So, today’s data release showing a second consecutive weekly increase in new unemployment claims surprised many. The press called it unexpected. It was not unexpected or surprising here at CERF. In fact, it is entirely consistent with our forecast.

We think that GDP will decline modestly in the current quarter and in the first quarter of 2010. Then, we expect a very slow recovery, held back by over-leveraged consumers and businesses, but especially by a weak banking system. The recovery in jobs will likely be weak and trail the GDP recovery by a few quarters.

To answer the question, we think the recession is not yet over, and it probably ends in the second quarter of 2010.

I think Fed policy has been too tight. Instead of paying interest on excess deposit, they should be charging a fee. Of course, many disagree and worry about inflation, and that is what I thought I was reading as Shelton proceeds with her thesis that the Fed’s policy may be fueling a new asset bubble. This is pretty standard stuff, boringly standard in fact. I was about to quit reading and go on to something else when I came to a paragraph that stopped me cold:

“Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.”

That paragraph is breathtaking, so wrong on so many levels, so counter to what we know to be true. I couldn’t believe that an economist would say that. So, I looked for her tag line. Sure enough, it says she’s an economist. I did a web search. She’s got at least one book out. She’s in the WSJ frequently. She’s all for a gold standard.

Shelton received her Ph.D. in Business Administration at the University of Utah, and she’s a professor at the Duxx Graduate School of Business at Monterrey, Mexico. One observer—goes by Federalist on the web, but I couldn’t find a name—described her as having few credentials. I don’t think that is exactly true. She has impressive credentials, just not as an economist.

Let’s correct her paragraph:

No one is going to mistake me for a Keynesian, but I’m certain that deflation is bad. Economists in general, not just Keynesian, know deflation is bad. I don’t know of one credible economist, from a top 50 school, with a Ph.D. in economics, who believes that deflation is not bad.

Shelton goes beyond saying deflation is not bad. She claims deflation is good, stimulative, spurring economic activity, “enabling struggling consumers to get back in the game.” Amazing.

Here’s the story on deflation: As prices fall, no one has an incentive to purchase anything, the cost will be less tomorrow; consumption and investment decline. Borrowers pay with deflated dollars, making real interest rates very high, again leading to less investment and consumption. Wages don’t adjust quickly, leading to unemployment, 25 percent in the depression. Asset values decline, but debts become more burdensome, leading to credit defaults and over-leveraged banks, businesses, and consumers. Lending, borrowing, consumption, investment, and economic activity decline.

One problem of smart people pontificating outside their field is that they come up with ideas that sound good, don’t hold up to serious analysis. Economists have performed a huge amount of research on inflation and deflation, empirical research and theoretical research. The profession has rejected the thesis that deflation is good. The risk is that someone with authority listens to someone like Shelton and tries to implement her recommendations. That would be tragic. Bad policy leads to a bad economy, and the costs of a bad economy are immense and not just financial. Serious recessions change lives, usually for the worse. Careers, families, and lives are destroyed. It is a shame that Shelton has a mouthpiece as big as the Wall Street Journal.

Yesterday, the FDIC released bank charge-off data, and it was disappointing and scary. I’ve posted the chart below.

It was well publicized last December when banks charged off record amounts of loans. At the time, I was hoping that it was a one-time cleanup. It wasn’t. Banks charged off approximately $50 billion in the second quarter, up from about $40 billion in the fourth quarter of last year and the first quarter of this year.

The reason this is so scary is that we can’t have a vigorous recovery until banks are recapitalized, and they can’t be recapitalized until charge-offs decline. This is another sign that, while the recession may be near its technical end, we are a long way from recovery.

While it is possible that GDP growth will be positive in the 3rd quarter, we believe that the private economy will be weak for some time to come. The evolution of this recession could look like a “W” or an “L”. GDP growth rates will be small, sometimes negative or near zero, with occasional bounces that will be driven by temporary household and/or government expenditures. If GDP is recalculated without foreign or government influences, then 2009 quarter 2 economic activity declined by 4 percent, see my August 5 blog on this topic. Real estate delinquencies and foreclosures continue at historically high levels. It appears that the tide of commercial foreclosures will continue to rise. Foreclosures hit the economy hard, having serious negative consequences for both Main Street and Wall Street. US economic growth might be positive in 2009 quarter 3, but the factors driving economic activity may conspire to reduce GDP growth in late 2009 or early 2010.