exports

/ / , , , , , , , /

The Outlook: Part 2

Following up on my short post yesterday about the Federal Reserve Board’s outlook for the economy, today I received the Congressional Budget Office [‘CBO’] forecast which takes the form of a briefing to Congress. The story is pretty much the same. But there are small differences we ought to be aware of.

The CBO takes a dimmer view of the outlook for unemployment. The Fed predicts the unemployment rate topping out at between 9.5% and 9.75%. The CBO expects it to go beyond 10.0%. The news this morning that jobless claims moderated very slightly seems to indicate that the job situation is settling down a little. The key statistic to watch is not the week to week data because that can easily be distorted by a single and unrepresentative event: last week’s figures was much higher because it included a rash of Chrysler lay-offs. Instead we should pay attention to a moving average stretching back a month or two. This allows us to remove distortions like the one caused by Chrysler and thus get a better reading on trends. When we do this the ‘bottoming out’ effect is more noticeable. It is clear that job losses are still very high, but that there is no discernible worsening. There’s a hint of stabilization. And I mean only a hint.

Nevertheless given the continued high level of job losses, and the very high degree of difficulty workers are encountering as they try to find new jobs – which is also embedded in this morning’s data release because continuing, as opposed to new, claims for unemployment benefits are still at record highs – I expect the CBO prediction to be more accurate. Plus I have a feeling the Fed deliberately erred on the optimistic side when talking about the job outlook because it wanted to use unemployment in its bank stress tests, and as you know, I think they wanted to soften those test for political reasons.

So unemployment will be a very significant drag on the economy right through the next year or two.

Having said that the CBO still predicts that the recession will end later this year and that we will see very slow growth during the third and fourth quarters of 2009 followed by a slightly better outlook in 2010. Currently the CBO is predicting GDP to grow by about 2.9%, adjusted for inflation, next year. There are two ways of looking at that. One is that it is quite low given that ‘normal’ recoveries usually get off to a flying start and then settle down later. The second is that it is quite good given the huge hole we are climbing out of and the ongoing risks we still have to overcome. I am in the second school.

There are huge imbalances still to be reduced. Consumer debt reduction will cramp consumption and business investment still looks very weak. And exports simply will not be a factor. The collapse in world trade has hammered economies that rely on exports: Japan’s economy dropped like a stone in the first quarter this year – it fell at an annualized rate of 15.2% from January through March which is astonishing by any standard – so it is extraordinarily unlikely that the US economy will be lifted by trade. That leaves government spending as the lynchpin of growth for a while to come. The Federal Deficit is the essential fuel we need until consumption adjusts to the new less indebted world of the future.

The problem with that is the glut of US government bonds that are now out on the world markets. There are signs that our ability to fund the debt will run into difficulty if the rate of deficit spending is not curtailed soon. Already recent bond auctions – the Treasury sells its debt through an auction process – have been less than enthusiastically received and there are even rumblings that the US may lose its AAA bond rating later this year. For those who doubt this I point to the UK as exhibit ‘A’: their bond rating was lowered by Standard and Poor’s just today. Rumors of a US downgrade are picking up steam. While not a catastrophe a downgrade would signify a historic moment for the US economy and would not just raise the interest rates the government has to pay, but, because so much domestic US debt is priced at spreads from Treasuries, it would cause the entire nation’s interest rate structure to shift upwards also. Plus, historians may well look back on such a downgrade as the defining moment in America’s transition from world economic dominance to mere parity with China or the European Union.

Who would benefit from higher rates?

The banks.

The CBO report documents that the credit markets have climbed back from the edge of doom: the apocalyptic spreads we saw in the immediate aftermath of the Lehmann debacle have fallen away to being merely high. Confidence is evidently flowing back into the world’s financial system -as it should given all the taxpayer money that we have thrown at it. Nonetheless as banks start to look forwards at earnings trends over the next few years their ability to grow profits will depend heavily on the nature of the yield curve – the difference between short and long term rates. Without a resurgence of inflation I expect the Fed to keep short term rates quite low for years ahead in order to help growth. The potential of higher US bond rates will tend to drive longer term rates upward and thus widen the yield curve. Why will this help banks? Because the essence of banking is to borrow short and lend long: their cost of funds lies at the lower end of the curve and the prices they charge on loans lies at the higher end. So the steeper the yield curve, the more profitable banking becomes.

This will make Tim Geithner smile since he is relying on the banks to ‘earn they way’ back out of their capital malaise. But it will tend to press down on borrowers, both consumers and businesses, and will thus slow the recovery.

Finally the CBO highlights an essential conundrum we should all be aware of: there is a massive conflict between the near term requirements of fiscal policy and the longer term requirements.

Near term we need to run huge deficits. That is the only way we know to stop the economy falling into a depression. It is testimony to the efforts that have been necessary so far to avoid total collapse that the US budget outlook over the near term is, frankly, terrible. The Federal Deficit has shot up as a result of things like TARP and the stimulus package. This is as it should be and follows the prescription of Keynesian economics perfectly. But: fiscal policy cannot remain that loose. At some point we will have to start work on reducing all this debt we are now issuing.

I have said before that our task has been made much worse by the Reagan/Bush legacy. We ran horribly lax fiscal policies through both the 1980’s and the 2000’s. The result is the world is awash with our bonds just as we need to flood the market even more. Hence the glut I mentioned above. Instead of running fiscally conservative policies both Reagan and Bush ran incredibly irresponsible ones. It was Cheney who famously said that ‘deficits don’t matter’. Well they always did. And they matter very much right now.

There is no doubt that fiscal policy will have to revert to very tight standards in a couple of years. That implies both higher taxes and less spending.

Once again this will put a lid on consumption.

So for all these reasons: debt reduction, the collapse of trade; higher cost of debt; and the need for higher taxes, I just cannot see a return to strong GDP growth for a while.

In fact that 2.9% GDP forecast by the CBO looks ambitious to me.

Let’s hope they’re right.

/ / , , , , , /

Our Trade Problem

Today’s trade release by the Commerce Department is interesting from a number of angles. Let’s get the hard data out of the way first: the US trade deficit widened in March, which is the month for which we have the latest information. The gap between exports and imports rose to $27.6 billion, up from $26.1 billion in February. The short term significance of this change is that the February number had been the smallest trade deficit for nine years and was the last of eight consecutive months during which the gap narrowed. The dramatic shrinkage in the trade gap since the middle of last year has been a fairly important factor in holding GDP higher than it would have been otherwise: net exports are counted as a component of GDP with exports adding and imports subtracting from the total. So the steady drop in imports implied that a higher percentage of our demand was being met from domestic production.

Or at least that’s the way it appears under normal circumstances.

In reality the drop had more to do with the collapse of world trade, the drop in US consumption, and the equally dramatic fall in world commodity prices. The fall in US domestic demand, which is the root problem we are trying to deal with, obviously resulted in less demand for imported goods. At the same time the worldwide recession caused prices of things such as oil to fall from their peaks and so imports cost less. So not only were we importing fewer things, they were costing less as well. That should have been a boost to our well being except that a large part of the gain was offset by the loss of export markets as foreign consumers cut back on their purchases of American made goods and services.

So not only was the gain in net trade smaller than it might have been, it was somewhat of an illusion. I have no doubt that once our economy regains momentum the trade deficit will start to widen again.

And therein lies the rub.

As we re-engineer our economy so it relies less on debt fueled consumption, which will be one of greatest challenges over the next decade, we will be faced with a conundrum: what will replace consumption as the engine of the economy?

I am not suggesting that consumption will ever be replaced as the major driver of growth. My point is that as we shift away from debt towards a more balanced approach to spending, and as savings chew up a larger portion of incomes, consumption will have to back away from being closer to 70% of GDP which is what is has been recently. I expect it will settle somewhere lower and contribute between 60% and 65% of GDP each year. That decline from 70% to 60% will need filling if we are to see GDP grow.

And that’s the dilemma policy makers must face.

Where will that needed addition to the economy come from?

Countries that have previously experienced the kind of severe downturns we going through have typically turned to trade as a primary source of that addition. Japan, whose experience in the late 1990’s we have all talked about so much recently, was able to mitigate its drop in domestic demand by boosting its exports with its Asian trade partners in particular. The boom in China nicely coincided with Japan’s need to find a way to support itself and so exports to China helped mask Japan’s population from their dramatic drop in consumption. Without the trade boom Japan saw at that time its economic woes would have been far more severe and had much more impact on its consumers.

I doubt we will be so lucky.

The recession is worldwide. America plunged down first, so it is likely it will re-emerge first also. That means most, if not all, our trade partners will be still battling the downturn just as we are looking for trade opportunities.

So just when we need trade the most to help offset our own lost demand, and to assist us restructure our economy, the chance of opening up trade will be severely limited.

This is why I think growth is likely to be well below historical averages for quite some time, even after the recovery is well established. In fact I think the adjustment period of slow growth could easily be as long as five years.

People who expect us to rebound back to a typical growth rate either underestimate the difficulty represented by this trade dilemma, or are expecting Americans to go back to their bad debt habits.

My own view is that ‘de-leveraging’ – the cutting back on debt – by both households and businesses will be a dominant theme for years to come. In fact I think the government too will be engaged in debt reduction.

Eventually the Chinese and other emerging markets represent our best hope of re-establishing a more healthy and balanced economy here in the US. Their drive towards higher living standards offers us the chance to export and meet some of their demand. But until those economies get back on track ours will be held back as well.

So trade is another cause of caution concerning the future.

Those trade gains we have seen since the middle of last year need to be made permanent.

Only this time for the right reasons.

/ / , , , , , , /

Forget Exports as Our Next Big Thing

The recently published IMF report on the state of the world economy is a very sobering [and very long!] read. It predicts that, for the first time in decades, the world’s economy will shrink. Normally a recession in one area is offset by continuing growth elsewhere, so the global economy keeps on expanding as a whole. Not this time. The recession, that started here and is now infecting everyone else will cause the world’s economy to shrink by as much as 1.3% this year. The report notes that this is, by far, the worst global downturn since the Great Depression. The outlook for 2010 has been revised sharply downward too, with a meagre growth of 1.9% predicted.

This somber outlook provides a cautionary tale for those who argue that the US can lift itself out of its own malaise by constraining domestic consumption – a worthy goal if we want to reduce our reliance on debt, which I think we do – while, at the same time relying on exports from a reinvigorated American manufacturing sector.

The problem can be expressed simply as this: who do export to?

The two industrial countries with the most severe contraction to deal with are Japan and Germany. They both have very similar economic models. They rely heavily on exports of manufactured goods to support a their economies and both have a much more modest level of domestic consumption than the US.

The news for both Japan and Germany is getting much worse.

Several economic think tanks in Germany are now predicting that GDP there will shrink by as much as 6% this year largely due to the collapse of trade. Also today, Japan is set to announce its first trade deficit in thirty years, also a result of trade market for its exports drying up.

The experience of Japan and Germany suggests that, apparently, the global nature of this downturn has taken away an export led recovery as one policy option we can consider.

The lesson is best learned by looking at the japanese experience. There has been much play made of the economic problems Japan had during the 1990’s: they were the most recent to experience the ‘zombie’ bank phenomenon we fear so much here. Their economy languished at close to zero growth for a decade because they made policy mistakes early on in the crisis, failed to inject a large enough stimulus, and were tentative in dealing with failed banks.

Sound familiar?

The Japanese economy revived largely because world demand sucked in Japanese products in sufficient volume to offset very low growth in domestic spending. So successful was this strategy that it has become the normal Japanese method for maintaining a rising standard of living. It is a model for economic management that works well as long as there is always somewhere in the rest of the world with a growing market for Japanese goods. It doesn’t work too well when the entire world goes down together as we now are.

Which brings us back home: if an export led boom is not a viable option for us, we have to rely on getting our own domestic house in order. Indeed, since America has become the world’s consumer sucking on goods from places like Japan and Germany, there must be plenty of foreign policy makers hoping we get our house in order too.

And we do that by pumping up demand and keeping savings low in the short run. Oh, and we have to fix the banking system … did I mention that?

So our recovery relies on the same tricks that got us into this mess: low savings and high consumption. Which is already presenting policy makers with a difficult, or should I say more layered, problem. The near term remedy is exactly the wrong medium term policy. Longer term we want to convert our economy by achieving a more balanced mix of savings and consumption. We want to re-establish the kind of structure it had back in the immediate post World War II decades.

Interestingly an economy built around a higher savings rate is one that can pay down government debt at a more rapid rate than one built around borrowing: those savings can be channelled into Treasuries. This is one, but not the only, reason why all the hue and cry about running up massive future debt loads is misplaced. As long as we are careful and construct a more fiscally balanced economy in the medium term, let’s say by 2015, then our ability to recover and return to relatively low and sustainable levels of national debt is assured. Those same post-war years provide a good example: US national debt at the end of World War II was very high, but within a decade it was returned to pre-war levels.

So: exports are not our answer. And we have a very delicate balancing act between the near and medium terms.

This really is quite a mess we got ourselves into.

«< 4 5 6 7 8