Growth Recession Continues

 

Factoring in a 4% Q4 growth rate, the U.S.

economy expanded by 3% in real terms from the

4th quarter of 2009 through the 4th quarter of

2010. Despite this rise in GDP, the unemployment

rate remained stubbornly high at 9.6% in the last

quarter of 2010, only slightly lower than the 10%

rate it averaged in the same quarter one year ago.

Positive real GDP growth with high unemployment

is the definition of a growth recession. An even

slower growth rate of real GDP should be recorded

over the next four quarters, suggesting the

unemployment rate will be essentially unchanged

a year from now. As we have noted previously,

this modest expansion is due to the significant

over-indebtedness of the U.S. economy. We see

seven main impediments to economic progress

in 2011 that will slow real GDP expansion to the

1.5%-2.5% range.

First, fiscal policy actions are neutral for

2011. Second, state and local sectors will continue

to be a drag on the economy and labor markets in

2011. Third, Quantitative Easing round 2 (QE2)

will likely produce only a slight economic benefit

as the Fed continues to encourage additional

leverage in an already over-indebted economy.

Fourth, while consumers boosted economic

growth in the second half of 2010 by sharply

reducing their personal saving rate, such actions

are not sustainable. Fifth, expanding inventory

investment, the main driver of economic growth

since the end of the recession in mid-2009, will

be absent in 2011. Sixth, housing will continue to

be a persistent drag on growth. Seventh, external

economic conditions are likely to retard U.S.

exports.

Fiscal Policy in Neutral

 

The recent tax compromise between the

President and Congress merely extended existing

tax rates for another two years and provided a

transitory 2% reduction in social security tax

withholding. Personal taxes, including federal and

non-federal, rose to 9.44% of personal income in

November, up from a low of 9.1% in the second

quarter of 2009 (Chart 1). Even with the tax

compromise this effective tax rate will continue

moving higher as a result of higher state and

local taxes. Economic research has documented

that temporary changes in tax rates are far less

beneficial than permanent ones since consumers

spend on the basis of permanent income. Higher

outlays for unemployment insurance were also

legislated, but these were negated by cuts in other

types of spending. Federal spending through early

March will mirror its pace in fiscal 2010, and the

rest of the 2011 budget will decline slightly in real

terms. Therefore, total real federal expenditures

are likely to contract in real terms this year.

 

If fiscal policy becomes focused on

long-run considerations (e.g. deficit reduction)

economic conditions will improve over time.

But, if fiscal policy remains focused on shortterm

stimulus, the economy’s prolonged underperformance

will persist since the government

expenditure multiplier is less than one, and

possibly close to zero.

The recent scientific work on the

expenditure multiplier is aligned with the

Ricardian equivalence theorem as well as the

views of the Austrian economists who continued

to follow Ricardo even when the Keynesian

revolution was ascendant. Economist Gary

Shilling made this point very well in his

outstanding new book, The Age of Deleveraging

– Investment Strategies for a Decade of Slow

Growth and Deflation.

Dr. Shilling’s analysis of the simplified

and unsubstantiated Keynesian multiplier (p.216)

still taught in many colleges and universities is

extremely insightful. “But the Austrian School

of economists like Friedrich Hayek and Ludwig

von Mises believed that the economy is much

more complicated… The Austrian view suggests

that the government spending multiplier may

be only 1.0 and that there are not any follow-on

effects. More recent academic studies indicate

that the multiplier is less than 1.0, and perhaps

much less.”

After recognizing the difficulty of

calculating the multiplier, Dr. Shilling writes,

“Also, the inherent inefficiencies of government

reduce the effects of deficit spending and lower

the multiplier.” Thus, if steps are taken to reduce

deficit spending, the economy’s growth rate will

recover after the initial transitory negative impact

as additional resources are provided to the private

sector.

State and Local Governments Drag

 

Municipal governments face substantial

cyclical deficits and significant underfunding

of their employee pension plans. In addition,

municipal bond yields rose sharply in the

second half of 2010, increasing borrowing costs,

probably an unintended consequence of QE2.

The municipal bond market proceeds are used

primarily for funding capital projects, which

suggests that such projects will be delayed. State

and local governments typically do not undertake

capital projects freely when they have large

cyclical deficits.

To reign in these financial imbalances,

state and local governments have five choices:

(1) cut personnel; (2) reduce expenditures

including retirement benefits; (3) raise taxes; (4)

borrow to fund operating deficits; or (5) declare

bankruptcy. All retard economic growth. Any

trend toward increased bankruptcy would raise

caution in the broader municipal market and

add to higher borrowing costs. Raising taxes

may give bondholders more confidence, but

such actions can fail to raise new revenue as

slower economic conditions retard spending.

The demographic trends in the decennial census

also show that people are increasingly moving to

low tax regions, contributing to worsening fiscal

imbalances from the exited areas.

QE2's Problems

 

Clearly, Fed actions have affected stock

and commodity prices. The benefits from higher

stock prices accrue very slowly, are small, and

are slanted to a limited number of households.

Conversely, higher commodity prices serve to

raise the cost of many basic necessities that play

a major role in the budget of virtually all low and

moderate income households.

For example, in late 2010 consumer fuel

expenditures amounted to 9.1% of wage and

salary income (Chart 2). In the past year, the

S&P GSCI Energy Index advanced by 14.6%.

Since energy demand is highly price inelastic, it

seems there is little alternative to purchasing these

energy items. Thus, with median family income at

approximately $50,000, annual fuel expenditures

rose by about $660 for the typical family. In late

2010, consumer food expenditures were 12.6% of

wage and salary income. In the past year, the S&P

GSCI Agricultural and Livestock Commodity

Price Index rose by 40%. If we conservatively

assume that just one quarter of these raw material

costs are ultimately passed through to consumers,

higher priced foods will have added another

roughly $626 per year of essential costs to the

median household budget. These increased

costs could be considered inflationary, however,

with wage income stagnant, higher food and fuel

prices will act like a tax increase. Indeed, the

approximately $1300 increase in food and fuel

prices is equal to 2.6% of median family income,

an amount that more than offsets the 2% reduction

in the social security tax for 2011.

Reflecting the inflationary psychology of

the higher stock and commodity prices, mortgage

rates and municipal bond yields have risen

significantly since QE2 was first proposed by the

Fed chairman, increasing the cost and decreasing

the availability of credit for two sectors with

serious underlying problems. Also, Fed policy

has pushed most consumer time, money market,

and saving deposit rates to 1% or less, thereby

reducing the principal source of investment

income for most households. Clearly the early

read on QE2 is negative for the economy.

Substitution Effects

In a November speech in Frankfurt,

Germany, Dr. Bernanke said that the use of the

term “quantitative easing” to refer to the Federal

Reserve’s policies is inappropriate. He stated

that quantitative easing typically refers to policies

that seek to have effects by changing the quantity

of bank reserves. These are channels that the

Chairman considers relatively weak, at least in

the U.S. context. Dr. Bernanke goes on to argue

that securities purchases work by affecting yields

on the acquired securities in investors’ portfolios,

via substitution effects in investors’ portfolios

on a wider range of assets. This may well be

true, but the substitution effects are just as likely

to be detrimental (i.e. the adverse implications

of increasing commodity prices and rising

borrowing costs for some and reducing interest

income for others). Importantly, the Fed has no

control over these substitution effects.

In his reputation establishing 2000

book, Essays on the Great Depression, Dr.

Bernanke argues that “some borrowers (especially

households, farmers and small firms) found

credit to be expensive and difficult to obtain.

The effects of this credit squeeze on aggregate

demand helped convert the severe, but not

unprecedented downturn of 1929-30 into a

protracted depression.” Interestingly, when QE2

drives up borrowing costs for homeowners and

municipalities, thereby restricting credit, the Fed

is creating (according to Dr. Bernanke's book)

the exact same circumstance, albeit on a reduced

scale, that helped cause the great depression---

rather bizarre!

Liquidity Mistakes

For the past twelve years the Fed's policy

response to economic problems has been to pump

more liquidity. These problems included: (1)

the failure of Long Term Capital Management

in 1998; (2) the high tech bust in 2000; (3) the

mild recession that began with a decline in real

GDP in the fall of 2000; (4) 9/11; (5) the mild

deflation of 2002-3; (6) the market crisis and

massive recession and housing implosion of

2007-9, and now, (7) the lack of a private sector,

self-sustaining recovery.

The Fed diagnosed each of these events as

being caused by insufficient liquidity. Actually,

the lack of liquidity was symptomatic of much

deeper problems caused by their own previous

actions. The liquidity injected during these events

led to a series of asset bubbles as the economy

utilized the Fed’s largesse to increase aggregate

indebtedness to record levels. The liquidity

problems arose as the asset bubbles burst when

debt extensions could not be repaid and generally

became unmanageable. Each succeeding

calamity or bust reflected reverberations from

prior Fed actions.

While governmental directives to Fannie

and Freddie to increase home ownership clearly

also played a role, the Fed supported this process

by providing excessive liquidity to fund the

housing bubble as well as other unprecedented

forms of leveraging of the U.S. economy. The

heavy leveraging and the associated asset

bubbles, however, produced only transitory and

below trend economic growth. Similarly, like its

predecessors, QE2 is designed to cure an overindebtedness

problem by creating more debt.

In addition to failing to revive the economy

permanently, major unintended consequences

have arisen. The LTCM bankruptcy created a

$3 billion loss, a very modest amount in view of

the sums required by subsequent bailouts. The

Fed's reaction to LTCM served to give market

participants a signal that the Fed would backstop

those regardless of whether they engaged

in or enabled bad behavior. Also, Fed actions

have conditioned Wall Street to seek Fed support

whenever stock prices come under downward

pressure. In fact, the process of leaking out QE2

began in the midst of a stock market sell off.

Well-intentioned actions to promote growth

and fine tune the economy by micromanagement

have instead produced failure. Although the Fed

had little choice in massively supporting financial

markets in 2007/8, no Fed intervention would

have been a more long-term productive stance in

the previous economic events. QE2 is another

example of flawed Fed policy operations.

The Saving Rate Decline

In the second half of 2010, real GDP grew

at an estimated 3.3% annual rate (assuming the

fourth quarter growth rate was 4%), up from

2.7% in the first half of the year. Transitory

developments in two of the most erratic and

unpredictable components of the economy---the

personal saving rate and inventory investment--

-accounted for all of this acceleration.

From 6.3% in June 2010, the personal

saving fell by a significant 1%, to 5.3% in

November (Table 1). Consumer spending is

slightly in excess of 70% of real GDP. Without

the one percentage point reduction in the personal

saving rate, the second half growth rate would

have been 2.6%, a shade slower than the first

half growth pace, and materially less than the

presumed second half growth rate.

When job insecurity is high, and defaults,

delinquencies and bankruptcies are at or near

record levels, a drawdown in the saving rate

would seem to be an unlikely event. This

development is certainly viewed favorably by

retailers but the issue is whether the economy's

future is better served by using the funds to

make mortgages current, pay other debts and

prepare consumers for potential emergency

needs. Thus, the lowering of the saving rate is

similar to running monetary and fiscal policy to

meet short-run needs while ignoring long-term

consequences.

Inventory Reversal

 

Inventory investment was the main

driver of economic growth since the recession

ended in mid-2009. Based on published data,

real GDP grew at a 2.9% annual rate over this

span. However, real final sales, which excludes

inventory investment from GDP, increased

at a paltry 1.1% pace. In the third quarter,

inventory investment surged to 3.7% of GDP

while preliminary fourth quarter figures on retail,

wholesale and manufacturing inventories indicate

this figure might have reached 4% (Chart 3).

In the final quarter of the recession, inventory

investment was -5.1% of GDP. Since 1990, the

period of modern inventory control mechanisms,

inventory investment averaged only 1.1%. At

a minimum, the dominant source of aggregate

economic strength will not repeat in 2011.

Housing Drag Persists

Housing will remain a drag on economic

activity in 2011. Prices have re-accelerated to the

downside over the past four months, as mortgage

yields have risen and the housing overhang has

increased. The housing overhang, as explained

by Laurie Goodman writing in the Amherst

Mortgage Insight, “is not caused solely by the

number of non-performing loans that exist in the

market. The problem also includes the high rates

at which re-performing loans are re-defaulting,

along with the relatively high rates at which

deeply underwater loans that have never been

delinquent are running two payments behind for

the first time.”

Another major problem is that home

prices are still too high. An excellent and

well-researched study by Danielle DiMartino

Booth and David Luttrell in the December 2010

Economic Letter from the Dallas Fed documents

this issue very authoritatively. Booth and Luttrell

write, “As gauged by an aggregate of housing

indexes dating to 1890, real home prices rose

85% to their highest level in August 2006. They

have since declined 33 percent… In fact, home

prices still must fall 23% if they are to revert to

their long-term mean.”

From the standpoint of most households,

the home is the main component of wealth, not

stock market investments. The continuing drop in

housing prices serves to underscore the ill advised

and likely temporary drop in the personal saving

rate that was so critical to economic performance

late last year.

Adverse Global Considerations

The global economy since 2009 may be

referred to as a two speed recovery, with China,

India, Brazil, and other emerging economies at

the high speed and the U.S. and Europe at the

slow speed. That pattern is likely to continue,

but with an important difference. China, India

and Brazil are likely to slow adversely affecting

the U.S. and Europe. Thus, the two speed

recovery will continue, but with the entire world

growing at a much more modest pace. Two

major considerations point to this outcome.

First, the higher food and fuel prices discussed

earlier will serve to significantly depress growth

in countries like China, India and Brazil where

food and fuel are known to be a much higher

percentage of household budgets. Already reports

have surfaced from international agencies on the

growing adverse consequences of higher food

prices, and social unrest has also been witnessed

on a limited basis.

Second, Chinese economic policy is

designed to slow growth and reduce inflationary

pressures. Although the People’s Bank of China

(PBoC) has already taken several actions to

contain surging inflation, more steps may be

needed. In China, as elsewhere, inflation is a

lagging indicator. It is worth considering that

the PBoC has never been able to engineer a

soft landing, which suggests that ultimately

a downturn in China may be greater than the

prevailing consensus.

Thus, changing global conditions should

serve to moderate U.S. exports. Ironically, the

U.S. current account deficit still may continue

to improve. A stabilization of the saving rate

will reduce U.S. imports, while a higher saving

rate will cut imports significantly. Already

this two speed global economy has resulted in

a reduction in the U.S. current account deficit

of approximately 3% of GDP (Chart 4). A

continuation of this trend will serve to underpin

the value of the dollar, which rose in 2010.

The firm dollar, in turn, will serve to keep U.S.

disinflationary trends intact.

 

Bond Market Conditions

                                                               

In spite of the adverse psychological

reaction to the QE2, long Treasury bond yields

dropped to 4.3% at the end of 2010, down 30

basis points from the close of 2009, producing

a total return of slightly more than 10% for a

portfolio of long Treasury and zero coupon

bonds. The problematic economic environment

and its depressive effect on inflation suggests

long Treasury bond yields could easily decrease

another 30 basis points in 2011, which would

produce another double-digit rate of return for a

similar portfolio. The probabilities of even lower

yields are significant.

Van R. Hoisington

Lacy H. Hunt, Ph.D.

 

(c) Hoisington Investment Management

www.hoisingtonmgmt.com