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The Economy Slows Down

As we all thought, our economic growth slowed dramatically in the first quarter this year. The headline figure you will be reading about is 1.8% growth, down from the fourth quarter of last year when growth was 3.1%. What you will not be reading is the sneaky rounding up involved to get us to that 1.8%! To two decimal places growth was 1.75%. So being more accurate makes things appear a little worse. No big deal, but indicative of the efforts going in to make the headline look as good as possible.

Here’s the breakdown by major category:

  • Consumption 4Q 2010 .. +2.79%
  • Consumption 1Q 2011 .. +1.91%
  • Private Investment 4Q 2010 .. -2.61%
  • Private Investment 1Q 2011 .. +1.01%
  • Net Trade 4Q 2010 .. +3.27%
  • Net Trade 1Q 2011 .. -0.08%
  • Government Spending 4Q 2010 -0.34%
  • Government Spending 1Q 2011 -1.09%

These figures are what is called the “advanced” report and so will be subject to quite a bit of revision. Even so, it seems that the economy cooled off which could be cause for concern. Or perhaps not as long as the declines can be explained away as oddities unlikely to be repeated. The problem I have with these explanations based on “quirks” is that the economy is replete with such things. There are usually one or two odd numbers that appear to have “one-off” explanations. So there is always an element of forth masking the underlying trend. This is why forecasting the economy is more divination than science – despite all the high paid analysts in the media and at the investment banks.

With that in mind, let’s look at the data.

Obviously the key is personal consumption. It amounts to such a large percentage of the whole that any shift there can make the entire economy move. As you can see consumption faded strongly in the first quarter. One reason could be that bad weather kept people away from stores and that the decline will be offset this quarter as better weather sets in. Frankly there isn’t a great deal of more recent evidence to support that view. Retail sales have been decent, but not great at all. A different view is simply that households have pulled back a bit because unemployment has not improved significantly, home prices are still falling, wages are flat, and debts still need paying off. The accumulation of these factors outweighed the need to spend. hence the decline. I think we will experience this kind of stop-start activity for as long as consumer confidence is depressed. Even though April’s confidence figures showed a slight jump up, they are still not suggestive of strong spending.

The big shift from negative to positive in private investment could be interpreted as businesses preparing for expansion. That would be wrong. Recent durable goods numbers do suggest such a trend. But the first quarter investment turnaround was driven entirely by inventories. Other forms of investment hardly moved at all. As I have said before inventory accumulation is a highly ambiguous number. Sometimes a run up in stocks of goods is a sign that retailers expect high sales and thus are gearing up. Other times an accumulation represents a rise in unsold goods because consumption has fallen away and retailers are stuck with an excess. Which is it now? Looking at the hints I find it hard to tell. A rise in imports along with a rise in inventories is usually a sign that retailers are getting ready for higher sales. That’s a positive sign. I think we should take this first quarter accumulation in this light since it offsets the overly large run down in inventories at the end of last year.

Unfortunately the more telling aspect of the investment numbers are much the same as they have been for a while: weak business investment, and very weak residential investment. Businesses are showing some signs of adding to their capital stocks, but as long as the economy has as much excess capacity as it does, there is no real need to add rapidly. And, of course, we all know that real estate is in the doldrums and likely to stay there.

Trade, too, showed a big shift. The sudden drop in contribution to GDP from trade was driven entirely by an equally large change in imports. This was expected because the fourth quarter saw some very strange and large declines in imports that were not sustainable. All that occurred in the first quarter was that we resumed a more normal level of activity. The bad news was that exports faded a little also, so the resumption of a more normal pattern of imports was not offset by stronger exports.

Lastly, government spending is trending down. This may shock the “big government” hawks, but the numbers don’t lie. Federal spending dropped 0.68%, mostly on the back of a decline in defense spending. This is a notoriously volatile figure depending on bulk purchases. So I don’t think it is indicative of a trend. More importantly, both Federal and State spending on small ticket items and wages is falling steadily. This is the trend to watch. Especially as the deficit debate heats up. We have gone from a point where government spending was acting as a stimulus, to where it now acting as a drag. Presumably this is what the austerity hawks want. It is inevitable that, if government spending is cut, it will act to shrink the economy. We can use the UK as an example. There is an austerity program already in effect in the UK and its negative impact has slowed their economy to a crawl. They are perilously close to recession. Given the relative weakness of our private sector, any strong move to cut government spending runs the risk of doing the same here.

This is all tedious to recite.

What should we make of it all?

The economy is evidently not so strong that it can withstand a bout of bad weather. If that is the key explanation being offered to explain the first quarter decline, then we are not in great shape. This seems to be a very slow recovery, and one that is still very susceptible to downside risks. I suppose there is no news in this, but it should give us all pause to reconsider the current mania for deficit cutting and inflation fears.

Neither the deficit nor inflation should be of great concern right now. The focus should be on unemployment and the huge slack in the economy that such unemployment implies. We have too large a pool of idle workers. That means we are radically underperforming in terms of wealth generation. We are leaving money on the table month after month. This affects us all, not just the unemployed. It would be sensible for us all to be involved in getting those people back to work. That means more support, through both continued easy monetary policy and deficit spending fiscal policy.

This won’t happen, of course, because the powers that be have moved on to combat their imaginary demons of inflation and deficits.

This is looking more and more like the 1930’s.

That didn’t work out too well.

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Do We Need Economists?

Not really.

They don’t seem to add much value.

This will not shock many of you, but it should cause some reflection amongst economists. The basis for my reflection on this is the comment Brad DeLong made recently that the solution to the economic and financial crisis could be found in ideas developed in the 1930’s, and in some cases in the 1890’s. So, to the naive eye, it is worth asking what have all those economists been doing since?

Not much apparently.

Well, one thing they’ve been doing a lot of is arguing. Take, for instance, the current spat between Paul Krugman and John Taylor. Both extremely well educated and intelligent economists who have very different interpretations of the recent increase in government spending.

One the one side, Taylor suggests that there has been an enormous increase in the government. As you know such an increase is a red flag to right wingers like Taylor, for whom the magic of the market is sacrosanct. To him the absorption of so much activity into the inefficient realm of “big” government is a dangerous sign of imminent demise for us all.

On the other side Krugman responds by pointing out that, while the increases are real, they can be explained not by resort to criticism of Obama and his supposed “big government” agenda, but by simple arithmetic. Since the private sector has shrunk, as it does during a recession, and government safety net spending has risen, as it does also during a recession, the apparent increase in government as a percentage of the economy is ephemeral. It is a manifestation of the private sector’s implosion, not the public sector’s explosion.

Ah, says, Taylor: that’s fine in the short term, but why is government still growing out in the future, let’s say in 2020, after the effects of the cyclical shift are presumably corrected?

Krugman answers that one with ease as well: demographics. Lots of demographics. Without one single policy added by Obama government spending will rise into the foreseeable future as the baby boomers all retire and start becoming part of the Medicare and Social Security world.

Phew.

Two grown up and highly educate economists adding very little to anything except to display their respective ideological views. Both right in their own way. Both wrong in others.

Then there is the inestimable Robert Lucas, whom as you all know I blame for the current irrelevance of economics to economies. Yes I know I am being unfair, so I apologize, but I feel I am allowed to be. Why? because Lucas, on one hand argues that economics should stay clear of practical policy making since it is simply the study of utopian systems – his words not mine – and is thus only precariously tied into reality where policy must be made. Then on the other he thinks nothing of appending his name, and thus his prestige, to letters to Congress urging draconian cuts in government spending. That’s called trying to have it both ways. Or hypocrisy. Depending on how harsh you want to be.

The point is this: economics is a giant mess. Economists know this. They excuse themselves by saying that it has always been this way, and that scholarly disagreements are the stuff of academic progress. From this hurly-burly springs forth new ideas and thus a greater contribution to society. So they say.

Except.

As DeLong points out, this argument is going nowhere. Indeed it seems to be preventing progress. It has simply devolved into an ideological spat. And is making economists appear useless. There is an economist to defend any hair-brained policy proposal. Anything a politician cares to suggest can be given a well argued, and reasonable defense by a well respected and tenured professor from somewhere.

And when economists are hopelessly wrong? Are they fired? Are they pilloried and thrown out of their tenured positions to suffer the voluntary unemployment lines they condemn others to? Dean Baker has recently thrown a hissy fit over this. Of course not. Failed economists are a dime a dozen in our best schools. They are still teaching whatever they first thought. No amount of empirical data threatens their prestige. Why? Here’s the great scam: because economics is a self-contained, self-referential pursuit disconnected, very deliberately and carefully, from the dangers of having to be useful. It is thus immune from disproof. All that Popperian conjectures and refutations mumbo-jumbo is not applicable to economics. Economists have constructed their world so as not to have to be practical. Instead they are quasi-philosphers, quasi-mathemeticians, quasi-physicists, quasi-psychologists, and quasi-sociologists. By so being they can dodge between the bullets of practical questioning and never have to improve their art. Being quasi-everything is a great defense. You can confuse all the specialists and answer to no one. Except yourself.

Think about this for a moment.

No one doubts that the study of economies is a very serious and potentially socially valuable pursuit. Most of its great advances have been at times when there were big political and social upheavals and dangers that required insight into the way in which an economy works. A real one. Not a made up one. Early economists were intrigued and influenced by the processes and challenges of industrialization. Prior to that they had been embroiled in arguments over taxation and trade, both of which were contentious and relevant topics to the newly emerging nation states of the 1600 and 1700’s.

Then along came Marx, who thundered away at the disruptive issues of early capitalism and its satanic mills. His critique was sufficient to demand a right wing response, which came in the form of marginalism and Walrasian systemic thinking. Those advances were an attempt to make economics scientific and thus immune to the implied Marxist charge that the early theories were simply justifications for capitalist favoring policies.

That attempt to shift economics from being politically motivated towards being scientific, and thus cleansed of political taint, gathered momentum and led to even greater discord in the 1930’s and later. One part of economics wandered off into the supposed safety of the self referential community I mentioned above, content to manipulate ever more abstract models until it ended up with people like Lucas openly calling his analysis utopian. The other channel was filled with people trying to engage a more “realistic” set of theories that recognized the vagaries and complexities of the world. But because those vagaries are intractable, or have been, to the tools economists inherited from their political economy origins, and because much of the subject’s key topics are still framed in 1800’s terminologies these realists have made less of an impression. They don’t appear as scientific. Their models are kluge-like and not filled with impressive mathematics. So the so-called scientists won. They invented “positive” economics, where theoretical discussions disdained empirical proof, and where math wizardry counted for more than connection with practical policy.

Which is why a recent poll of economics post-graduate students showed a belief that being good in math is more important to being a good economist, than knowing anything about the economy. Abstraction for abstraction’s sake is the watchword of modern mainstream economics.

This, in turn, is why DeLong is correct: our crisis could be solved using old ideas. Thus, I wonder whether we need economists. Especially those who don’t study real things.

I know. I know. This is all old stuff. But it continues to irritate me. Especially when we see supposedly big name economists wading into politics and advocating policies that will have a huge impact on the lives and futures of millions of their fellow citizens.

You’d think that, at the very least, they would stress test their advice. That they would check their theories against some evidence of their efficacy. That they would have the ethical decency to do no harm. Before, that is, and not after, they urge policies whose consequences, both intended and unintended, we all have to live through.

Is that too much to ask?

And if not, why do we need economists?

If we are to salvage economics from its current cul-de-sac, and I for one hope we can because of its enormous social consequences, we need to acknowledge the failure of its positive tradition. All economics begins with ideological content. It cannot avoid its attachment to politics simply because it is seeking answer questions that society asks, and which society will benefit from. And such a process is carried on within a political framework.

So there are as many forms of economics as there are political positions. And economics is an archipelago not a continent.

There’s nothing wrong with that. It’s called being realistic.

We should just make sure we teach it that way, and not as a monolith.

But that’s another question.

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Good Capital Goods

Just a quick note on a busy day to pass along the news that durable goods orders rose at a decent 2.5% clip in March which suggests that manufacturing is still on the rebound. February’s data was also revised to show a slight 0.7% increase – originally it had been a decline.

The key here is to focus on the non-defense and non-transportation number. Both those sectors include very chunky items that can distort the underlying trend. So we exclude them when we want to get an idea of how much manufacturers and businesses generally are spending as they gear up for higher production. That adjusted figure, known as core capital goods, showed a healthy 3.7% increase. It is this report that supports a slightly more upbeat view of manufacturing. It also contrasts with some of the data we were seeing in the last few weeks that suggested a breather in the rebound. Perhaps that breather was weather related. In any case today’s news should be cause for cautious optimism.

My expectation remains for modest growth throughout the year. Not good. Modest.

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Home Prices Fall Again

One of the factors weighing down on consumer sentiment is the persistent fall in home values. So it is worth noting today’s report on the Case-Shiller Index, which showed yet another month of decline – by 1.1% in February, the latest month of data available.

The index is a composite of prices in the top twenty housing cities in the country, and of those twenty only one, Detroit, has an increase in February. And only one, Washington DC, has shown an increase over the past twelve months.

Clearly the real estate market is still stuck deeply in the mire of the aftermath of the bubble. Indeed, after a brief rise in prices in late 2009 and early 2010, the market has either moved sideways or fallen slightly. We are now very close to giving up all that slight recovery. Prices fell 3.3% overall in the last year and are still headed down. Since the peak in prices back in 2005 they have fallen 32.5%.

The market is plagued by problems in both supply and demand. On the supply side there remains a very large, but not clearly defined, ‘shadow inventory’ of homes people would like to sell but which are not actively listed for sale because of low prices. The glut of foreclosed properties is also exerting downward pressure, and making it difficult to determine exactly what a sustainable price is in some areas. Even after the dramatic collapse in construction the supply of unsold new homes, at about 7.5 months worth of sales, is well above levels we see during times of healthy economic activity. On the demand side, even well qualified buyers are having a hard time finding financing as the banks do their usual about face on credit standards – banks always overcompensate for their sins, and hence add volatility to the very markets they complain about being volatile.

One of the great ironies of this cycle has been that an incredibly loose monetary policy has had little effect in boosting the interest rate sensitive aspects of the economy. With mortgage rates as low as they have been, we could have expected a more rapid recovery in housing. But the enormous drag of unemployment and the ongoing fragility of banking have overwhelmed the Fed’s efforts to boost activity.

When will this decline end?

Who knows.

In many respects we are at risk of overshooting the bottom in prices. By this I mean we are likely to see prices drop below the long term trend that affordability ratios suggest is the “normal” level around which prices cluster. The problem at the moment is that stagnant wages are preventing that long term trend line form rising, and the other factors, all of which are short term in nature, are thus dominating price formation.

Look for prices to keep on going down. One respite could be during the spring months as buyers sense interest rates might rise. In view of such potential they might be impelled to buy now rather than wait for even lower prices. Don’t bet on it though. Consumer sentiment is rotten despite April’s slight increase in confidence. Those higher gasoline prices are going to sap away at confidence over the summer, so, in the absence of a sudden pick up in the jobs market, I expect housing to fester all year long and well into next year too.

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Where Are We?

It’s tough to tell exactly how the recovery is going. Since this is a busy week for data reports it behooves us to step back and set the stage.

If you recall, at the end of last year the economy was growing at around 3.0% to 3.5% at annual rates. That was a marked improvement, but not earth shattering in the context of post-war recoveries. The general opinion was that we would pick up speed into the first quarter before settling down into a post-recovery ‘normal’ period of steady growth. I was always a slight dissenter to this view because I put more emphasis on our lingering unemployment problems, the risk still abundant in banking, and the downward weight resulting from the real estate collapse. Plus the fourth quarter had one or two oddities – trade and inventories – that pulled reported growth from its underlying trajectory. So my view was that growth would stick in that 3.0% range and then fall a little as we went through this year.

It looks as if we were all wrong.

The problem with the first quarter, we sill see the initial estimate this week, is that the string of oddities has continued. This time things like the very bad weather have taken their toll, and so we should all expect a much lower growth rate than originally thought. If we use the so-called Blue Chip consensus as our guide, the original commonly accepted growth rate was somewhere near 4.0%. This was based on the idea that the recovery was still accelerating, and had not yet peaked, and that consumer demand was bouncing nicely away from the depths plumbed in the recession.

Now that same consensus is looking for a first quarter of 1.7%, with the dramatic revision due to the weather and the fact that consumers have turned much more pessimistic again.

Apparently, one bad winter, and a sudden spike in oil and food prices, have done the recovery in.

So much for robust.

This, in a roundabout way, supports my view, although I make no claim for prescience. The issue is straightforward: as long as unemployment is high, and as long as home prices are weak, households will not shake off their sense of siege completely. It won’t take much to set them back into a savings mode. Likewise, banks may be reporting solid profits – or at least some of them are – but much of the improvement is coming from changes in loss rates, and trading rather form the basic banking that engages with the real economy. This is why I still think we are in a long haul and slow recovery, rather than in the middle stages of a typical post-war bounce back.

Add in the short term rise in consumer inflation caused by those food and oil price increases, and the mood has changed quickly.

This morning’s data on real estate is illustrative.

Sales of new homes in March climbed well: up 11% from February. On its face this is solid. But February was especially depresses because of that bad weather, so a large share of the rebound is simply the working off of a mild backlog. The average between the two months gives us a better longer term measure of sales, and that is essentially flat. Couple this with the news that builder expectations are still at incredibly low levels, and that the inventory of unsold new homes, at 183,000, is stuck somewhere around its 1967 levels – i.e. at near all time lows – and any image of recovery pales away to be replaced by one of decidedly abnormal and low activity. Certainly nothing in real estate suggests a return to good growth. Right now moderate growth would suffice.

The reason I am belaboring this is that when GDP for the first quarter is announced we will all be trying to divine its import for the rest of the year. I am arguing that it may not be much of a signpost at all. It may be too riddled with quirks. That implies we are better served looking at the more frequently announced numbers to get an idea of the general health of the economy.

And those numbers support a very modest outlook.

So what are the risks or problems that prevent us from moving along at a great clip?

  1. The absolute size of the hole we dug back in 2008/2009. This was one mother of a recession, and it has left immense slack throughout the economy. Until that slack is picked up there is little to no incentive for businesses to invest. This is despite interest rates being at ludicrously low levels. Some analysts argue that the Fed’s loose monetary policy has had no discernible effect on investment and thus is a failure. I disagree. It wasn’t a bust. It wasn’t a roaring success either. It just was. It is tough to critique the Fed when the entire system was so close to crumbling. Let’s all remember: the private sector vanished in very short order. Were it not for the government we would have vanished along with it. Business is rightly cagey when faced with skittish consumers and goods of spare capacity. So we can take robust investment off the table as a driver of near term growth.
  2. Austerity budgets will cause at least short term pain. They probably will cause long term pain as well, but that’s not our issue here. Luckily for us the debate will ramble of for a while, so the impact of less government spending will not be hugely significant this year. But it will be a real and noticeable drag when it does show up.
  3. Unemployment is still way too high. Yes, the trends have improved, but by any standard we are a very long way from a return to normal. The labor markets are very fragile. I expect them to stay this way for many more quarters.
  4. World imbalances will leak over into the US economy. Particularly in the form of a continued run up in some consumer prices. There is an argument to make that the world economy is headed into a period of generally higher prices due to the rapid growth of emerging economies and the stress that puts on supply of raw materials and food. But the recent spike in prices is not necessarily indicative of where that longer term price level will be. Short term supply constraints and like the turmoil in the Middle East, and rotten harvests, are masking the long term trend. I expect prices to settle back down, rather than to escalate wildly out of control. Nonetheless in the near term this spike has illustrated jut how vulnerable consumers are.
  5. That is the lesson we need to absorb. Confidence is fragile. To the extent that we rely on consumption and a return to healthy levels of sustainable demand, we are a long way from cured. This past few months have taught us, vividly, that consumers are acting as if on a knife edge. They are pessimistic one day, then optimistic, and then back in the doldrums. The battering they have taken has numbed them sufficiently that they will take a great deal of persuasion before they declare the recovery complete enough to spend the way they once did.
  6. Banking is not yet safe. Since we didn’t reform the banks to make them less dangerous, we have to assume that they are busily constructing their next disaster. Which we, inevitably, will be expected to pay for. Like all habitual blackmailers, the banks will not reform of their own accord. They need to be forced to behave. We will not achieve long term sustainable growth whilst banks are more interested in gambling than in underwriting loans that support the real economy. This shouldn’t be hard to understand, But apparently it is.
  7. Imbalances within the economy lower its potential trajectory. This is a longer term effect and perhaps out of place here, but I would be remiss for not mentioning that our enormously divided economy, between the haves and the have nots, is in itself acting as a brake on growth. It is my view that when the middle class is deprived of disposable income over long periods it cannot act as the economy’s primary consumption engine. It is no secret that the American economy is now so split with respect to the fruits of productivity, and thus income allocation, that its the middle class is now no longer capable of driving spending with sufficient force to justify investment. This sets in motion a steady spiral downwards. As investment is restricted, so future income growth is impaired. This encourages short term thinking in business in the form of cost cutting and wage freezes in order to maintain profit growth. The net result being a shift in income allocation away from wages towards profits and the steady throttling back of potential growth. If this view is correct, then the very clear bias in favor of profits as opposed to wage growth that has dominated American business for the past three decades will end up reducing long term profit. The greed of shareholders will ultimately be self-defeating as they stifle the middle class and thus the very source of their profit.

This is not an exhaustive list, but one point I want to make quite clear: I don’t think that the Federal deficit or the near term bulge in US debt is a particular problem. Our response maybe. Meanwhile we have left unaddressed many of the more obvious sources of risk, like the ones listed above. So as long as were are exposed to such a list we should expect a bumpy and not very fast growth pattern. There’s just too much out there lurking to derail us, and too little policy focus on a long term strategy to reduce inequality, for us to be upbeat.

So look for a lot of sideways motion.

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