allow the company to fail spectacularly without any planning whatsoever so that the whole financial system faces financial Armageddon. The hope is that this solution does not produce despotism, war or famine. Let's call this unpreparedness. This is what was originally tried with Lehman Brothers.

2. Crony Capitalism. Prop the institution up through bailouts, government backstops and guarantees, creating a moral hazard so that other banks know they too need to be too big to fail in order to avoid the consequences of market discipline. Let's call this kleptocracy. This is what happened to AIG, Citigroup, and Bank of America after Lehman's failure created panic.

3. Free market. Stop poor or potentially illegal lending and excess credit growth and risk through prudent regulation in order to prevent a spectacular bust and crisis. But, if presented with a bust, allow the institution to fail and potentially be liquidated in a controlled resolution process. This is what I am advocating. I see this as a more realistic free market solution.

What was needed when Lehman failed is also what is still needed today: a robust too big to fail resolution process. This should be priority one for regulatory reform in order to restore market discipline and reduce moral hazard. The heads of Standard Chartered, JPMorgan Chase and the FDIC understand this. Yet, there has been zero discussion of this issue in Congress.

What might this process look like?

1. Lay out specific rules regarding the provision of liquidity by the central bank at a penalty rate of interest or collateral to prevent bankruptcy if the true problem is liquidity and not solvency.

2. Set up a special court for adjudicating bankruptcies of large financial institutions quickly.

3. Mandate guidelines on haircuts equity and subordinated debtholders must take before any taxpayer money is used.

4. If liquidation is necessary, require a strict timetable for milestones in the process.

5. Set strict guidelines on what if any government guarantees a bankrupt or soon to be liquidated organization should receive and what the government should receive in return as compensation.

These are just a few ideas. The point is that a robust TBTF resolution process can definitely be crafted if the effort is made. Future Lehmans can happen in the future without bringing the whole system down.

Lehman will happen again

Below is a 40-minute panel interview I did with Canadian TV station TVO and its program "The Agenda with Steve Paiken" just over two weeks ago. The questions: Saving Wall Street but forgetting Main Street? One year after the financial sector came close to collapse; could it happen again?

The answer is yes and yes.

Alan Greenspan was right when he reviewed lessons learned from Lehman's collapse and said about the excesses leading up to the crisis:

"It's human nature, unless somebody can find a way to change human nature, we will have more crises and none of them will look like this because no two crises have anything in common, except human nature."

But let's not absolve ourselves of the need to take action to prevent the negative fallout as Greenspan attempts to do. If we set the right course, we can also prevent a future economic crisis from being as severe as this one has been.

Edward Harrison blogs at Creditwritedowns.com, where this  piece originally appeared.