View From Down Under

When the US GDP numbers for Q4 09 were first announced, I mentioned they were likely to be revised upward.  Turns out they were, from 5.7% to 5.9%.

Despite the strong fourth quarter, and continued evidence of recovery,  economists are wary of forecasting growth.  The dreaded double dip is a continued worry.  The consensus economic forecast for the US economy in 2010 is 3%.  Although this is up from 2.4% a few months ago, it is still too bearish.

In another well written article, Forbes columnists Brian S Wesbury and Robert Stein recently explained why they are more bullish.

The consensus is still underestimating the resilience and robustness of the U.S. economy and remains stuck on expectations of a “new normal.” But productivity is strong, monetary policy is (and will continue to be) easy, inventories are razor-thin and corporate profits are growing rapidly.

The biggest risk to recovery?  Not the deficit.  Government spending has clearly had a positive impact on the US economy, and helped to lessen the severity of the recession.  Although I do believe that deficits matter and fiscal responsibility is important, the level of US debt is nowhere near crisis proportions.

The view from down under is that the biggest risk to continued economic growth is China.  If the plural of anecdote is data, there are some clear signs of a Chinese real estate driven bubble.  If China’s economic growth drops from its current 8-9% per year, the impact on the global economy could be severe.  Even if China maintains 4-5% growth (which would be considered extremely robust in developed economies) it could still push the OECD into strife.  This is because most investments being made in China are based on the assumption of continued high growth rates, and any drop in those rates will cause many of these investments to be shelved.

This risk was highlighted last week when Chinese Premier Wen Jiabao warned that China may not be able to sustain their growth.  There is no question that China’s growth is unsustainable over the long term, and the only question is when – not if – the slowdown will come.  I suspect we are several years away, and by then the global economy will have had a full recovery.  But if I’m wrong …

I like data.  Data is powerful.  Data can be misused or misinterpreted, but it doesn’t lie.  It has no agenda.  It is what it is.

When I test rhetoric against data, I find some interesting dichotomies, and over the years this process has driven me from right of center to somewhat left of center.

Here’s a case in point.  The right wing has long painted the Democrats as big spenders, eager to take the hard earned money from the honest, small business owning, risk taking entrepreneurs and give it to the lazy, shiftless, leeches of society through major handout programs and massive pork barrel programs of little benefit to the nation as a whole.

This continues even today, with a recent editorial by Peggy Noonan painting the GOP as the party of fiscal restraint.

“The GOP itself should be going forward with its philosophy, with the things it’s long stood for and, in some cases, newly rediscovered, and painting the broader picture of the implications of endless, compulsive high spending.”

Here’s the data.  Taking the federal deficit as a % of GDP, and adding up the numbers for each President’s budget terms, the cumulative deficit numbers look like this*:

Admittedly, this is a somewhat blunt analysis, but however the analysis is done, the picture is clear: Democratic Presidents, on the whole, have been remarkably responsible (fiscally). Republican Presidents have been the “compulsive high spenders”.

Of course, this is not new, or news worthy, but it continues to amaze me that the right wing still genuinely believe that Democrats are fiscally irresponsible.

* I have not included Obama because these numbers are actual (not budget) and Obama has no actual numbers.  He has proposed only one budget (although the expected deficit of nearly 10% of GDP would put him in the big spending category).

According to the New York Times, the Senate and the White House are close to announcing a council of regulators whose focus is to identify systemic risk in the financial system.

This is a good idea.  After previous financial crises, Congress enacted knee jerk, Sarbanes Oxley kind of legislation that added layers of compliance costs without adding any value to society.  They seem to be learning, and there are apparently enough Congressmen with the sense to recognize that they cannot legislate away the next crisis by trying to legislate away the last one.

Senator Mark R. Warner (D-VA) showed some rare economic sense when he said:  “You need a vigorous, focused group. You don’t need to create some massive new bureaucracy, but a place to share information and do some level of analysis.”

Admittedly an oversimplification, but the last financial crisis was mainly fuelled by asset inflation driven by financial innovation – financial products created in the last few years, sold by people with no economic interest in anything beyond the sale, and bought by investors who could not understand the risk.  These products were not so much outside the existing regulatory system as they were above it, with different agencies responsible for regulating different parts but no regulator looking at the whole.

The Senate/White House plan will give the President and Congress the ability to say they have acted as a result of the financial meltdown, and may even help prevent another similar crisis, but shouldn’t add costly layers of additional regulation.

Regardless of what form the legislation takes, it is a certainty that there will be another financial crisis at some point in the next decade or so.  The next financial crisis will be both similar and different to the last one.  It will be similar in that some assets will be overpriced, with lenders willing to lend far more than is prudent.  It will be different in that the overpriced assets will not be collateralised mortgage obligations.  After the asset inflation, there will be a liquidity crunch precipitated by an unsuspected event.  That event could be anything from a slowdown of growth in China, to a sovereign wealth default, to the realisation that some assets are fundamentally overvalued (a la dotcoms, tulip bulbs, or CMOs).

Therefore it is a certainty that no legislation will prevent every future financial crisis.  However, a council involving several regulatory agencies whose brief is to look for systemic risk is far more likely to be effective than creating a Consumer Financial Protection Agency, or any other proposal I’ve seen so far.

With the President’s budget last week, he seems to have succumbed to the pressure to cut spending now.  This is bad policy.

Unlike Dick Cheney (at least when he was VP) I do understand that deficits matter.  In the long term, the US needs to reign in its spending and try to have at least balanced budgets.

But not now.  The country is barely starting to recover from a debilitating recession.  US unemployment is still staggeringly high.  The President and Congress should be discussing further stimulus focused on job creation, not arguing over what job creating programs to cut. 

Cutting government spending now risks derailing the recovery.  Nothing I’ve seen in the data suggests a double dip recession, but a concerted push to reduce government spending could be the game changer.  When FDR reduced the deficit in 1937 and 1938, it sent the economy into another devastating tailspin and prolonged the depression.

Does the deficit matter?  Of course it does.  Should the long term goal be a balanced budget?  Absolutely.  But “for everything there is a season…”

A responsible government should run surpluses in good years, and be prepared to move into deficits when economic cycles turn.  Unfortunately, the US has not been a responsible government for some time.  The last budget surplus was Clinton’s final budget in 2000.  Before Clinton’s four balanced budgets, you have to go back to Johnson’s final budget in 1969 to find surplus.  Kennedy, Nixon, Ford, Carter, Reagan, George HW Bush, and George W Bush never had a balanced budget.  Not one.  Johnson managed one. 

Trying to cut government spending is decidedly hard.  There is no apparent political gain from a balanced budget, and no apparent political pain from deficit spending.  (This, BTW, was what Cheney was referring to when he said deficits don’t matter.)  So getting Congress to reduce spending when there is nothing in it for them is near impossible.  Add to this the fact that most of the budget is untouchable, and it is a terribly difficult task.

Ultimately, the best the US can realistically hope for is some long term concerted efforts to control spending until the economy grows enough to make the debt less relevant.  I am not optimistic about this.

But clearly trying to address the deficit now risks sabotaging the recovery.

The Commerce Department released their latest figures on GDP last week – up 5.7% in the fourth quarter.  Big contributors were inventory additions (3.4%) and personal expenditures (1.4%).

Most economists I’ve read suggest we treat this with caution because of the high contribution from inventory growth, which is clearly not sustainable.  As true as this cautionary note is, the numbers are also full of upbeat results.

Personal expenditures are up.  This is in spite of a drop of 0.57% in motor vehicles (against a strong third quarter boosted by Cash for Clunkers).  Clothing and footwear spending is up for the first time in six quarters.

Overall fixed private investment is up for the first time in ten quarters.  You have to go all way back to June 07 to find the last up quarter in private investment.  This has been driven by growth in equipment and software.

Government spending was down 0.2% during the quarter as the stimulus spending stopped growing.  We should expect this to continue to decline as the stimulus plays out.  Remember the GDP numbers measure change quarter to quarter, not absolute level of spend, so as the stimulus spend starts to slow the impact on GDP growth will be negative.

The last bit of good news is that I think this number is likely to be revised up in the next month.  After getting the last one so wrong (initial announcement of 3.5% growth with a revised number of 2.2%), the BEA analysts have likely taken a very conservative view on their estimates this time.

The economy has not “recovered”, and there is a long way to go before the 7 million people who lost their jobs will be back at work.  But I continue to doubt the double dip thesis, and remain bullish on the prospects for the US economy in 2010.

Back in November, I wrote that the recession was over – though it may not feel like it.

This week, the Conference Board released their data on leading indicators.  The index was up again in December, and has “risen steadily for for nine consecutive months.”  Here’s the chart:

The Coincident index has been rising as well, up for five of the last six months.  Building permits, stock prices, consumer expectations, business capital expenditure, industrial production, manufacturing sales – all up.

Interestingly, consumer confidence is lagging, and consumer assessment of the economy is decidedly bad.

A recent Gallup poll shows how pessimistic consumers are on the economic situation.  Asked the open-ended question “Just your best guess, how long do you think it will be before the US economy starts to recover?”  Remember that, from an economist’s perspective, recovery probably began in July/August last year.  Here’s the results:

Fully 85% of the people surveyed expected it would be one year or more before the economy starts to recover.  About half the survey expect it will be three years or more.  Put another way, half of the population thinks the US will be in recession for at least another two years.

Now, it’s possible (in fact, highly likely) that the average consumer’s definition of recovery is different to economic definitions, and the survey respondents are actually answering a different question.  They may think it will be two years before the economy is back to where it was in 2007 (which is also historically pessimistic).  Psychologically, the last 18-24 months experience is much more relevant to most people than experience prior to that.  Recent experience is still felt emotionally while more distant experience is only a memory.

Clearly, to most Americans, it does not feel like the recession is over.  And there are some highly acclaimed economists who are concerned about a ‘double dip’.  But with leading indicators climbing that dramatically, and the rest of the world pulling out of recession as well, a double dip looks less and less likely.

The Labor department released its December employment situation update yesterday.   Non farm payroll down slightly (85,000).  Unemployment rate remained steady, as a result of people dropping out of the job market.

In the last two US recessions, unemployment has lagged economic recovery by much more than previous recessions.  From an article by Mark Thoma in November comes this interesting graph:

The delay in unemployment reduction led both the last two recoveries to be labelled jobless recoveries.  I believe this one will be as well.

Improvement in technology has changed the way much work is performed.  However, most companies do not lay off employees when they improve their systems and processes.  Instead, they tend to either redeploy them or fail to completely capture the benefit of the upgrades.  During a recession, companies are forced to reduce staff.  Often they find that there is the ability to stretch productivity during this time, and as the economy recovers they manage to keep pace with the recovery with a smaller staff.  This process has accelerated since the 1981-82 recession, and I believe is one of the key reasons for the jobless recoveries (although there are other reasons also).

The view from down under is not as pessimistic as many economists (including many much more qualified and eloquent than I), but the prospects for major reductions in unemployment before the mid term elections next November looks grim.

2009 was clearly the year of stimulus.  Governments around the world responded to the financial crisis with very strong fiscal and monetary stimulus programs.  The year also validated stimulus as an effective method of helping economies out of a recession.  This was true in Australia, China, much of Europe, and even the US (although the US stimulus was relatively light and the impact less pronounced).

All of the world’s economies are likely now out of technical recession – with the possible exception of Iceland and one or two others.  However, that does not mean the world’s economies are out of danger.  The possibility of slipping back into negative GDP territory is still real – as was demonstrated when Singapore shrank 6.8% in the fourth quarter vs growth of 14.9% in the third.

The big challenge for 2010 will be how to unwind the stimulus programs without pushing the economy back into recession.  Nobel prize winning economist (and self confessed liberal) Paul Krugman believes the likelihood that the US gets this wrong is “better than even”.  Other economists are also concerned that low underlying growth and withdrawal of stimulus will cause a double dip recession.

There are some lessons from other countries’ efforts to unwind their stimulus.  Australia, which had the mildest recession of any OECD country, has already raised interest rates three times and their fiscal stimulus programs are largely finished.  Stimulus programs included reducing interest rates (by 4% from September 08 to February 09) and cash handouts to low and middle income families in October and December 2008.  Reducing interest rates has a bigger impact in Australia than the US because about 80% of Australian households have variable rate mortgages.  As you can see below, the impact on retail sales was pronounced, spiking as the cash payments were received.  However, since April and the withdrawal of stimulus, retail sales have been slightly negative overall.  (Fortunately, Australian GDP does not depend entirely on retail sales, but it is a major component.)

Clearly the removal of all stimulus for the US economy now would cause the economy to slip back into recession.  That won’t happen, but there is a likelihood that without further stimulus the economy will still falter.  Personally I am more bullish about the odds than Mr Krugman, but the Fed and Congress need to manage the process carefully and some further fiscal stimulus may well be appropriate.

With a bit of luck, the year of stimulus will be followed by year of the gradual unwind.

When I defend the various economic stimulus programs used to fight the latest recession, the typical response from my right wing friends is that government is not the answer to our problems.  The private sector is always better at producing cost effective outcomes, and the less government interference there is, the better.

This is the common understanding of supply side economics.  Lower taxes and less regulation equals higher output, higher government revenue, and better living for all.*

But are the two incompatible?  Does a belief in supply side mean you have to believe the stimulus packages actually made things worse?

The data on economic stimulus is quite clear.  Most economists agree that the US stimulus package has kept the recession from being much worse than it was  – the only argument is by how much.

Recessions are often associated (at their front end) with financial crises and flight from risk.  During good times, investors typically take more risks than they understand (chasing last year’s gains).  They buy equity in highly leveraged businesses which themselves own risky assets (CMOs, Russian bonds, dotcom startups), and often use margin loans to do it.  When things start to unwind, investors flee risky assets.  The resulting collapse in asset values creates uncertainty among both businesses and consumers, who pull back on their own spending and investment plans.  As a result, GDP contracts and recession ensues.

The appropriate government response is to buy risky assets to provide liquidity to the system and prevent financial meltdown (TARP), and to stimulate demand through a combination of lower interest rates and direct government spending  (stimulus).  The 1930s taught us what happens when you do something else.  The fact that the first part of these programs was agreed by President Bush, Barack Obama, and John McCain testifies to the logic.

Only the government is in a position to provide liquidity and stimulus in times of recession.  Not only is it appropriate for the government to do so, it is imperative.

This does not mean government is the answer to everything, or that government should try to ‘micro-manage’ demand over the cycles.  As Bob McTeer, former President of the Federal Reserve Bank of Dallas, writes:  “I don’t get why we can’t be supply-siders in normal times and yet accept that Keynes is relevant for depressions and deep recessions.  Both supply and demand are important.  Why must each side ridicule the other?”

The data I’ve seen supports this view.  In general, less government intervention is better (in economic terms), but there are times when government intervention is appropriate.  I believe government intervention is appropriate where externalities are not properly priced (pollution control); where free riders thwart effective outcomes – otherwise known as ‘public goods’ (fire fighting, street lights, health care); and when economic cycles turn down.  In other (much more eloquent) words:  to establish justice, insure domestic tranquillity, and promote the general welfare.

*This is not actually my understanding of supply side economics.  My understanding of the Laffer curve is that lower taxes only equals higher government revenue if marginal tax rates are greater than t*.  The reduced income tax receipts after the Bush tax cuts suggest the US is somewhere below t*.

There is little doubt that inadequate regulation contributed to the financial meltdown of 2008.  Financial institutions were using government guaranteed funds to purchase ‘innovative’ financial products whose risks were poorly understood.  Investment banks were creating these new products with little or no oversight, generating billions in fees for reallocating risk from those who owned it to those who thought they weren’t buying it.  Governments around the world were forced to intervene to prevent catastrophic failure of the global financial system.  A major revamp of US financial regulation is an appropriate response.

Ideally, the government should review existing regulation, understand where it fell short in the last financial crisis, and develop ways to fill those gaps.

Unfortunately, the US political system does not work that way.  The House passed legislation last week that focuses on punishing the banks, inserting Congress into the decision making of the Federal Reserve, and shifting consumer credit regulation from the Fed to a new agency.

The Consumer Financial Protection Agency is Barney Frank’s reaction to the subprime lending crisis.  Democrats in the House apparently believe the subprime crisis was a failure of consumer protection.  If the new agency is to have the effect of preventing another subprime crisis, it should be charged with restricting lending to consumers who should not borrow.  But of course, it is not.  The objectives of the agency are to ensure that: consumers have the information they need to make responsible decisions; consumers are protected from abuse, unfairness, and discrimination; markets for consumer financial products operate fairly and efficiently; and traditionally underserved consumers and communities have equal access to responsible financial services.

Barney Frank does not seem to understand that the financial crisis was caused by an explosion of innovative financial products, sold to investors who did not understand the risks, underwritten by insurers who did not understand the risk, and aggressively leveraged by lenders who did not understand the risks.  A large number of consumers were caught in this process, consumers who should not have qualified for loans in the first place.  But nothing I’ve seen in the house bill addresses the fundamental breakdown in financial regulation prior to the crash, and more consumer protection (as noble as it sounds) will not prevent another financial crisis.