Economics
Curb your enthusiasm
ECONOMIC optimism fills the air, like the petals of the cherry blossoms around the tidal basin. On its front page Thursday the Wall Street Journal declares, "Evidence mounts of strong recovery." USA Today blares, "New jobs fan rising economic optimism." Newsweek's cover proclaims America "The Comeback Country" and Bloomberg BusinessWeek tells us, "Obamanomics is working better than you think."
Curb your enthusiasm. Yes, the economy is recovering, as everyone save the nihilists expected. However, the debate ought to be about the strength, not the fact, of the recovery. At the risk of gross oversimplification, the debate is this: do we follow the strong recovery model (the "V") which holds that deep recessions are followed by strong recoveries, or the weak recovery model (the "U") that holds that recessions caused by financial crises are followed by weak recoveries? I have long been in the latter camp. In fact, I describe my forecast as "reverse square root", sort of a cross between a V and U (credit to George Soros for the term): an early cyclical rebound followed by muted growth. I'm still there.
Wait a minute, didn't The Economist lead this cheerleading with a cover proclaiming, "Hope at last"? Well yes, but our hope concerns the composition of growth, not its magnitude. We think (or hope) that in coming years, exports and investment will lead, consumption and housing will lag, saving will rise and the current account deficit will shrink. That can be true whether growth is weak or strong, although it would be infinitely easier were growth strong. (In fairness, most other news organisations have not equated these green shoots with a V.)
I find it interesting that amidst all this optimism and the stock market's solid rally, the Federal Reserve has not lifted its own economic forecasts. Don Kohn, the vice-chairman, said last week that his outlook hasn't changed since October; things have more or less progressed as he expected. Kohn also subscribes to the post-crisis recovery model.
Now, to the evidence. So far, the magnitude of growth does not validate the V. GDP fell more during the 2007-2009 recession than in either 1973-75 or 1981-82 and has recovered less. Assuming GDP grew 3% (annualised) in the first quarter, which is the consensus, then it will be up 2.8% (not annualised) in the nine months since the recession ended, compared to 3.8% after 1975 and 5.6% after 1982. Yes, employment is finally rising, but as The Economist notes, its performance is far worse than after other recessions.
Second, the composition of growth looks unsustainable. A disproportionate amount so far has come from inventories which are not a sustainable source of demand. Relative to expectations, final demand is a wash: consumption has been stronger but housing has been weaker. Our special report argued consumer spending cannot lead the recovery because wealth has been devastated and credit is tight. Contrary to that thesis, consumption has outgrown income in the past quarter, saving has declined, and the trade deficit has widened, though only a bit.
Can that be sustained? Yes, if credit were flowing easily. V shaped recoveries derive their shape from the Federal Reserve: when it tightens, it suppresses interest-sensitive demand. When it eases, it unleashes pent up demand. But after a financial crisis a traumatised financial system stops the benefits of easy monetary policy from reaching households. Banks have tightened their underwriting standards, and even if they hadn't, many households wouldn't qualify with their homes worth less than their mortgages. Meanwhile, the shadow banking system of securitised loans, though coming back to life, remains (ahem) a shadow of its former self. Bank credit may have stopped shrinking but it has collapsed by more than it seems. Economies can grow while credit contracts but American and international experience says they don't grow rapidly.
Banks are healthier than we had a right to expect a year ago for which Tim Geithner deserves credit. But the new narrative about Geithner"”that he braved political peril to pursue the most economically effective solution to the crisis"”is too kind. That would have meant spending hundreds of billions of public dollars buying up, and extinguishing, bad mortgages. He did not. (I don't really blame him"”the politics were lethal.) Those mortgages still clog the financial system and will continue to until banks have earned enough to write them off without endangering their capital.
An important reason for caution is that much of the recovery we've seen so far is down to fiscal stimulus. It probably accounted for half of the estimated 3% growth in the first quarter. Its contribution will turn negative by the third quarter. We need a virtuous cycle of incomes and spending underway by then, which means stronger job creation than we've seen so far. I still think it will happen. The economy is highly unlikely to dip back into recession; 3% growth seems a safe bet. But I don't yet see the makings of the 5%-plus growth that would characterize a V, though I'd love to be wrong.
The underpinnings of growth are fragile enough that monetary policy should still err on the side of ease. The Federal Reserve can take its time about tightening, either conventionally or by selling assets, since core inflation is running well below its 2% target. For fiscal policy, the equation is more complicated. Were market conditions no object, it too should err on the side of ease. But deficits and debts are on a dangerous trajectory. With downside risks to the economy shrinking, Obama can afford to let stimulus expire, and rely on a patient Fed to keep the recovery alive. But he should remain alert to the risk of a stumble in the third quarter"”in which case, all bets are off.
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1st, the stock market rally is due to people more willing to take on that risk. Sure people are buying things, but they are gaming the housing market, betting on a bailout.
"In the state of California, for example, more than 10% of credit card-carrying consumers were choosing to pay that bill rather than their mortgage as of last fall, according to a recent study published by the credit reporting agency TransUnion."
"The TransUnion study revealed that the number of consumers who were delinquent on their mortgage but current on their credit card stood at 6.6% in the second half of 2009, up from 4.3% at the start of 2008."
http://money.cnn.com/2010/04/15/news/companies/consumer_debt_payments/in...
Just as things can't go up forever, things can't go down forever.
"If something is unsustainable, then it will stop." - Herb Stein
Regards
Within the limited scope of my reading, the V-shaped recovery has only been mentioned for a quick dismissal. Rather than bulls and bears, I'm looking for economists to read who, having accepted a long, slow road back to economic health, debate the merits of policies and practices best suited to making anemic growth temporary and tolerable.
To start the party, I think if the sustained return to real (mild) growth means anything it should mean this: The first wave of policies meant to slow the contraction by encouraging the pre-crash mix of behaviors are now obsolete and should be allowed to lapse.As one example, while I agree that things are still too flaccid for monetary policy not to err on the side of laxness, it seems like a good time to start leaning slightly towards tighter credit.
Thinking about a horrifying chart from another of the blog entries, what does GDP growth look like if you subtract the taxpayer-financed rebound of financial sector profits? Profits which aren't translating in to credit availability for small business or lower rates for revolving consumer credit? Profits which are still insanely allocated to bonuses for the main culprits of our present crisis?
My big picture view is much dimmer. All the debt--private and public--represents GDI borrowed from the future (as has been argued here before, I'm a proponent of GDI as a measure of beneficial economic activity). If you subtract the added debt over the last quarter things are still contracting. The stagnation of inflation adjusted wages over the last 40 years suggests to me that perhaps our economy really hasn't grown at all since the 70s. We've borrowed all our supposed growth, and redistributed from the middle class and investment toward the wealthy and consumption. From that view, the road ahead is ugly and necessarily filled with sacrifices of all sorts. Let's just hope the one thing that isn't sacrificed is investment. Otherwise it's going to be more than ugly and for much longer.
Pacer,
The stagnation of wages...
Perhaps the demand curve for labor shifted over that period, but due to Boomers and GenXcessers, the supply curve of labor shifted.
Perhaps the gains that were made were eaten up due to employer health insurance costs.
Just a few things to think about.
As for debt growth stoking GDP, you are correct. Regards
How exactly are banks going to earn enough to write off their losses on their bad mortgages? Putting aside the concern that most of these mortgages are worth nothing (to the tune of 1-2 Trillion in losses); where are the banks going to make their money?
They previously made their grossly distorted profits through loose credit and fradulent mortgages; are they now supposed to find a way to make huge profits without spurring on another bubble?
Perhaps they'll get their hands on Social Security and play with that money. That'll give them the short-term profits they love so much; it'll destroy Social Security, but we don't seem to care if Finance destroys us or not.
My impression is that most of this growth is due to the billions diverted into the finance industry, at future cost to the Treasury, and billions into state and local governments for short term stimulus projects and stabilization of state and local spending while their tax revenues were contracting. As the stimulus spending is wound up, expect that state and local governments will have to contract their employment and wages and benefits. CA, NJ, IL and MI are the basket cases - they look like Greece without the possibility of an IMF bailout. Until we see business investment beyond inventory growth, we do not have sustainable growth. With factory utilization in the low 70%, it is not clear which industries will be making the investment. Government spending at the current rate is not sustainable. In Indiana, local school boards are offering early retirement to teachers so they can hire cheaper inexperienced teachers and dump the old teachers onto the state's pension rolls. This is not saving money just reassigning who gets stuck with the cost. But it is reported as growth. With so much distortion in the economy, it is very hard to discern what is really happening.
No one in his right mind thinks this is going to be easy. We're not all that far from the edge.
Doug:
The truth will make you free (credit where due - Jesus said that). My extension is that lies make you a slave. The banks are slave to a lie - that all that dreck on their balance sheets is worth what it's marked at. The economy can't grow strongly until lending resumes; lending can't resume because the banks are trying to hide the truth of their balance sheets rather than face it.
Of course, if they faced the truth, a bunch of them would be insolvent. But that would be good for the rest of us in the end, because the management that got them there would be removed, and the Feds would step in and clean up the mess. That would be expensive, but IT WOULD ACTUALLY HELP, unlike much of the government intervention so far, which, if it helped, did so mostly around the edges. (The reason that the intervention would actually help is that it would leave banks that were properly capitalized, and therefor able to lend.)
"Contrary to that thesis, consumption has outgrown income in the past quarter, saving has declined, and the trade deficit has widened, though only a bit.
Can that be sustained? Yes, if credit were flowing easily. "
I thought this crisis was partly because of the fact that, no, growth based solely on credit cannot be sustained.
As for the excellent comments in this post, I have to say I agree with you all. I see a grim situation in which our economy has no clothes, yet no one in power can actually say it.
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
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