James Pethokoukis

Via the GS econ team (as excerpted and outlined by me):

1. We see two main scenarios for the economy over the next 6-9 months—a fairly bad one in which the economy grows at a 1½%-2% rate through the middle of next year and the unemployment rate rises moderately to 10%, and a very bad one in which the economy returns to an outright recession.

2. There is not much probability of a significantly better outcome.  The reason is that “short-cycle” factors such as the inventory cycle and the impulse from fiscal policy are likely to continue deteriorating through early 2011, keeping GDP growth very sluggish.

3. However, the recession scenario also has significant probability (we still think about 25%-30%).

4. Relative to our baseline scenario of extension of the lower- and middle-income tax cuts, we estimate that full expiration would result in a further hit to GDP growth in early 2011 of nearly 2 percentage points (annualized).

5. Meanwhile, the slow-motion improvement in areas such as excess housing supply and bank credit quality is likely to continue.  This should add up to a gradual acceleration in growth to a trend or slightly above-trend pace by late 2011 and going into 2012.

The Goldman Sachs econ team gives a rousing “meh” to the new Obama economic plan:

The White House has announced three new measures to stimulate growth: 100% up-front depreciation of capital investments; a permanent and slightly expanded research and experimentation (R&E) tax credit; and $50bn in infrastructure spending. While potentially helpful, we do not expect these proposals to have a large effect on growth for three reasons:

(1) we are skeptical that temporary expensing of capital investments will alter corporate behavior, particularly in 2010 or early 2011; (2) the expanded R&E tax credit, while positive, is too small to have much effect on growth; and (3) additional infrastructure spending, which could have a more significant growth effect, seems the least likely to become law. To the extent that these proposals become law and do have an effect on growth, we would expect the effect to be concentrated later in 2011.

The econ team at Goldman Sachs is sounding worried. Here are a few snippets from a new report:

1.   Friday’s jobs numbers were disturbing.  At best, they show an economy that is growing only quickly enough to keep the unemployment rate flat near 10%.  At worst, they suggest that the labor market is once again turning down.

2. With inventory investment now again close to a normal rate, GDP growth is likely to converge to final demand growth, which has averaged only 1½% since mid-2009 and is unlikely to accelerate given the various headwinds facing the economy.

3. The weak labor market implies not only a great deal of hardship for workers, but also a growing risk of deflation.

4. So what is to be done?  On the monetary side, the possibilities include additional purchases of Treasuries and mortgage-backed securities, as well as TALF-like structures—i.e., special purpose vehicles that lend to nonbanks using equity provided by the Treasury and debt provided by the Fed.

5. On the fiscal side, we hope that Congress passes the extension of emergency unemployment insurance, continued aid to state and local governments, and at least a temporary extension of the bulk of the 2001/2003 tax cuts beyond the end of 2010.

6. A failure to enact additional stimulus—at a minimum, extended unemployment benefits, state fiscal assistance, and extension of the bulk of the 2001/2003 tax cuts—would imply a downside risk to our GDP and employment forecasts, specifically for 2011.

Can the Securities and Exchange Commission ride Goldman Sachs back to credibility? Perhaps, but it will take more than one high-profile lawsuit to restore the reputation of America’s top financial cop. L’Affaire Madoff was pretty close to a brand killer. But the move is powerful evidence — and warning — that the agency is out of the doughnut shop and back on the beat.

The all-points bulletin went out not long ago. Under the leadership of a new chairman and enforcement director, the SEC’s Obama years have marked a hard switch from the laissez-faire enforcement posture of the Bush administration. In 2009, the regulator opened twice as many investigations as in 2008, with fines up 35 percent. The new assertiveness helped tamp down talk on Capitol Hill that the SEC should be merged with the Commodity Futures Trading Commission or subsumed into a giant super-regulator.

But aggression can also lead to unforced errors. The regulator was impatient with the New York attorney general’s office during its tag-team litigation effort against Bank of America. So it dumped its legal partner and went it alone. The result: A judge threw out a $33 million SEC fine against BofA regarding bonuses paid to Merrill Lynch employees. And the judge called a later $150 million settlement between the two sides “half-baked justice at best”.

The SEC also failed to execute in its case against Cohmad Securities and the firm’s involvement with Bernard Madoff. In February, a federal court dismissed the SEC’s “flimsy” charges that Cohmad helped enable the notorious Ponzi schemer. And little has transpired in the more than nine months since the agency filed an insider trading complaint against former Countrywide boss Angelo Mozilo.

So a failed case against Goldman for alleged securities fraud might leave the SEC in worse shape. It would also open the watchdog to charges that the timing of its charges, right in the middle of a debate over financial reform, was merely an attempt by the Obama administration to intimidate Wall Street into supporting its get-tough legislation. But in the meantime, the financial industry will be looking hard over its shoulder for the first time in years.

A few thoughts on the SEC charges against Goldman Sachs:

1) Goldman Sachs gave the Obama campaign $994k during the 2008 election, his biggest donor. Doesn’t this undercut the theory just a bit that Washington is under the thumb of Wall Street?Even a tiny bit? (No, say Simon Johnson and James Kwak.)

2) I can’t help but think this boosts the odds of financial reform passing and a shift it to the left, as well. You might even see more GOPers advocate for breaking up the banks, as do some Fed regional presidents.

3) Certainly under the leadership of a new chairman and enforcement director, the SEC’s Obama years have marked a hard switch from the posture of the Bush SEC. In 2009, the regulator opened twice as many investigations as in 2008, with fines up 35 percent. The new assertiveness helped cool talk the Hill that the SEC should be merged with the CFTC pushed into a giant super-regulator

4) But its aggression can also lead to unforced errors. A judge threw out a $33 million SEC fine against BofA regarding bonuses paid to Merrill Lynch employees. The SEC also failed to execute in its case against Cohmad Securities and the firm’s involvement with Bernard Madoff. In February, a federal court dismissed the SEC’s “flimsy” charges that Cohmad helped enable the notorious Ponzi schemer.

5) A failed case against Goldman for alleged securities fraud might leave the SEC in worse shape. It would also open the watchdog to charges that the timing of its charges, right in the middle of a debate over financial reform, was merely an attempt by the Obama administration to intimidate Wall Street into supporting its get-tough legislation.

6) This is exactly the sort of scenario a bank exec outlined to me a few months back. The exec worried that the longer FinReg reform dragged on, the odds increased that some bolt-from-the-blue news would change the political calculus and push the bill to the left.

Goldman Sachs thinks 4Q growth could be as a high as 6 percent. But don’t think the firm is as cheery about the labor market despite the “stable” 10 percent unemployment rate in December. Some bullet points:

1. The persistent underperformance of the household survey strongly suggests that the establishment survey’s “birth-death model” is too optimistic and future “benchmark” revisions to payrolls will be negative.

2. Since December 2008, participation has fallen 1.2 percentage points, the biggest drop of the postwar period. If participation had remained constant over the past year, unemployment would now be over 11½%.

3. The combination of inventory-driven GDP strength and employment weakness is not good news because it means that we have “used up” a larger-than-expected share of the inventory boost without having anything to show for it in terms of employment.

4. The ISM composite index (a weighted average of manufacturing and nonmanufacturing) remains barely above 50. This is historically consistent with only about 2% GDP growth, which would not be enough to create jobs on a scale sufficient to push down the unemployment rate.

5. The parallels with the early part of the recovery from the 2001 recession remain substantial. Back then, the initial GDP release for the first quarter of 2002 showed 5.8% growth with a massive contribution from inventories. Meanwhile, payrolls stubbornly refused to show significant growth, and the employment/population ratio continued to drop. The GDP strength ultimately proved unsustainable, the economy slowed to a below-trend growth pace later in the year, and the unemployment rate didn’t peak until more than a year later.

Goldman Sachs has boosted its 4Q GDP outlook to 4 percent from 3 percent, yet continues to believe in the gloomy New Normal. Here’s why:

By our estimates, fiscal policy contributed around 2½ percentage points (annualized) to real final demand growth in the second half of 2009. …  The conclusion thus seems to be that fiscal policy has been responsible for most, if not all, of the growth of final demand in the second half of 2009.

While fiscal policy will remain supportive to growth for most of 2010, the size of this boost is set to decline, modestly in the first half and sharply in the second half. (Indeed, our current estimates imply a negative impact in the fourth quarter, although this is obviously subject to new congressional initiatives as the midterm elections approach.) This means that we need an underlying improvement in final demand just to offset the impact of policy through 2010. While we do expect such an improvement, we believe it will be U-shaped rather than V-shaped and hence insufficient to produce an acceleration in final demand growth once the fiscal pattern is taken into account.

Me: Moreover, the firm still thinks job growth will only average 100k a month, not counting census temps. If that number shot up to, say, 250k a month — a level that would really start lowering the unemployment rate, the firm said it might change its view that the private economy was still muddling through at a 2 percent GDP rate without government steroids.

This would be New Normal with extreme prejudice. Bad for Democratic incumbents in the 2010 congressional midterms, but it should make the White House political team nervous as well for 2012. If Goldman Sachs is right, of course. Here is the firm’s 2011 forecast:

The key features of our 2011 outlook: (1) a strengthening in growth from 2.1% on average in 2010 to 2.4% in 2011, with real GDP rising at an above-potential 3½% pace in late 2011; (2) a peaking in unemployment in mid-2011 at about 10¾%; (3) extremely low inflation – close to zero on a core basis during 2011; and (4) a continuation of the Fed’s (near) zero interest rate policy (ZIRP) throughout 2011.

That said we see risks that could upset these markets.  On the one hand, we might be underestimating the vigor of the economic recovery, and therefore the pressures for Fed tightening.  In addition, surging asset prices and worries about a “bubble” could prompt Fed officials to tighten before such a move seems warranted on real-economy grounds.  On the other hand, the economy (and the markets) could struggle under the weight of credit restraint for small businesses, weakness in commercial real estate markets, or fiscal tightening, especially by state and local governments.

The implications? I hardly know where to begin: a) with unemployment rising all next year, a GOP blowout in 2010; b) certainly more job creation packages; c) no capandtrade; d) increased anti-Wall Street/Fed sentiment; e) third party prez candidate in 2012; an Obama challenger in 2012 (Dean?). But who really knows. This would be like a technological singularity where seeing beyond the event is pretty much impossible. Such a Long Recession (essentially) would be so contrary to American expecatations — such a slow-mo, psychological shock — that it would be a full-out system perturbation equivalent to 9-11 or the Iraq War.

The PR folks working for Big Oil have to be breathing a sigh of relief these days. All the populist outrage that is usually spewed at the Exxons and Halliburtons of the world is being  redirected at Goldman Sachs — and its gleaming, glittering $2.7 billion second-quarter profit amid the wreckage of the American financial system.

The specific charge is that Goldman is supposedly making big profits via risky trading activities financed, in effect, by Uncle Sam.  Two pieces of evidence here: First, Goldman’s Value-at-Risk measure, a much-debated way of calculating daily losses, has  been steadily increasing.

Second, Goldman is benefiting from several government interventions and programs — such as the guarantee of its debt, an ability to tap the Fed’s discount window and its implicit too-big-to-fail status — that give it access to supercheap capital (thus the snarky nicknames “Government Sachs” and “Goldie Mac”).

To those who hate Goldman as a symbol for modern capitalism, that evidence is merely a current reaffirmation that the firm is a “great vampire squid wrapped around the face of humanity,” as a recent Rolling Stone article put it.

Rather than an example of succubus capitalism, a more reasoned and clear-headed analysis would see Goldman’s government-enabled success as a market distortion caused by an unprecedented government intervention into the private economy.

And to the extent that such fat profits would not exist without government and taxpayer backing, what should be government’s response to the distortion? New regulations to limit trading activities, perhaps, or a bailout tax paid by Goldman and other TBTF firms (We’re looking at you, JPMorgan.)

Then again, maybe what’s necessary is to remove the distortion. This is all so reminiscent of the constant worrying by good-government types about the influence of lobbyists and campaign cash on the political process. The usual suggested remedy is limits on political donations, whether in the form of cash or cash-in-kind such as independently produced political advertisements.

Of course, lobbying government is a rational response when government can tax, spend, regulate and subsidize this or that business activity to the tune of trillions of dollars every year. (Now there’s your vampire squid.)

So why not try an alternative response: Shrink government largess and power, thus reducing the need and incentive to influence it with campaign cash.

Goldman plays the lobbying game. During the 2008 campaign, the company (via its political action committee and employees) donated just under $1 million to the Obama campaign and just under a quarter of a million to the McCain campaign. And right now, it is unapologetically playing the bailout game, too.

It’s also worth keeping in mind that to some extent Team Obama wants banks to play the game, to take advantage of  government financing (as well as the Fed’s zero interest rate policy) to earn their way out of trouble and avoid nationalization or further direct federal financial aid needing congressional approval

Of course, if Goldman is out of the woods and acting more like a hedge fund than a bank, then perhaps it should be stripped of bank status and cut off from all government aid, as Charlie Gasparino of CNBC has suggested.

Yet even then, Goldman will still benefit from the implied TBTF guarantee. So one possible solution is to end that market distortion by preventing financial institutions from getting big enough to need rescue. Even better would be to end market expectations of government rescue, though that doesn’t seem likely under the current administration, which has embraced the TBTF policy by advocating the creation of a systemic risk regulator to monitor such firms.

Yet even then, Goldman, thanks to its huge role on Wall Street and Washington, is likely to be a popular target for populists across the political spectrum. What academic Bernard Lewis has said of the West also seems true of Goldman: “It is not possible to be rich, strong, and successful and be loved by those who are none of these things.”

Oh, and if Goldman is capable of generating bubbles, as the Rolling Stone article suggests, it might want to gin one up in oil and get people agitated about Big Oil again.