Think Structure, Not Cycle (9/4/2010)

September 4, 2010

GDP growth forecasts for the next 12 months have been reduced from about 3% to 2.0-2.5%.  It will be an unsatisfying, muddle-through economy, essentially what I have been forecasting for a year. A few foresee an actual decline, a so-called “double-dip”. I am not in that camp but admit the risk of its occurring is not trivial.

Perhaps we, all of us, practitioners and policy makers included, have been blinded into thinking too much in conventional cyclical terms. Mohammed El-Arian, the CEO of PIMCO and a person whom I respect highly, has said that we must discard the cyclical context for economic policy and adopt a structural context. I believe he is correct. Put differently, our economic problems are not stemming from the business cycle as we came to know it over the past 60 years. They are deeply structural in nature.

The most overriding of our structural problems is, of course, the immense debt load the private economy assumed during the two decades leading up to the financial crisis, and which is now being whittled away by paydowns, foreclosures, and bankruptcies. As it is being reduced, the public debt has soared as a result of lower tax collections and higher spending, as we have attempted to stimulate the economy, both fiscally and monetarily.

The financial system has stepped back from the edge of an abyss, but remains stressed. Bank asset quality is still lousy, and many assets remain to be written down or off. And because the private demand for credit among qualified borrowers is weak, the Fed is unable to increase the money supply.

State and local governments, experiencing lower revenues from property taxes, sales taxes, and income taxes, have found themselves face-to-face with the spending excesses and contractual obligations, e.g., pension guarantees, of a bygone era. At the federal level, our politicians seemingly ignore the ticking time bombs of Medicare and Social Security, and show no signs of producing a credible plan to bring the deficits under control.

Both residential and commercial construction remain extraordinarily depressed and no sharp recovery for either is likely for a long time ahead. Temporary tax credits and other stimuli have proven unable to jumpstart either housing or auto demand.

We also have some very basic structural problems including a public primary and secondary educational system that is “the pits”, and a public transportation structure that is woefully inadequate and inefficient

Overcoming these structural issues will take at least 3-5 years for some of them and a generation for others. We, both politicians and business, need to think in terms of providing an environment for the private economy that encourages risk taking and entrepreneurial energy, and less in terms of stimulating immediate job creation.

Economic Policy Mix Has Been Successful (Though it May Not Appear So)

So far, most observers view the results of our economic policy mix as disappointing; unemployment remains high, and private final demand has risen only very slowly and modestly, more so than in any previous economic recovery. But rather than thinking solely in terms of how little economic recovery we have engineered, we should recognize what serious economic problems been circumvented before judging success or failure.

In that spirit, let me refer to an interesting paper just published by Alan Blinder and Mark Zandi entitled How the Great Recession Was Brought to an End. It is an econometric analysis of the results of both the monetary and fiscal stimuli that have been applied to the U.S. economy since the financial crisis/recession began. Those interested in the paper may access it here: http://www.princeton.edu/~blinder/End-of-Great-Recession.pdf

(Alan Blinder is an economics professor at Princeton University, a member of the President Clinton’s Council of Economic Advisors, and former Vice-Chairman of the Federal Reserve Board.  Mark Zandi, who has a Phd. in economics from my alma mater, the University of Pennsylvania, is Chief Economist at Moody’s Analytics.)

Their conclusions are quite staggering.

They found that the effects on real GDP, jobs, and inflation have been huge, and probably averted a serious depression. For example, they estimate that, without the government’s response, GDP in 2010 would be about 11.5% lower, payroll employment would be less by some 8½ million jobs, and the nation would now be experiencing deflation.

Before telling you more, let me say that my impression is that the numbers are so big that they don’t seem entirely credible. Even so, they convince me that I have tended to underestimate how truly bad the Great Recession was and how big a positive difference monetary and fiscal actions have made.

Econometric models are complex things, but they are built on a foundation of past interrelationships of the many variables. They have proven to be quite good in measuring the impact of changes in variables of a normally expectable magnitude. However, they have never before had to digest changes of the immense magnitude of the recent past. Consider, for example, that the total budgetary cost of this anti- recession fight will be about $2.4 trillion or about 16% of GDP.  The savings and loan crisis of the early 1990’s cost $350 billion, or 6% of GDP at that time. So, what if the bottom line of Blinder/Zandi model is a bit exaggerated? I am still impressed because the model assuredly catches both the direction of change and the general magnitude of that movement. (It is, of course, unrealistic to compare what happened to what would have happened had we done nothing. We would have done something!)

The model indicates that monetary actions have been substantially more important than fiscal stimulation, although fiscal moves did have significant effects, raising 2010 real GDP by about 3.4%, holding the unem­ployment rate about 1½ percentage points lower, and adding almost 2.7 million jobs to U.S. payrolls.

In December of 2008 and again in March 2009, I emphatically stated in these Musings that the Federal Reserve had taken a depression off the table. I still hold to that view, and the positive magnitude of the effects of the Fed’s actions, as estimated by Blinder/Zandi, exceeds what I would have estimated.

The dilemma for policy makers at this juncture stems from the political unpopularity of federal deficits on the one hand and the powerlessness of the Federal Reserve, already having interest rates close to zero.  Congress is very unlikely to pass any further significant stimulus. True, the Fed can push more reserves into the banking system, but stagnant private demand for credit by qualified borrowers makes the “pushing on a string” analogy an apt one.

I have written before about an economic outlook that variously has been called The New Normal, The New Mix, and a Rebalancing. By whatever handle, it’s an economy that is expanding very slowly and irregularly, begrudgingly creating jobs, and flirting with deflation.

The Brighter Side

A brighter way to look at it is that consumer deleveraging is continuing, as it must if we are to regain a sound economic footing. Every month that consumer debt contracts brings us closer to where we want to be.

Meanwhile, housing starts are scraping bottom. Even if they rose 50% they would still be badly depressed.  Housing has become quite affordable as prices have declined and mortgage rates are at record lows. While I can’t forecast any near-term strength in housing, I also can’t believe that it will become more depressed. I can say this: the next major move in housing activity will be up, probably sharply.

The same is true of many consumer durable goods.  Appliances and home furnishings, reliant as they are on new housing and the turnover of the existing housing stock, are quite depressed, and demand backlogs are building. Autos, selling at an 11 million annual rate, are below the normal scrappage rate and 5 million or more units below where we were in the years before the Great Recession. It may be that the scrappage rate has declined as a result of higher quality vehicles, but this will ultimately work its way through the system.

Technology has continued to produce new and attractive products that experience strong demand (think iPads, ereaders, smart phones).  Cloud computing is on our threshold. Electric cars are here. So there is plenty of stuff to captivate us.

The stock market continues to be range-bound, with no net movement in almost a full year.  But I have been able to find high quality companies at prices I believe will prove to be attractive given a couple of years.  I listen to the talking heads on CNBC who seem to be consumed by trying to make money from short-term market movements.  A few of them will succeed. Most will not.

So hang in there

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