In my 4-part 2009 economic outlook, I stated my belief that I thought that the US economy was at a key long-term inflection point. The first two installments dealt with the long-term problems facing the US, namely that US economic policy is geared toward promoting consumption and residential housing investment, leading to chronic trade deficits and the resultant high US indebtedness, and that this trend has probably run its course. The second two installments posited that the bursting of the real estate bubble would result in $1.8 trillion of bank losses and that the banking system would be hobbled without offsetting injections of capital, which could delay the recession’s end into early 2010.
The obvious problem is that dealing with the short term issues surrounding the collapse of the housing bubble and the associated damage to the financial system almost by definition postpones dealing with our long-term structural issues. The corollary is that policies designed to fix America’s long-term problems would inflict major short-term damage on a global economy that is geared toward American consumption and housing investment. The world will need wise leaders that can thread the needle by providing short-term economic support while moving together toward long-term sustainability. The problem is that such a shift would probably require the US (and the UK, Ireland, Spain, etc.) to endure a soft depression similar to what has been endured by Japan and Germany for the past 15 years. The US electorate is less docile than the Japanese, however, and is more likely to take a more active role in shaping economic policy in a way that put the interests of the United States above that of the global economy as a whole. So while 2010 is likely to be a pretty good year for the US economy, I expect the “Tens” to be a volatile, crisis-laden decade.
Real estate vs. everything else. We should make no mistake that the financial panic of 2007-2009 was centered around the housing bubble. The housing bubble was aided and abetted by just about the entire globe. The US government encouraged it, foreign governments encouraged it, conservatives encouraged it and liberals encouraged it. The US government encouraged it with tax deductions (encouraged by conservatives and liberals) and with direct subsidies (encouraged mostly by liberals). The US financial system encouraged it by getting the math wrong on derivatives and securitizations (abetted by conservatives that relaxed banking regulations). The bubble was abetted by foreign central banks that created trade surpluses by recycling dollars from abroad into US agency securities. The bubble was also abetted by the US Fed, which printed money in response to the fallout from the tech investment bubble of the late 1990s. Since banks have become “universal” in services, particularly the money center banks in New York, the collapse of housing finance and the associated large losses restricted the availability of capital for everything else: auto and credit card receivables, business loans, commercial paper, municipal finance, buyout loans, venture capital. Without action to stop the banking panic, the entire financial system would have collapsed in a “vicious cycle” of debt deflation.
The financial crisis recedes. The government executed on a good strategy to stem the collapse of the banking system. The combination of the $245 billion invested in banks under TARP, the $1 trillion expansion of the Fed’s balance sheet, the $200+ billion of private capital that has been raised, the $350 billion of Federal debt guarantees, an unlimited backstop for Fannie Mae and Freddie Mac, high bank profits from the steep yield curve and the suspension of mark-to-market accounting rules stopped the debt deflation cycle. As a result of all of these actions, the equity and credit markets began to rise again around the end of March. The old-fashioned financial panic that had pulled the economy down so hard in the fourth quarter of 2008 and the first quarter of 2009 was over. The “second derivative” of economic growth bottomed in the second quarter and GDP returned to positive growth in the third quarter.
The collapse in the demand for credit. I last year’s economic outlook I erred in thinking that stopping the banking system collapse was primarily what was needed to “normalize” the economy. I was focused on the fact that there was a shortage of the supply of credit. What I missed was that there was (and still is) an epochal decline in the demand for credit as well. US consumers, realizing that the “free lunch” of rising real estate collateral has come to an end, have logically pulled in their horns. US household indebtedness has fallen by $255 billion from its peak in the second quarter of 2008 to the third quarter of 2009. While that sounds like a lot, it is only a 2% decline from the more than $13.8 trillion peak. Household debt as a percent of GDP has declined from 97% at the depth of the recession to 95% in the third quarter. Household debt was only $7.3 trillion and 73% of GDP at the trough of the 2001 recession, so there is more room to the downside. In addition, financial sector debt has declined by over $1 trillion since the fourth quarter of 2008, from a peak of about 120% of GDP to 113% of GDP.
The effect of the stimulus. As I discussed in my November 4th post Government Deficits are Necessary (for now), the huge surge in private sector saving to 10% of GDP in 2009 from -4% in 2006 has resulted in a nearly $2 trillion drain of demand from the world economy. There were similar swings in Spain, Ireland and the UK. All of the US, UK, Spain, Ireland and Japan are making up for the loss of private demand by running government deficits in excess of 10% of GDP. The wide trade deficits of the US, UK and Ireland have shrunk significantly. These government deficits are not “crowding out” private investment. If they were, treasury rates would be above their equilibrium rates, whereby the treasury would be competing with private demand, which they are not currently. The fact that we are running a trade deficit of 2.8% of GDP means that we are still pulling more than our share of the weight of global demand, but this is an improvement from the trade deficits of around 6% of GDP at the height of the housing bubble in 2005-2006.
Transition to “normalization”. In 2010 we will see if the economy can transition to normalization in a way that allows for a sustainable expansion. The demand for private credit will continue to be weak. The housing market is not likely to work off its excess until 2011, which hobbles consumer finance in general. In addition, (much needed) banking regulations will likely be passed in 2010, which will require greater capital cushions and suppress the expansion of financial sector debt. Businesses have ample cash flow to self-finance investment and hiring, however, which should in turn help consumer spending by increasing incomes. Government transfers are also helping consumer spending and direct government stimulus spending will add to demand for the first two quarters of 2010. Without the downward pull of the financial panic, the economy should at the very least get a nice cyclical bounce back to “normal” levels of output in sectors not related to housing. GDP growth could get a boost to over 4% in the fourth quarter of 2009, just by virtue of a halt to the decline in business inventories. Auto and chemical production has been increasing and the new economy sectors of IT and health care will resume growth. Aircraft production (the US’s biggest export) should start ramping up, as well.
Durable manufacturing. In 2009 US manufacturing capacity utilization averaged 66%, while output plunged 14% from 2007 to 2009. Much of the decline was in the volatile durable goods area. At the 2007 peak, US durable goods manufacturing was 16% higher than the late 1990s peak, but has since declined by 19%. Industry groups that saw increases in output in the 2000s vs. the late 1990s were “new economy” sectors like computer and electronic products (which nearly doubled production from 1999 to 2007), medical devices and aerospace, as well as housing-related sectors like wood products, non-metallic mineral products, furniture and fabricated metal products. The new economy sectors have an average capacity utilization of 69% today, down from around 80% at the peak, with production down an average of 9%. We should expect to see these sectors ramp back relatively quickly over the next year or two. The housing-related sectors, on the other hand, have seen their capacity utilization fall to an average of 58%, down from around 82% at the peak (in 2006), with production down 31% on average. The truly sickening declines came in motor vehicle and primary metal production, which fell by around 50% from 2005 peak to 2009 trough. Both have since snapped back by 30-40% after the “cash-for-clunkers” program cleared auto inventories and the auto financing markets were stabilized. Motor vehicle capacity utilization stands at only 53% (up from 37%!) and primary metal utilization is at 59% (up from 45%). While an infrastructure-focused stimulus program could quickly bring primary metal production up to pre-crisis levels, auto manufacturing capacity will likely shrink a great deal. A large chunk of the US manufacturing base related to housing and autos has been permanently impaired by the long-term declines in auto production and housing investment.
The excess capacity problem. The problem of excess capacity is not limited to the United States. China, Japan and Germany run chronic trade surpluses, meaning their production exceeds domestic demand as a matter of course. While the cyclical decline in capacity utilization will reverse with the help of global stimulus, the structural excess capacity in Chinese, Japanese and German “old economy” manufacturing and in housing-related sectors in the US and the EU periphery will not go away anytime soon. The way out is known (an increase in domestic Chinese demand), but if the Chinese don’t muster the political will to reverse their mercantilist trade policies, other remedies may end up being put in place (US tariffs) that will do more to upset the global economic order. Instead, the current Chinese stimulus program is geared toward infrastructure investment, increasing production capacity, while they continue to build currency reserves, suppressing demand for imports and contributing to global excess savings.
Is deflation still a threat? When the world suffers from excess capacity, the threat of deflation is real. The developed world is awash in deflation, but deflation has been offset by the rampant printing of paper currencies. Reserve-building countries in Asia are fighting developed country currency depreciation and artificially holding down sovereign interest rates. The safety valve has been the rising price of gold. The US dollar has fallen roughly 66% against the value of gold since the late 1990s boom, while the Euro has fallen 48%. The US dollar has fallen only 22% against the basket of consumer goods represented by the CPI. This means the market is anticipating significant currency debasement as an antidote to the deflationary undertow.
So what does this all mean for 2010? It is key to remember that it is natural for the economy to grow. Recessions are caused by the sudden restriction of credit, whether it’s induced by the Fed or by a banking panic. With the banking panic over, the resilient parts of the economy will resume growth. That means technology, health care, aerospace, mining, agriculture, oil & gas, chemicals, leisure and hospitality services will resume their upward trends. Non-housing-related durable goods manufacturing will have a nice cyclical recovery. Productivity growth will be monstrously high, and we are likely to see several quarters of 3.5%-4.5% growth. Housing, retail and finance are likely to remain problem areas as the market works off excess capacity. The good news for GDP growth is that housing investment has probably bottomed at the lowest level relative to GDP since World War II (down to 2.6% of GDP from a high of 6.1% of GDP).
The trillion-dollar question will be whether business investment will be in a position to take the baton after the effects of government stimulus and inventory restocking begins to fade in the second half of 2010. Signs to look for will be manufacturing capacity utilization jumping to the mid-to-high 70s, a move to a positive change in business inventories, and a continued decline in the trade deficit.
Policy debates will continue to be interesting, with financial reform and climate change legislation on deck for early 2010. In addition, if economic growth is as rapid as I expect, we will likely see rising interest rates in the middle of the interest rate curve and a debate around a deficit-reduction package that will consist largely of tax hikes. The 2010 elections will likely be fought largely on the ground of tax and spending policy. With the Bush tax cuts expiring in 2011 and huge projected budget deficits, it should be quite a show. I project that as usual the US electorate will make the right choice…it just isn’t clear yet what’s the right choice.
It should be a fascinating ride. Happy New Year!