GDP

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Debt Conundrum

What I am about to say is not novel, but nor is it trite: if the austerians – the word we now use to describe those who advocate cutting public spending and debt – really believe that a reduction in public spending can spur, without doubt, economic growth, then the gap opened up by that reduction must be more than filled by something else.

So what is that something else?

Well, a sudden shift in trade could do the trick. That means a sudden expansion of US exports so that the US trade balance zooms from a sea of red ink towards being securely in the black. Canada managed this solution when it had budgetary difficulties. As did Sweden. Somehow I see this as unlikely here. Our appetite for oil sets a fairly high threshold for us to jump over, and the dollar would need to drop some more. With world oil prices moving higher, and not lower, the degree of difficulty is increased. At least near term.

And where would these exports go?

The data suggests there are only three viable trade partners to absorb enough US goods: Europe, Japan, and China. The Euro zone as we know is not in too good a shape, and has already reduced its trade imbalance with the US. The other two are more problematic. Japan is in all sorts of difficulties as result of the recent disaster, its economy is weakened in the short term, and any recovery there may not support a boom in US trade. That leaves China which continues to resist strong currency adjustment and thus blunts the possibility of a US trade surge.

So, even though the world economy is growing at a decent clip, it is not at all clear US exports are about to take off sufficiently to plug the gap opened up by reduced government spending.

So that throws the spotlight onto the private sector.

There we have two possibilities: investment and consumption.

I have berated big business enough times for you all to realize that I am highly skeptical about the probability of investment suddenly rising to the task of leading an economic charge. Business is awash with cash; profits are at very high levels – last year’s profit growth was the best since 1950 – and still investment is more of a dribble than anything else. Indeed the latest numbers suggest companies have reached a plateau in most forms of investment, and are now sitting around waiting to see if demand picks up enough to justify a second installment. The recent durable goods data shows a definite flattening out of growth in investment. There doesn’t seem to much else on the horizon.

So despite all that idle cash waiting to be deployed into productive activity, business investment is much too slow to offset the imminent reduction in the economy planned by the austerians. Every day that pile of cash goes unused the more the opportunity lost costs money. Since I don’t believe business willingly leaves profits on the table uncontested, there must be something preventing action. Clearly the business world is nervous about something.

And that something is the shape of household demand.

Which gets us to the center of our dilemma.

The current outlook for households is not exactly rosy. Wages are flat, indeed when the impact of inflation is accounted for they are going in the wrong direction. The job market still casts a pall across the economy, and causes enough anxiety to restrict much free spending. Home prices have dropped and caused a perceived need to replace that loss on household balance sheets with other assets. That means savings need to rise at least temporarily. That implies a decline, or at least a flattening out, of consumption. So little growth is likely from this quarter.

We have reached an impasse: none of the potential sources of replacement activity seem likely to play that role. Thus, a decline in public spending inevitably will lead to a smaller economy. GDP will decline from its current path. Whether that decline will be large enough to push us into recession I doubt. But it will be enough to throw us into a potentially endless sideways movement with constant high unemployment, and ugly performance in most important categories of activity. Stagnation beckons.

Unless.

Unless we go through a great boom in private debt.

Yes. That’s right. The only way the austerian project is viable is if household debt levels grow sufficiently to provide the spending power needed to offset the lost government spending.

This is truly perverse.

After berating us all for reckless borrowing and the damage it did to our economic stability, the austerity police are now relying on us plunging more deeply into debt so that they can cut public debt without cutting the economy. They just don’t want to admit it. Their entire plan relies on pumping private debt up beyond where it is currently. This does not mean that those folks who went into debt too deeply before have to return there. It means that others, people with healthy balance sheets, people who don’t normally borrow, and people who have cash anyway, all have to fill the void. As the crisis abates and the cleaning up of the bad debts accumulated back in the bubble are worked off, the austerians assume there is a pool of new borrowers waiting to jump in and provide the boost we need.

Some of this borrowing could come, I suppose, from businesses tapping into the banks and credit markets. But, as I said, business is awash with cash. Business doesn’t need to borrow. Besides they don’t seem keen to spend.

No. This increase in debt has to come from households. Especially those who sat out the last boom in debt.

Is this likely?

You answer that one.

I don’t think it is.

That means the austerity programs being shoved into place can have only one impact: they will contract the economy. Demand will fall. It isn’t too large a government budget that scares business into hoarding its cash. It is too small a government. Every dollar cut from government spending is a dollar less flowing through the pockets of business, both large and small. That means fewer jobs, not just because we fired a bunch of teachers or firefighters, but because we drained demand from the private sector and thus reduced the need to hire workers.

Expectations play a key role in the economy. As long as the austerians scream panic and cut, those expectations will tend towards being negative. This is the exact opposite of what the orthodox economists would preach. But they’re wrong anyway.

We have a debt conundrum: the fiscal conservatives are advocating fiscal recklessness. They just don’t want to say so. Then again, these are the same folks who brought us the Reagan and Bush deficits. So we should not be surprised. Not surprised at all.

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What Spring?

It’s a couple of years since Ben Bernanke used the springtime “green shoots” description of the economy. Since then we have had a few good quarters of warming weather, but we never arrived at a fully fledged summer. We seem, to extend the saying, stuck in perpetual springtime.

The reason, I think, is clear. Average folks are not seeing much to cheer about. And since they form the bulk of the consuming population they are not providing the power to generate that burst sufficient to allow us to break out.

A couple of recent statistics get at the heart of the problem.

House prices continue to drop. It is astonishing how long this decline has been going on. Yes, there have been a few false dawns along the way, but the trend remains resolutely downwards. Today’s Case-Shiller index merely confirms the gloomy news. Our housing malaise is a long way from being settled. Eighteen of the twenty cities in the index have seen declines in the last twelve months. The worst affected was Phoenix where the drop was 9.1%, whereas Boston saw the least decline at 0.6%. Only San Diego and Washington DC saw increases. Even then San Diego’s growth was minimal at 0.1%. The 3.1% drop in the overall index in January was worse than the 2.4% drop recorded in last December, and the outlook remains bleak

It is glaringly obvious that our housing problems are here for a while longer, and while they linger the shadow they cast is very long indeed. The real estate market has yet to end its adjustment back to a sustainable price level. The inventory of unsold homes is an illusion since it fails to account for a very large number of homes people would like to sell, but are unwilling to do so at what they consider to be temporarily reduced prices. I am surprised that it is taking so long for sellers to realize that their homes are simply not worth what they would like to receive for them. This imbalance, this inability or unwillingness to grasp reality, is creating a burden in the market that is depressing activity and making matters worse. By elongating the period of adjustment we have allowed the adverse psychology to build to a point where the market clearing price is probably lower than it might have been had sellers been willing, or able, to withstand the earlier price declines. In other words had the original decline been sharp enough, and had people acted to dump homes in order to avoid further losses, we might well have arrived at a position from which the market could recover. Instead we are stuck in a long winded meandering decline that casts a pall over whatever recovery may be going on elsewhere.

This story has become so prolonged that there is no real news in it anymore. Yet is is still important to reflect on. As long as the housing market fades the way it is, households will remain reluctant to spend, and will be forced to save to offset the steady erosion of wealth caused by lost home values. The support of the vaunted wealth effect has become the erosion of an insidious poverty effect. Such is the inevitable way with real estate, an asset we should all view with as much skepticism as any other.

As if to support this thesis immediately, consumer confidence has taken a decided turn for the worse.

The Conference Board reports that its measure of consumer confidence dropped sharply in March, down to 63.4 from February’s 72.0. Prior to this decline the index had shown five months of steady increase, so March’s drop stands out as being a sudden reversal of trend. There is no real surprise in the factors driving the decline: food and gasoline prices have spiked up sharply lately; and wages are not keeping up. Add in the rotten employment market and people are realizing that the economy is just not as healthy as it ought to be. Yes, it has risen from the depths of the crisis, but, no, most of the benefit of that recovery has not flowed into average households. Indeed with disposable incomes under pressure from the spike in prices and with profits rather than wagesscarfing up the gains from the recovery we are building a platform for possible decline in growth from its current rather poor level. Big businesses seem intent on shooting themselves in the foot by hoarding cash and not investing. And our government seems intent on aiding and abetting the decline by cutting government expenditure – which means jobs – before we have accelerated enough to withstand the blow. So our economy is not just leaderless, it is being badly led. The direction is the wrong one, and households are reacting by being more circumspect and pessimistic about their prospects.

In essence our leadership, business, political, and professional, has abandoned the task of encouraging economic growth and has entered a phase of self-destructive policy and strategy decision making. Presumably this is the course of least resistance. For business it is always easier to cut costs that to generate new streams of revenues. It is always simpler to offshore activities to low cost production facilities than it is to innovate domestically. And it is more straightforward to deploy attorneys and accountants to reduce tax burdens than it is to boost gross revenues.

As for the politicians. It is a much easier task to sell austerity and reduction, than it is to explain why we need to run larger deficits. After all voters understand the rhetoric of cutbacks more than the more convoluted argument in favor of spending.

So we are locked into decline. Or rather mediocrity. Voters accept that the economy is not going to provide for them. This acceptance is borne out of thirty years of experience with the stagnation associated with the relaxation of regulation and the massive growth in power of business. We have produced an economy that protects profit well. The cost has been the loss of opportunity and relative wealth of the very households who we now need to carry us along. That their confidence is dented or skittish, and that their belief in our leadership is skeptical to say the least, should come as no surprise. The combination of cynicism, anger, and abandonment embodied in our political discourse is dangerous. These are unhealthy times for democracy. But for capitalists the boom continues.

Good for them.

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Growth, But Not Enough

Solid is one of those words none of us wants to hear as a description of our abilities. Solid is not exciting. Solid is very middling. There is no va-va-voom in solid. But then again neither is it bad. No, solid is just dull. Very dull.

Our economy is solid.

Ugh.

Today’s reports on GDP for the fourth quarter 2010 has growth at an annualized 3.1% rate. That’s good. It just is not good enough. If you recall, the previous estimate was for growth at 2.8%, so evidently the later data has been on the plus side. The biggest contributors to the increase appear to have been a revised inventory number, which was less of a downward drag than previously thought; and a stronger business investment figure. Neither of these was the prime motor for growth, however, since the main boost came from a combination of higher personal consumption and a better trade balance. Since this is the third and final report of the fourth quarter this is the one that goes into the books. It also brings to a close the revising of the overall 2010 performance which is now settled at 2.9%, compared with the drop of 2.6% in 2009.

While that turn around appears terrific I must warn you that it is nowhere near good enough. A more typical recovery would have seen much faster growth in the first full year after a recession. Then again, the economy has gone through significant changes over the last three decades, one consequence of which is the the days of very fast recoveries seem to be over. The trajectory in the last three recessions has been for much less rapid recovery from a much longer decline. My view is that this change stems, at least in part, from the reduced emphasis on manufacturing in the overall economy. In the earlier post-war recessions, the cycle was dominated by sudden shifts in factory employment. The adjustments were quick and dramatic. But as finance, and other services, grew in importance those dramatic shifts have given way to much longer and more difficult adjustment periods. Those famous V shaped recessions have given way to elongated U’s. And the Great Recession was so deep, and so shocking, that we are still lingering near the bottom and are nowhere near climbing back to where we would have been had there been no downturn.

That, I think, is what most people overlook.

Had we avoided the downturn we would have had an economy chugging along between 2.5% and 3.0% a year. OK, but not great. Solid in fact. But we blew a great hole in that history so the long term trend line now shows a big downward dip. If we plot our actual performance against the trend line we would all notice that we are not back to where we would have been. That means we still have lost momentum to recover. And don’t forget: to the extent we wallow about beneath the long term trend line we are forgoing wealth that we will never recover. Not, that is, unless we accelerate to growth rates well above the trend line.

And therein lies our problem.

GDP growth in 2010 was insufficient to recoup our lost wealth. So that loss is permanent. In effect we have recovered in name only. The deeper reality is that we have an impoverished economy more limping than running along.

The slowness of growth last year is very worrying because there are many signs pointing to weakness at the moment. Real estate is stuck so deep in a hole that no one can credibly suggest it returns to be the boost it was during the 2000’s. Which is probably good in view of the damage it wrought. Exports are our best shot at getting medium term growth, but for that to come to fruition we need a further devaluation of the dollar and some cooperative adjustments in our trading partners to deal with their own imbalances. In particular, the Chinese, Japanese, and Germans all need to reduce their export reliance by boosting their domestic consumption. Their economies are built around excessive employment in exporting businesses which deprives us of jobs and their own people of consumer goods. Unless there is a willingness to deal with these imbalances, I doubt that our trade position will provide the boost to our GDP growth I would like to see.

So what else could?

Not much.

Business investment could be one area of extra growth, but there is little sign of a boom there. Companies are sitting on piles of cash and are not deploying it productively at the moment. This is with historically low interest rates which implies very low investment hurdle rates. If business can’t find profitable opportunities at these rates I doubt they will suddenly burst into activity any time soon.

Consumption would be another possibility for higher growth, but that too looks set for drift rather than acceleration. Households are still grappling with rebuilding their balance sheets to compensate for lost home values While the stock market has recovered, and thus boosted some family portfolios, housing was always a bigger wealth provider for the majority of people. So as long as home prices remain weak, and they have just begun to decline again, most households will look to save more than before to create a cushion against uncertainty. This, obviously, shifts a portion of income from spending to savings and thus slows GDP down. The possible offset to this slowdown would be if those savings found their way into an expansion of investment, but as I just said, there is no evidence of much growth in that sector.

The last possible area for growth would be government spending, but as we are all painfully aware the current emphasis is on reducing not increasing government activity. So, far from being a net boost, I expect the cost cutting mania now sweeping the nation to become a net drag on growth. Yes, this is dumb. And, no, it won’t change. We appear hell bent on slowing growth down.

All of this means that the outlook for GDP is not too terrific. The economy is out of the deepest parts of the hole it fell into, but it is not yet healthy enough for us to breath easily. The ugly truth is that we appear set for drift. There is no appetite for fiscal policy remedies, which leaves us reliant on the Fed’s loose monetary policy. With interest rates at practically zero we have no room to maneuver. Not that this worries policy makers. They have all moved on to the deficit and debt as their problems to solve. The fact that the best solution would have been a rapidly expanding economy eludes them.

Oh. And one more thing. Buried on today’s report is data on corporate profits. Guess what? Despite all the moaning about the administration’s supposedly anti-business attitude, and despite the gloom and doom we hear constantly from the Chamber of Commerce, profits soared. And I mean soared. Before tax corporate profits grew 36.8% in 2010. Read that agin and digest it fully. Profits boomed. Last year was the best year for profits since 1950 which was an odd year itself as business boomed after the post war recession. No wonder stock prices rose. Couple this with the news that GE is getting a tax rebate of over $3 billion on gross profits of over $14.2 billion – of which $5.1 billion was in the US – and it easy to understand why workers might be perplexed by the idea that they need to give back more in order to solve our supposed “debt crisis”.

These are boom times for capitalists. Just not for the rest of us.Today’s report simply confirms this.

Until we restore a more equable balance the economy will remain merely solid. That’s not good enough.

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More Real Estate Problems

When you build your economy primarily on the basis of finance and real estate, as the US appears to have done during the past two decades, you are relying on economic sectors renowned for their fickle and unreliable properties. When you then combine them via unscrupulous lending and tricky derivative activity, you are definitively playing with fire. You had better have a back up plan.

Now we all know the US, and many other places had no such plan, and thus much of the GDP growth generated by relying on those chimeric sectors was a total illusion. On the upside the “wealth effect” unleashed a whole lot of consumption as households strutted about in the glow of the inflationary gains they accrued simply by sitting on a home bought years ago. Such folks supplemented their spending by borrowing gleefully as the equity in their homes shot out of sensible limits and into fantasy orbit.

But what the bubble sows the bubble reaps.

So here we are languishing in the worst real estate market in recent memory. Deservedly so. Today’s data shows just how much trouble we are in.

Here we are supposedly enjoying an economic recovery, with many of the top level statistics now well above the terrible floors they all reached a few quarters back. But real estate is still slipping. Sales of existing homes fell 9.6% in February, back down to an annual rate of 4.88 million. That’s down 2.8% on the same month last year. And don’t forget: 2010 saw the lowest level of sales since 1997.

Worse for those wealth effect fans – Alan Greenspan I am looking at you – average home prices continue to tick downwards. They fell to $156,100 last month which is off 5.2% over the past year. So just as all that goodwill supplied extra energy on the upside, now all the price declines are supplying boatloads of negativity on the downside. People feel more poor because their home price is dropping rather than rising. That forces them to re-evaluate the way in which they spend and consume. If a home is no longer the safe nest egg it seemed before, then something else has to provide for retirement. And since we were so dependent on real estate, the depressing shock of realizing it is not safe, is causing a massive shift in habits. All those safe guaranteed retirement plans – the defined benefits or yore – have been replaced by the volatility of defined contributions. Who really knows what they will have when they retire. The house was supposed to offset that instability. Now it compounds it. People are exposed to more risk than ever before. So they retrench. And the economy stalls.

Whether that shift is temporary or longer term will depend on the success or failure of households ability to reconfigure their balance sheets and cash flows.

Right now the evidence suggests that the reconfiguration is going to be longer and more difficult than many analysts first imagined.

The problem is that when we remove the house price inflation from the equation we suddenly find that other sources of wealth, for the average household, have failed completely to provide growth. They have added risk, but no return. Wages are in terrible shape. Most people have insufficient funds to save for much other than a house. And then with wages falling behind over the past three decades, even housing became a risky financial bet requiring marginal risks unheard of thirty years ago.

Not only this but we are now learning that returns on the cost of education no longer cover the cost of that education. The middle class value proposition: go to school and by your own home and you will emerge stable and secure, is being undermined by the economy’s failure to distribute the spoils of growth widely enough. Throw in out of control health care costs and the fabric from which the post-war increase in the middle class was cut is in tatters.

We are going backwards, not forwards. Or at least most of us are. The lucky few are immune to this, which is why today’s real estate numbers reveal that a full 33% of all sales last month were for cash. That’s much higher than usual and tells me that investors are speculating on housing. Those with the cash will make out well. The average household will struggle.

That’s a consequence of building an unequal economy.

It’s going to be a long road back.

What a waste.

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We Keep On Muddling Along

The economic news continues to be mixed. Not bad, but the good always comes with a twist.

Industrial Production:

Take today’s report that industrial production dropped 0.1% last month. The view on the “street” was that it would grow 0.7%. Even if we discount the analyst’s views, as we should given their optimistic bias and rotten track record, to miss the mark by such a margin requires an explanation.

This is especially true when we also read that the Philadelphia Fed’s index of manufacturing activity has reached 43.4, its highest reading since 1984. The Philly Fed’s upbeat report is backed up by the Institute of Supply Management index that has national manufacturing activity at it highest since 2004.

Taking all this together we are driven to odd conclusions. Either Philly is booming and the rest of the country is in dire straits, or, more likely, the data is being muddled up by something. That something being utility activity which is included as manufacturing, but which marches to a different rhythm. Weather matters. The past month has seen some warmer weather and that has cut utility demand. That cut translates into enough of a drop in power plant production that the overall manufacturing numbers decline rather than increase. If we focus simply on factory output we see that it rose 0.4% in February, the seventh straight month of increase and is now up about 7.0% over the past twelve months. The details within this report reveal that the strength is spread across most industries, which a good sign of overall economic health, with hi-tech and automobiles leading the way. Production of cars is up 14.3% over that last year; and hi-tech activity has risen 16.8%.

Inflation:

The news on inflation is much more mixed, and a little concerning in the short term.

It comes as no surprise to read that the headline inflation index rose sharply last month, by 0.5%. This obviously reflects what we all know: food and fuel prices have risen quickly as various crises and supply issues have disrupted markets. Besides those temporary problems, the underlying shift has been towards prices rising in the face of demand driven by the economic recovery well underway world wide. The trick for policy makers is to tease apart the more problematic longer term trend from the fluctuations caused by these short term disruptions. That’s why they tend to use the so-called core inflation rate rather than the headline number. At this core level, inflation is still relatively low: it rose 0.2% last month. This is well within acceptable bounds and is unlikely to prompt an anti-inflationary interest rate increase any time soon.

Naturally none of this will prevent the austerity hawks from jumping up and down and warning of an impending inflation disaster. They are driven by ideology and not facts, so they will see such a disaster under every possible rock. The confrontation between the Fed’s longer term perspective and the austerity hawk’s opportunistic view leads to some awkward moments. One such was last week when Bernanke tried to explain he was not worried by the jump in food and fuel prices – at least not yet – because they appear to be temporary. He and other Fed officials then pointed to the introduction of the iPad2 and its price as an example of the way in which innovation holds the price of goods down and thus mitigates inflation. The Fed has a valid technical point: we should evaluate prices in the context of the service rendered at that price. If we pay the same for new products that outperform the old ones, then the real price has gone down – we are getting more bang for the same buck. Unfortunately this argument gets clouded quickly in the minds of both austerity driven politicians and the media, leading to headlines that read: “The Fed Says Let Them Eat iPads”. This is what we read in the more sensational press the following day, and is not exactly what poor old Bernanke was saying. It can be difficult sometimes to maintain coherence in the face of determined ideological opposition.

Overall consumer prices have risen about 2.1% over the last twelve months, which is a clear acceleration from the annual rate we were reporting back in November and December.

So the pace is picking up. But by not as much as food and fuel prices would indicate.

Wages:

One normal source of inflationary pressure during a recovery is wage increases. Not this time. Real average hourly earnings dropped 0.5% last month because wages stayed flat and inflation rose. Those flat nominal numbers thus were not a source of inflationary pressure. Over the last year wages adjusted for inflation have fallen 0.4% – since the CPI has risen 2.1% this implies nominal wages have risen only 1.7%. This includes the impact of overtime and longer work weeks as employers ramp up output. Clearly workers are not benefitting from the recovery as much as they used to. The huge unemployment overhang has much to to do with that. Employers have no incentive to raise wages when workers are abundant and relatively cheap. Having said that there is no real evidence of employers increasing their workforces anyway. Which all means that most of the wealth generated from the recovery so far is going to profit and corporate cash flows, and not into household pockets.

Unemployment:

The last piece of news to report today is the weekly data for new claims for unemployment assistance. They fell by 16,000 to 385,000, which brings the four week moving average down to 386,250.

Claims numbers have been very volatile recently and so difficult to read for their significance. I think we can say two things: (1) they are moving in the right direction; and (2) they are moving too slowly. There is still no hard evidence of a strong recovery in the jobs outlook. We appear to be stuck in no man’s land. People who survived the crisis, and did not lose their job, are now feeling the threat of dismissal ebb. This gives them cause to spend and start planning a more normal consumption pattern. But those who lost their jobs are facing a very different outlook. There is no spate of new jobs for them to apply for; their savings and other forms of support are dwindling – if not already exhausted; and their skills are steadily eroding. In other words the economy has split into two very different communities. The one struggling to get back to normal, the other struggling simply to survive.

This separation has bred a feeling of complacency in politics where the emphasis is no longer on recovery, but on shaping the economy beyond the recovery. Hence the sudden shift towards discussions about debt and deficit reduction even while millions of our fellow citizens wallow in misery. Since things are no longer getting worse, the assumption has become it is time to look into the medium or longer term future. This is completely wrong. We are not yet out of the woods. At the current rate of growth it will take years to absorb the unemployed workers back into the workforce. But the more likely outcome is that many of them will simply abandon any attempt to find work and will just drop out of the workforce. This has the effect of reducing the economy’s capacity to grow and thus limits our overall wealth accumulation prospect.

This should be a reason to continue our efforts to expand the recovery by pumping up demand to create jobs. Apparently not. The ideologues are winning, and we are abandoning the unemployed to fend for themselves. Ultimately we all lose as the economy’s potential growth path is shifted down. Since that seems hard to explain not many people are bothering any more.

So: the upshot of today’s news is that we are still muddling along.

The economy is growing at a decent, but not great, rate. The fact that wages are not getting their share of the growth suggests that the shape of the recovery will be biased in the same way as the last one. Profits will do well. That means stock prices will rise. Jobs will be scarce and not well paid. And the squeeze on the lower echelons of society will tighten.

And this with a Democratic president. It shouldn’t be this way.

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