OECD LEIs Raise Some Bright Red Cautionary Flags

The OECD trend restored leading indicators show that a slowdown is in progress. The OECD likes to look at its indices in terms of changes over six-months and on that basis the overall OECD, the OECD-7 and the US OECD LEIs all are not just showing less lift than they were six-months ago but are declining in absolute terms. The six-month percentage changes are plotted in the chart above and show the historic record of this indicator in picking out recession episodes since 1980 (we plot all data Vs the US recession cycles).

The US LEI has dipped below zero over six months on several occasions in the past without there being a recession. The current dip is relatively shallow as recessions bring dips on the order of minus six percent (or worse). But, of course, declines that large do not appear right at the outset of recession, the move lower tends to gather pace. So at this point we must be guarded about what this fall-off means. For example, ahead of the US 1991 downturn the US OECD LEI went from a drop of 2.% over six months in August of 1990 to 3.8% by August and 5.95% by January of 2001. The progression to a large decline can be swift. That is a period of five months. Current data are for July. Five months from where we are in real time is December just three-months away, not five. Three could be when it happens but five would be when we would ‘know it.’

Not surprisingly the US indicator is more volatile than the OECD indicator. The US indicator is part of an averaged OECD conglomerate while the US index alone is not averaged in with other countries’ results. Averaging is a process that would tend to blend the data and smooth out the highs and lows. When averaged in with the rest of the regions the OECD result is somewhat damped compared to the US result when it stands alone. For that reason perhaps we should be a bit worried that the OECD index is down more sharply that the US index over the most recent six months. That is unusual.

Even though, in the chart above, the US and the OECD lines track closely you can see that when the OECD slips into recession (when the index falls sharply) the blue line (for the US) usually is below the red line (for the OECD). But as of July of 2011 it is the OECD index in negative territory and leading the way lower, below the blue line that depicts the US situation.

Most of the time when the OECD index is weaker it is during a period of expansion when the US is growing more strongly (not less slowly). Right now that is certainly not the way I would describe the world economy.

Europe’s debt problems are weighing heavily on Europe. Japan is still struggling as it is not mounting even the kind of post disaster growth that had been expected of it. That is partly because of the sudden strengthening of the yen that has Japanese authorities worried that the extreme strength of the yen coupled with rolling electricity shortages that could exacerbate the trend toward outsourcing on the part of Japanese firms.

While a widely publicized and thorough study by UBS has documented the sorts of costs a Euro-Area break-up could have, history tells us that these sorts of calculations made in the past have not always prevented countries from cutting off their noses to spite their faces and, moreover, sometimes that trick has resulted in a better looking profile! The resignation of Juergen Stark from the ECB board has highlighted German resistance to the sorts of policies being conducted at the ECB and of German resistance to continuing to finance that which seems to need more and more financing. I have written several times about, and continue to point out, the eerie similarities of this EMU crisis to the interwar period and the decision by the UK to go back to its pre-war gold parity because that was the ‘financially responsible and proper thing to do’ according to most experts at the time. However, eventually letting the pound devalue proved to be much better medicine for the UK economy which was uncompetitive at the higher gold parity.

Similarly the Euro-Area has many countries trapped in what can be construed as a fixed rate system with exchange rates that are far too high (price levels that have crept up Vs Germany’s since admission to the Zone). For example, the Greek price level has risen 25% above the price level in Germany since Greece has joined EMU. Put all the financing needs aside and ask how can Greece surmount that- a 25% price disadvantage? It is the ‘same’ as having an overvalued currency under the gold standard except it is problem harder to fix with only one monetary policy for the whole of the region in which you have the price disjuncture.

It may be that the UBS calculations are correct about the price of leaving the euro but another plan is for the strong to leave the euro and keep the weak in it. That would be cruel fate for Mario Draghi who would then be the captain of a lesser ship. Certainly a lot is in train here. The recent pressure on French banks reminds us that markets are starting to mark Greek (and other) debt to market already. Once the market has done this, much of the pain will have been reflected in the important balance sheets. Leaving the euro or being left in a softer, weaker, euro zone would still be painful, both those who leave and those who stay. Choosing sides would probably be most difficult for France and perhaps for Italy, but Italy may not have a choice of where to go.

It is a very interesting experiment. I wonder if the Zone fails if it will cause economists to rethink their love for optimal currency areas (OCAs)? Are they rethinking it all now? Is there any such thing as an OCA that does not really meld itself into a single unit including fiscal policy? Europe’s choices may have a lot to do with the answer to this question. What is at stake here is less about economics and more about how Europe wants to view itself and if Europeans long to be European first and think they can find common ground.

Are the Germans willing to become a little less ‘German’ and are the Greeks willing to become a little less ‘Greek?’ If not the union is not long for this world. For what is at stake here is more than just financing. It is about fundamental social values, the role of government, the willingness to pay the taxes you owe and so on. We know that Germany is willing to suffer great pain to unify with a region that shares its values. That is a clear lesson from the re-unification of Germany. But is Germany willing to undergo some pain that also requires it to lose some of its identity? That is the 64trillion euro question. We ask it of each country that would stay stuck in this union.