Monday, October 22, 2012

The Reluctant Recovery: Part 4

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes some of the key points of the presentation, and is the fourth in a series (see Part 1 here, Part 2 here, and Part 3 here.). In this fourth part, the main focus is the state of the economy. I argue that although this is the weakest recovery in generations, with a few exceptions the economy has undergone some significant adjustments and is continuing to expand, although growth is likely to continue to be rather slow and disappointing until and unless we get significant improvement in fiscal and monetary policy.

This chart is plotted with a logarithmic y-axis (as are many of my charts) in order to highlight the trend rate of growth of the economy, which for most of the past 50 years has been about 3% per year. Recessions throw the economy off track, but it usually comes back to trend after a few years. I discuss this in more detail here. This recovery, however, has been miserable. This chart suggests the economy is about 12% smaller than it otherwise could have been if the recovery were "normal." That translates to almost $2 trillion in lost output or income. This very likely the weakest recovery ever, and I think it's due to the tremendous amount of fiscal and monetary "stimulus" that has been applied in the past several years. Fiscal "stimulus" that consists of a massive increase in transfer payments only weakens growth. In the same vein, monetary "stimulus" that consists of a promise to keep rates close to zero for years, and a commitment to keep banks flush with reserves, only stimulates speculative activity while also depressing savings. In addition, it creates tremendous uncertainty about the future value of the dollar. This all combines to weaken growth because it saps the confidence and the wherewithal to make major investment decisions. 

The Eurozone has taken a big hit, but industrial production there appears to be recovering in recent months, as predicted by the huge decline in Eurozone swap spreads so far this year. U.S. industrial production has been relatively stagnant this year, but there is no sign here of any collapse. 

The above chart suggests that the recovery in the stock market has tracked the improvement in the underlying fundamentals of the labor market. As the pace of layoffs has dropped, equities have risen. This is my general thesis: the equity market has not been driven by rising optimism, but rather by declining pessimism. Equities have rallied reluctantly, since the economy has improved—albeit very slowly—in contrast to the very pessimistic assumptions embodied in equity prices and bond yields as I discussed in Part 1. The market's expectations, in other words, have consistently been for the economy to be in worse shape than it has actually been. The future, in other words, has turned out to be somewhat better than expected, and that is what has forced equity prices to rise, reluctantly.

The growth in jobs has been generally disappointing, but nevertheless the economy is still creating additional jobs, and there is no sign in this chart of the decline in jobs that traditionally marks a recession. We are still in the recovery phase of the business cycle, no matter how disappointing the recovery may be. With markets still braced for another recession (or worse), a continuation of modest growth should have a positive impact on equity valuations.

The chart above compares households' monthly financial payment obligations to disposable income. Thanks to rising incomes, higher savings, deleveraging, and mortgage defaults, households have significantly reduced their financial burdens in the past several years. Financial burdens today are about as low as they have been at any time in the past 40 years, in fact. Recessions are all about negative surprises and the adjustments they force. By this measure there has been a significant amount of adjustment, and that in turn lays the foundation for healthier growth in the future. All that's lacking at this point is confidence. People are still reluctant to believe that the future is bright.

The delinquency rate on credit cards and consumer loans in general has dropped considerably since the end of the recession, another sign that households are in much better financial shape these days. 

In contrast to the general private sector deleveraging that has been underway in recent years, student loans are expanding at a rapid pace. This is the only category of consumer credit that has grown since the recession, in fact—consumer credit excluding student loans has actually declined by $240 billion since its peak in 2008. Student loans now account for 18% of consumer credit, whereas they were only 4% at the end of 2008. What accounts for this counterintuitive growth? The rapid growth started in early 2009, right around the time that the federal government essentially took over the student loan market. Virtually all of the increase in loans since that time has come from and is held by government agencies that have no qualms about suffering losses, since they are passed on to taxpayers. Like the housing market, which was force-fed with unaffordable loans that eventually went bust, the student loan market is a bubble in the making. The rapid growth in government-backed student loans is helping higher educational institutions to keep inflating their costs and their prices. This will likely end in tears (and defaults), with colleges and universities eventually forced to undergo the painful restructuring already experienced by the residential construction industry. The increase in student loan borrowing is not a portent of a stronger economy. There are still problems out there, and that's why everyone is reluctant to be optimistic about the future.

Auto sales are the very picture of a V-shaped recovery. Sales have increased at a 14.5% annualized pace since their recession low. Sales are still below "normal" levels, of course, but this kind of outsized growth has ripple effects throughout the economy. Sales have consistently exceeded forecasts, and this means that factories have no choice but to ramp up production and increase hiring. Real change happens when the unexpected occurs, and that is what is driving the auto industry.

Residential construction is now in the midst of a V-shaped recovery. Since early last year, housing starts have jumped by 60%, vastly exceeding virtually everyone's expectations. This also has positive ripple effects throughout the economy, and is a good sign that the housing bubble has burst. The necessary adjustments have been made (e.g., a significant decline in the inventory of new homes) to permit a return to growth. Residential construction could add as much as 1% per year to GDP growth over the next several years. It matters little that starts are still extremely low; what matters the most is the change on the margin, and that is very encouraging.

With construction rebounding, it's not surprising that housing prices are firming and even beginning to rise in many areas. The Radar Logic survey of housing prices shows they rose 5% in August compared to a year earlier. Housing today is more affordable than ever, thanks to extremely low mortgage rates and a 35% average decline in housing prices across the country in the past six years. But of course the consensus of opinion still appears to be dominated by a reluctance to believe that housing has really turned the corner—after all, there are still so many homeowners with underwater mortgages and so many foreclosed homes waiting to be sold. What the worriers ignore, however, is that while the supply of homes could increase, the demand for homes could increase as well, if confidence in the future were to increase.

The chart above shows that bank lending to small and medium-sized businesses is up over 22% in the past two years. Lending standards are still relatively strict, but banks are nevertheless lending more and relaxing lending standards on the margin. This is very encouraging because it reflects increased confidence on the part of both banks and businesses. Banks are more willing to lend, businesses in aggregate are more willing to borrow.

The chart above shows the fairly reliable relationship between the ISM manufacturing index and quarterly GDP growth. Manufacturing was one of the key sources of growth early in the recession, and although it is now less strong, the most recent index reading of 51.5 is still consistent with GDP growth of about 2%. The service sector version of this same index is currently at 55, and that too points to continued, albeit relatively slow, growth. Slow growth is disappointing, and there are many millions still out of work, but growing is better than not growing, and there is no sign at all in these key surveys of a recession. 

Capital goods orders are a good proxy for business investment, which is the seed corn of future growth. Growth which produces rising living standards requires that we produce more with a given number of inputs. Productivity, in other words, is the source of real growth, and it requires investment in new plant and equipment, new computers, and new technology. The slowdown in business investment in recent months is disappointing, because it means growth in the future is likely to remain weak or weaken further. I think business investment has declined because of the growing uncertainty surrounding the "fiscal cliff" which is scheduled to arrive in just over two months; I don't think this is a harbinger of recession as it typically would be. Everyone knows that tax rates could soar in few months, and a drastic cut in defense spending could have negative ripple effects throughout many industries. No one knows at this point how this problem is going to be resolved; it could end up being very bad for growth or very good. This kind of binary uncertainty is likely inhibiting all sorts of decisions right now, contributing to the reluctance of investors and businessmen to embrace the equity rally and the economic recovery.

I'm optimistic that Washington and the electorate will arrive at a reasonable solution, but I can't be sure. Still, if I'm right and the markets are still braced for a recession, it's possible that even a suboptimal resolution of the fiscal cliff would fail to be unexpectedly bad news. 

Next installment: conclusions.


Gloeschi said...

So according to Scott, the 12% output gap was caused by misguided fiscal stimulus.
Have you ever contemplated how large the output gap would have been without stimulus?
Has it ever crossed your mind we could possibly be in a debt-driven economy, where the delta in debt is the biggest driver of GDP growth? And as combined debt (government, households, corporations, financial institutions) hit the debt ceiling, 3% trend growth proves elusive? Constant growth rates you find in communist command economies. Given your allegiance to Romney, I don't think you wanted to see the US adopt a sovjet-style system.

Benjamin Cole said...

Very thorough and credible wrap-up.

I remain convinced the GDP plunge was deepened by an overly restrictive monetary policy, on the heels of deplorably ill-considered public- and private-sector real estate lending. That lending led to a bust (in both CMBS and federalized RMBS markets).

At long last, the Fed is getting more aggressive, and hence we are seeing recovery.

The size of the federal deficit is almost meaningless, in terms of recovery. If the Fed asphyxiates the economy, the deficit can go to the moon and do nothing (see Japan).

I prefer a very aggressive Fed policy, and a federal government stabilized at 15 percent of GDP, taxes and spending.

That would require large cuts in defense, VA and Homeland Security outlays, and an increase in the age to qualify for Social Security and Medicare.

But the GOP loves agency spending, and the D=Party loves social welfare outlays, so look to big deficits under Obama, or even bigger deficits under Romney.

Benjamin Cole said...

"and a drastic cut in defense spending could have negative ripple effects throughout many industries"--Grannis.

Was surprised to find this sentiment expressed.

Cuts in federal outlays, especially agency spending, can only be good for the USA economy.

Those resources are freed up to participate in the private sector, producing useful goods and services, and raising our standard of living.

A dollar spent on a military base is wasted, in terms of living standards. But if that dollar is spent by someone in the private sector, it is by definition a worthy outlay, that someone derives $1 (or more) of benefit from.

In terms of our economy, all federal spending is suspect, but the worst is that done by agencies, and of that, the worst is by the defense department.

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Gloeschi said...

"Overly restrictive monetary policy"


How are things going today in the world of "all bad stuff is priced in"? DD begs to differ.

NormanB said...

One of the great American city names: Sheboygan!! I just love to say it.

William said...

Bloomberg: U.S. Imports Most Container Boxes in Five Years

"U.S. imports of containerized goods are the highest since before the recession as the economic recovery gains traction....“The imports are consistent with the macroeconomic picture in the U.S., and things just turned significantly better,” said Nigel Prentis, the head of research at HSBC Shipping Ltd…..“

William said...

American Trucking Associations Tonnage Index Rose 0.4% in September

"....Compared with September 2011, the SA index was 2.4% higher, the smallest year-over-year increase since December 2009....the acceleration in housing starts, which is helping truck tonnage, is being countered by a flattening in manufacturing output and elevated inventories throughout the supply chain."