stimulus

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Back To the Stimulus Debate

It was bound to happen sooner or later. There are growing rumblings that we will need another round of government stimulus, a.k.a. deficit spending, before we can be assured that the economy can reach a sustainable growth path.

The most recent source of the discontent from which those rumblings are emerging is last week’s poor unemployment statistics. With unemployment now at 9.8% and rising it is a certainty that we will go above the 10.0% mark in the next month or two, and there are few if any signs that the outlook for jobs will improve anytime soon.

So, perhaps, it is time to start thinking about adding more fuel to the fire in the hopes it doesn’t flicker out early next year.

There is no surprise in this story. None. It was fairly clear to many observers, including yours truly, that the stimulus package that eventually was passed into law earlier this year was not sufficient. By coming in at a little under $800 billion it was probably about 50% or $400 billion short of the level needed.

That’s an awful lot of money. So we should spend a moment to revise what a stimulus is and how we should calculate it. I realize this is boring, but with the economy hanging on a knife edge we all ought to have an idea of the issues as they start to re-appear in Washington.

The purpose of a government stimulus is to fill a gap that opens up in the private economy. The American economy is somewhere in the range of $14 trillion per year. During late 2007 and throughout 2008 the non-government part of the economy began to shrink rather than keeping on its ‘normal’ 3% per year growth path. The contraction, as we all know, was caused by the collapse of the real estate bubble and the knock-on failure of large financial institutions who had gambled on stupidly underwritten loans and even more insanely constructed financial instruments like Credit Default Swaps and other derivatives.

The cards came tumbling down and, more to the point, three decades of economic illusion suddenly were exposed as fraudulent. America was suddenly aware that its thirty year debt binge and denial about some critical imbalances in its economic system were totally unsustainable.

Three decades of economic neglect and erroneous thinking had allowed those massive imbalances to accumulate. We have lived through three insane binges: the dot-com boom that spawned IPO wealth on paper and little lasting effect, other than the infrastructure of the internet; the stock market inflation that was associated it; and latterly the equally ludicrous real estate price inflation.

None of these were dealt with competently at the national economic policy level. On the contrary, each problem seemed to be met with an urge to reduce the effectiveness of government and to increase reliance on the same private sector that was creating the problem. The era of ‘self-regulation’ and ‘government is the problem’ had a singular worldview and a singular policy option: reduce regulation, and somehow the market will solve all our economic woes.

It was John Keynes who said:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly supposed. Indeed the world is ruled by little else.”

The problem of the past three decades has been that the ideas were wrong. So now we pay for it.

The collapse was dramatic. By the time the dust settled it became apparent that the economy will have shrunk so much that we will lose about $2 trillion in wealth over about a two year period. That’s big by any calculation.

We were facing the opening up of a vast hole in the private sector: demand was simply insufficient to soak up the available output, so businesses started the inevitable shrinking process that is needed to shift resources away from rotten activities towards the remaining profitable ones, and to eliminate idle capacity.

Jobs were cut.

7.6 million so far and counting.

The textbook tells us that the immediate response by a government when faced by the implosion of the private sector is to reduce interest rates. This should have the effect of making borrowing cheaper and thence stimulating demand. Lower interest rates usually does the trick: after a few months of adjustment cheap money creates an increase in demand and the private sector rebounds.

This was not an option this time.

Why?

Because we had already lowered interest rates close to zero in the early stages of the credit crisis and therefore had no ‘ammunition’ left to shoot as demand cratered. It is simply not possible to have negative interest rates. More precisely it is not possible to have negative ‘nominal’ interest rates. Remember that nominal in this context means unadjusted for the effects of inflation. In truth we have had negative ‘real’ [i.e. inflation adjusted] rates for a while.

Faced with this impotence of the normal ‘monetary’ policy, we have to dust off the Keynesian solution: huge Federal deficits. The idea being this: if private people and businesses are to afraid to spend, then the government should in order to get thing going again. This is that classic pre-1970’s prescription. It was discredited, wrongly, during the stagflation of that decade and replaced by the more modern monetarism of Milton Friedman and then Robert Lucas.

With the Friedman/Lucas school of thought now exposed as intellectually bankrupt – that fight is still raging – policy makers had to resort to the policies of an earlier era.

The big question then becomes how much stimulus is needed?

This is calculated by estimating the lost wealth that needs replacing – in this case that $2 trillion I mentioned earlier, and then adjusting it by the effects of way in which money flows through the economy.

This latter step is tricky.

It requires us to calculate how much impact a single dollar of deficit spending has. Keynes called this the ‘multiplier’ effect. A dollar spent creates an ability for its recipient to spend, which means that the original effect compounds on itself as it keeps on rippling through the economy. This ripple gradually fades away after the dollar has changed hands a few times. Typically the multiplier is thought to be between 1.2 and 1.5. This means that a single dollar of stimulus has the ultimate effect of creating between $1.2 and $1.5 of demand.

Returning to the stimulus earlier this year.

The administration’s experts calculated the lost demand as that $2 trillion and that the multiplier of any stimulus was likely to be about 1.5. Given some fine tuning that meant the stimulus should have been $1.2 trillion.

We didn’t get that.

In fact that number never even made it to the President’s desk for consideration. The reason was raw political calculation. The political side of the White House vetoed anything larger than $800 billion on the basis that they saw no way to get enough Congressional support for it. So we ended up with a stimulus that the experts knew was inadequate from the get go. They were hoping it would be sufficient to stave off disaster – which it has – but they knew it may not be up to the ultimate task of re-igniting self-sustaining growth in the private sector. That has also proven to be an accurate guess.

The economy is certainly no growing, the combined effects of the weak stimulus and an inventory correction have ended the recession, but few observers now think that continued growth is assured. In fact, as last week’s miserable unemployment figures indicated, there is a growing threat of a return to recession sometime in 2010.

The political calculus will extraordinarily difficult this time. Opposition to the Obama agenda has solidified. His popularity has fallen. The Republicans have nothing to gain by being cooperative. This is not Obama’s recession, but it is his to fix. The slow recovery has hobbled his claims that a stimulus works. Instead the Republicans are arguing for more of the policies that caused the problem: more market freedom. The resonance with the 1930’s is stunning: the original opposition to FDR came from exactly the same quarter and for exactly the same reason. Some very famous economists – Schumpeter not least – were vehement in their insistence that the market should be allowed to follow its natural course. We have the same today with people like Lucas arguing that any stimulus is wasted money.

It’s as if we hadn’t learned anything from the success of Keynesian economics in the later 1930’s.

So here we are back, not just to the debate of earlier this year, but to the debate of 1934.

That cannot be good.

And it could have been avoided had we had more courage and sense at the critical moment earlier this year.

Hopefully we can get that missing $400 billion stimulus enacted.

I doubt it.

And that tells me next year could be very rough – meanwhile unemployment keeps on mounting. Presumably those opposed to stimulus don’t care about unemployment.

Shame on them.

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Ugly Unemployment Numbers

Put this into the category of bad news. Since everyone, well nearly everyone, was predicting a drop, the news that unemployment rose last month is a shocker. August’s payroll loss was revised down to 201,000, and September’s came in at 263,000. The consensus had been that we would see something in the order of 165,000. So not only was the actual number worse than expected, but it was much worse.

To put this in context: September’s loss was the 21st straight month of job losses which is unparalleled since the Great Depression. Plus the unemployment rate now stands at 9.8% which is the worst for 26 years.

Every subset of the data is poor. We have lost about 7.6 million jobs during the recession; the total of unemployed people has mushroomed to 15.1 million; long term unemployment has exploded and is now at 5.4 million; and 35.6% of all unemployed people have been without a job for 27 weeks or longer.This is ugly news indeed.

If we add in discouraged workers to the unemployed the figure of people looking for work and unable to find it bloats up to 17.0%. There is no way to spin that figure in a positive way.

Simply put: we should be seeing some improvement by now. That we are not suggests a much deeper weakness than the third quarter GDP figures will show when we see them on October 29th.

The ramifications are obvious: the recovery will depend upon our ability to get demand rising. That means people have to go out and spend. Once that happens the recovery can become self-sustaining in a virtuous cycle of spending being the cause of re-hiring, which leads to wage growth and more spending.

Instead of this virtuous cycle we are stuck in the opposite. That leads me to be concerned about the sustainability of the recovery. Without more jobs there is no way that the economy can keep growing. Today’s news casts a long and unexpected shadow over the outlook for such growth.

Put another way: once the one time impact of the current inventory adjustment has been absorbed, and once the administration’s stimulus plan has started to fade, the economy private sector will have to stand on its own feet. At the moment it seems not to have enough confidence to be able to do that.

That implies that the likelihood of another recession sometime next year is now rising.

I have talked about this before: as businesses examine their own forecasts of what sales they expect next year and in 2011, they will invest or hire workers accordingly. To the extent those forecasts are diminished by limited or pessimistic sales expectations businesses will act to defend their profits by staying ‘lean’ and avoiding adding expenses. They may even cut further. The result is that the poor forecasts end up becoming self-fulfilled.

This is a case of fear driving us deeper into a hole.

All this would be entirely rational too. That’s what makes it so frustrating. By everyone being sensible and acting to defend their self-interest, the economy as a whole continues to shrink and everyone ends up worse off.

This is a classic paradox of thrift.

And is ended only by Keynesian style expansionary fiscal policy.

We may need another stimulus to break the cycle of fear.

The problem with that is the political situation.

The Republicans have already touted today’s numbers as ‘proof’ that the stimulus didn’t work. This is from a group that has no alternative policy and was opposed to the stimulus anyway. In fact one of the reason’s that the stimulus has taken a while to bite is that the administration caved into Republican demands and added too much of a tax cut component to the stimulus. I have beaten that horse to death over the past few months, but it bears repeating: tax cuts are awful stimulants. People who are scared about losing their jobs tend to save, and not spend, any cash they get by way of a tax cut. So by diverting stimulus money into tax cuts the Republicans managed to neuter the stimulus to a large degree. If the stimulus didn’t work – and it is working so their attacks are vapid and irrelevant – it would have been their fault anyway.

Nonetheless Republicans being what they are, they will kick up a huge stink if we have to ask for more stimulus. Their opposition puts the recovery at risk. So hopefully we won’t need to go that route.

Unfortunately today’s unemployment data suggests it will be touch and go though.

Let’s hope September is an aberration, rather than the onset of a new downward trend.

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Good GDP Data

This morning’s news about the second quarter GDP decline was actually good: the drop from the first to second quarters has been revised to only 0.7%, which compares with the original estimate of 1.0%.

So the second quarter contraction in the economy was less than originally thought, and less than most forecasters dared hope. Clearly the economy has begun to improve.

The major causes of the change between the original and this latest estimate were minor adjustments in exports and business investment, both of which were stronger than first measured.

Now what?

I think we can look forward with some confidence to the first cut at the third quarter which is due to be published on October 29th. Most analysts are predicting GDP growth of between 3.5% and 4.0%. The reasoning behind this apparent jump from contraction to expansion is, as we have mentioned here many times, that businesses have begun to re-stock shelves. That little spurt in inventory build up will be enough to support growth by itself. Add in the fact that most of the economy is no longer as weak as it was just six months ago, and it is easy to concoct a quarter, or maybe even two, of 3.0%+ growth.

The problem though is what happens deeper into 2010? Is this growth sustainable? Or will it fade?

And here the answers get very murky.

The is nothing in the data that suggests great strength is about to burst forth. On the contrary all signs point towards a very slow recovery riven through with significant risk. Anyone running a large number of computer simulations of the likely trajectory of the economy over the next two or three years will be faced by an unusually widely dispersed set of results. In other words: your guess is as good as anyone’s.

The problem boils down to business expectations.

This, naturally, flies in the face of economic theory, but, given the recent performance of that theory I think we are justified in ignoring the textbook entirely.

Business expectations are vital for a couple of reasons:

  1. They drive investment decisions: an optimistic outlook provides the basis for gearing up factories etc so as to meet higher sales; while a pessimistic forecast does the opposite and would entail more cut backs in order to preserve profit
  2. This means that unemployment would start to decline. OK this is really part of the first point, but it is so important I wanted to emphasize it.

It is here we hit a wall.

Businesses are being extremely cautious at the moment and are showing few, if any, signs of shifting from a defensive mode. Large scale lay-offs are still quite frequent – more so than makes sense were business about to ramp up; and business investment, while growing, is not exactly lighting the place up. Slow and steady appears to be the mantra.

Of course this all becomes self fulfilling. Weak prognostications beget weak investment beget weak outcomes, which justify and reinforce weak prognostications. Very Old Testament, but apt.

The odd thing is that the financial press – the Wall Street Journal etc – has gone from giddy statements about the return of growth, to ultra cautious statements and concern about a ‘double dip’ recession, without there having been any really radical change in the data. The flow of information seems to be what it was a few weeks ago, and what I expect it to be for the rest of the year: things have become a lot more stable, albeit still slow.

One last thing while we are on the subject of GDP: the amount of decline in the economy is not the amount we have to ‘make up’ in order to recapture our lost wealth. We need to get much more than that. The reason is, of course, that the recession interrupted an upward trend. Getting back to the start is insufficient, we also have to recapture the growth we have lost. The actual numbers are still in flux, but by the time we start climbing back the peak to trough decline will have been in the order of 3.7% t0 4.0%, given that under normal circumstances we should have had about a 3.0% growth during that same timeframe, the actual lost wealth is around the sum of those two or 6.7% to 7.0%. That’s a whole lot more difficult, even with the burst we are likely to see when the third quarter data is released.

The point of bringing this up is that it is the larger figure that we should bear in mind when we argue over stimulus packages etc. We are trying to get back to where we should have been, not to where we were. There’s a big difference.

Still, this morning’s announcement is clearly a step in the right direction.

The recession is over. Just what happens next is very uncertain.

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Up and Down We Go

As if right on cue today’s news encapsulates everything we’ve been talking about all week: despite all the brouhaha about recovery our progress is precarious.

First: durable goods orders.

Today’s report is bad news. Durable goods orders fell at a 2.4% rate in August. That’s the second drop in the last three months, but follows what we all thought was a turn around in July when they rose a strong 4.8%.

As usual I caution everyone about taking one month’s data and making it the whole story. Durable goods orders are notoriously ‘chunky’. The numbers include a whole mix of things and run the gamut from refrigerators to airplanes. One order for a few airplanes and the index can leap, only to plummet next month. So we should look at the numbers in both more detail and over time.

The problem with this is that the story doesn’t improve too much.

Durable goods orders are typically seen a harbinger of future activity since they include machinery needed to re-tool factories. They are also, obviously, a factory based set of products so they give us insight into the state of play in manufacturing.

There are two major possible distortions that could cause the data to mislead us: the aircraft orders I mentioned already, and defense spending. Both tend to come in batches of large orders and thus can skew the data off of a ‘normal’ trajectory. Since it is that trajectory we are interested in it is sensible to look at the data without them.

Unfortunately that doesn’t help us. Take out aircraft and defense and orders still declined. Clearly businesses are being very reticent about investment. They are sitting and waiting for more insight into the nature of the economy as it grows over the next few months. This report suggests a continuing lack of optimism throughout the business world.

Worse: the drop in orders has now caused the backlog of unfilled orders to decline. That means our factories are looking at a few months of flat or slightly lower activity. If this data means anything it tells us that the hope for an acceleration in manufacturing is more hope than reality.

One consequence of this is that factories are not about to begin a burst of re-hiring. So our job market will remain weak, at least in the manufacturing sector. A flat order book provides no incentive to re-hire or to expand capacity, and with so much idle capacity already out there we are probably looking at a few more months of moving sideways rather than making solid gains.

On a different front today’s report of weaker than expected new home sales is also bad news. They rose only a meager 0.7%, which is a poor record given that home prices have dropped so significantly over the past year or so. The mean price of a new home dropped 9.5% between July and August – the largest one month decline on record – and the median price has declined by 11.7% over the past year. Couple these price drops with the recent tax credit for first time buyers, and I think many people expected a stronger performance in August. In this context that 0.7% gain looks anemic to say the least.

As I wrote yesterday the housing market is all muddle at the moment. Builders are completing fewer new homes as they try to avoid sitting on inventories of unsold homes: completions dropped 5.8% last month, and that helped reduce the inventory of unsold homes to about a 7 month supply – the lowest since early 2007. But builders are facing very stiff competition for buyers because of the flood of cheap foreclosed homes: many first time buyers who normally would have bought a new home were able to purchase a cheaper foreclosed home. The bad news within the data is that a new home, once completed is now taking as much as a year to sell. We are used to thinking of a 6 month unsold home inventory as ‘normal’, so, given the ‘stickiness’ of sales it looks as if it will be a few months more before we reach that level – perhaps by the first quarter next year. After that I think the market will stabilize around a lower volume, at which point housing will once again be a net positive for the economy as a whole.

Rather than leave you on such a low note I should also mention today’s release of the University of Michigan’s regular Consumer Sentiment survey. The index of confidence jumped from 70.2 to 73.5 in the the first couple of weeks of September and compares really strongly with August’s overall reading of 65.7. Consumer confidence is a very difficult statistic to get our arms around simply because it is intangible. The big question is whether rising confidence will lead to more sales. If it does then the steady improvement we are now seeing in consumer outlooks should translate into the kind of consumption that would cause those reticent businesses I mentioned earlier to start investing and blowing the cobwebs off their factories.

Setting this all in the big picture:

Our economy is suffering from a massive reduction in demand. We have production capacity sitting idle waiting for signs of a revival in spending. While that revival looks suspect or way off in the future businesses will not invest – this is why durable goods orders are weak at the moment and is also why we will continue to keep an eye on them. Every month we go without getting back on track costs us hugely in lost wealth we will never recoup: at our current rate we are losing, for ever, around $200 billion of national wealth. So that uptick in consumer confidence cannot come at a better time – let’s hope it translates into sales in the stores.

Meanwhile: keep in mind that $200 billion a month figure.

Nest time someone you know argues about the cost of bail-outs or stimulus plans think about their cost in the context of the wealth leaking away. The contraction has cost us almost $2 trillion. So the spending of about $trillion to get things going again was a good deal. Remember that without that spending we would have fallen deeper and longer into the abyss. At that point the $2 trillion loss could easily have doubled.

Yes, it is expensive to have the government bail out the private economy, but the private sector collapsed and we had no option. Deficit spending is not something I advocate as a permanent policy, far from it, but there is a time and place for it.

Like now.

It works. Now let’s move on.

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Upbeat News – Maybe

This morning’s release of the Conference Board’s Index of Leading Indicators brings us more good news: last month was the fifth straight month that the index gained. Yes the August increase of 0.6% was weaker than either July (0.9%) or June (0.8%), but it keeps the upbeat rhythm going and helps to confirm the growing sentiment that the recession finally ended in the third quarter.

By now there is, of course, no surprise in this. For several weeks now it has been clear that the economy reached its nadir sometime this summer and is now slowly edging away from the abyss.

The Conference Board also publishes two other indices that are supposed to track the economy one coincidentally and one with a lag. Both those are showing the same trend. The Coincident Index has now stopped declining and is essentially flat, while the lagging index is still falling, but now at a much slower rate.

Things are evidently looking up.

Up to what?

Here the difficulty arises.

I have written before about the variety of interpretations concerning the direction and strength of the economy from here on out. Depending upon your degree of inherent optimism we are now rebounding nicely, or we are teetering on the brink of falling backwards. Neither position will be exactly correct and the most likely course for growth seems to be ‘patchily and slowly upward’.

The current phase of growth depends heavily on a combination of inventory adjustment – businesses re-stocking depleted shelves – and the administration’s stimulus plan. Take those two elements away and we are still mired in recession. In other words the economy has not yet entered a self-sustaining growth cycle where consumption is sufficient to drive job, incomes and hence spending growth.

The degree of optimism built into anyone’s forecast at the moment depends entirely upon their view as to what happens when the ‘training wheels’ of inventory adjustment and stimulus plan are taken away.

My own view is that once those effects fade, as they will towards the middle of next year, the risk of a second contraction – renewed recession – remains high.

I say this for two major reasons that are inter-linked:

  1. Unemployment hangs very heavily over us and will continue to exert a negative drag on spending.
  2. Related to this: the economy has accumulated enormous excess capacity, which has to be used up before we can return to a more normal cycle of expansion.

As long as that capacity overhang exists business can expand and meet growing sales without either investing in new factories and other forms of capital, or, and this is crucial, investing in an expanded labor force. So the outlook for job growth is spotty to say the least. In fact I think it likely that unemployment will continue to edge up throughout this year even though we are out of recession. Last week’s unemployment data – new claims for unemployment insurance – concerns me. That fact that we seem stuck and are still losing half a million jobs every week or so gives me great pause. There is no sign whatever of the private sector re-hiring. On the contrary belt tightening still seems to be the order of the day.

Setting aside the obvious attendant human misery that this unemployment trend is creating, we need to focus on the drag this places on the recovery. It appears as though businesses are still in a defensive mode. If this is the case throughout the next few months then there is no way that a recovery can become self sustaining: as each business seeks to preserve its own profit it acts to diminish the sum total of all profits – a cut cost for you is lost income for me. This is what caused us to sink so low, and it could be sufficient to sink us again.

In other words the private sector still is fearful enough that it could self destruct and derail the recovery next year some time.

Think of it this way: businesses have to make guesses about their future sales – let’s dignify this and call them ‘forecasts’ – they then make decisions about buying raw materials and hiring workers based upon those forecasts. So the economy of late 2010 depends heavily upon business expectations today. To a very large degree those expectations become self fulfilling: if the forecasts were for higher sales then the act of tooling up to meet those expectations creates much of the growth – the new jobs and raw material purchases generate incomes which, in turn, create the sales that the businesses were forecasting.

Economists have a fancy name for this: ‘Say’s Law’, which roughly translates into the supply side mantra that ‘production will create its own demand’. This idea lies at the heart of classical economics. The problem comes when expectations are for insufficient sales: then it seems that Say’s Law breaks down and, instead we enter a Keynesian world that he called ‘the paradox of thrift’ – cuts lead to more cuts and so on downwards. This is the exact opposite of what the classical textbook predicts.

So business expectations are vital to the recovery, and a key variable informing those expectations is the availability of disposable income which, in turn, depends highly upon job growth.

Advocates of a more robust recovery are clearly predicting a much stronger uptick in employment. I just don’t see anything to support that view – remember that the last two recoveries have also seen very weak job growth, and it was one of our major criticisms of the Bush era that it simply failed to generate enough jobs. Clearly the US economy has a different tenor than it did a few decades ago and those job growth surges so characteristic of earlier recoveries are no longer ‘normal’.

So, while there are many anecdotal signs of jobs ‘out there’, the aggregate story remains both dull and challenging.

We will get more information on Thursday when the weekly claims for unemployment insurance numbers are published. Most people are forecasting another drop, but the relevant question is whether that drop is large enough to undermine my more cautious outlook.

Stay tuned.

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