National Security Studies Seminar – Syracuse University (April 28, 2011) Sidney L. Jones
REALITY IS JUST AROUND THE CORNER
Extraordinary monetary, fiscal, and regulatory accommodation using borrowed and created money – Helicopter Economics – did move the U.S. economy to Somewhere Over the Rainbow in 2010 as expected. Policies have created a “slow, long, and erratic” cyclical recovery providing short-term political/economic relief with long-term risks – a clear preference for current consumption and delayed restraint. But reality is just around the corner. Although the precise timing cannot be predicted, it will begin when creditors (rest of the world) adjust the potential cost and supply of debt available to borrowers (United States) dependent upon public and private debt and the phony money illusion of inflation in a competitive and realigned global economy. Our national sovereignty will be determined by creativity and productivity rather than clever financial manipulation.
The 11th postwar recession began in December 2007 and officially ended in June 2009. It was the deepest (4.15% output loss), longest (18 months), and widely diffused downturn since the Great Depression of the 1930s. It began as a financial market debacle, when liquidity and solvency crises linked to egregious housing sector errors converged, and evolved into a synchronized global recession as consumers curtailed spending and foreign trade and investment plummeted leading to restricted business investment and rapid liquidation of inventory stocks. The Fed adopted an aggressive “zero boundary” policy interest rate target and unprecedented quantitative easing tactics to support the financial markets and attempt to manipulate market interest rates. Federal spending and tax cuts provided temporary support but created astonishing chronic budget deficits and national debt. Regulatory guidelines were revised and preferential government aid was given to selected private companies to offset liquidity and solvency stress. The sustained U.S. current account deficit briefly improved, but global imbalances continued. Private spending and investment, plus the lagged effects of monetary and fiscal policies, created a vacillating cyclical recovery that finally gained extended traction by yearend 2010. The Great Expansion from December 1982 to December 2007, with only two mild and brief official recessions from July 1990 to March 1991 and March 2001 to November 2001, has ended. The anticipated “demographic twist” has begun, caused by the accelerating retirement of the baby boom generation, which will require massive cash payments for prolonged retirement income and health care benefits from “cashless” federal trust fund accounts with irrelevant positive accounting balances. Consumers have tentatively begun the painful “deleveraging” process of increasing savings and reducing personal debts after decades of indulgent consumption financed by borrowed and created money. The historic shift of economic power from the West to the East has accelerated. Fiscal policy is trapped in a political gridlock that will continue to produce unique budget deficits. The central bank has assumed responsibility for “fine-tuning” the entire economy rather than concentrating on the basic roles of controlling inflation and sustaining financial markets.
My baseline forecast is that real GDP will increase 3¼% during 2011 (measured 4th to 4th quarters), slightly above the 2½% to 3% target growth rate -- a 65% probability. Monetary/fiscal stimulus provides about ¾ percentage point. An even faster pace, based on a breakout of consumer and business spending, is a 25% probability and a slower rate, caused by more aggressive household “deleveraging,” is a 10% probability. This modest acceleration gradually will reduce the level of unemployment and underemployment, but the official figure probably will remain near 9% throughout the year. Inflation will rise slowly given a large “GDP gap” between potential and actual output caused by sluggish labor market conditions and existing unused production capacity. Energy and food prices probably will push the volatile “headline” CPI into the 2% zone and the key “core” CPI (energy and food prices deleted) will fluctuate around 1%. The chronic current account deficit will increase as imports rise even more rapidly than exports. A tenuous political compromise will prevail until after the pivotal 2012 national elections resulting in budget deficits in the $1 to $11/2 trillion zone even through the gross national debt has increased from $5.6 trillion in 2000 to $14 trillion by the end of 2010. The central bank will avoid restrictive policies until significant progress is made in reducing unemployment and the scheduled unconventional quantitative easing (QE2) program will be completed, or even expanded. Faster GDP growth will be welcome, following the severe recession, but most politicians and economists still claim that structural budget deficits and unconventional monetary accommodation should be used to prevent another cyclical downturn. Existing economic policies will continue until the global financial markets respond to reality.
CRITIQUE OF THE 2010 FORECAST
My forecast presented at our 2010 meeting predicted that the “slow, long, and erratic” expansion phase of the business cycle that began in July 2009 would continue with “bold” monetary and fiscal policies despite “lingering unemployment and potential inflation” conditions in the context of a global turnaround. The vulnerable status of the recovery was emphasized, but the risk of a “double-dip” experience was given a low 15% probability. Only a 20% probability was given to a surge above the Optimum Feasible Path, or trend target, of 21/2% to 3%. The baseline forecast was summarized as follows.
My baseline forecast is that real GDP growth will continue at a moderate 21/2% pace (measured 4th quarter to 4th quarter) during 2010; the sensitive unemployment rate will rise above 101/2%; near-term inflation figures will remain in the moderate 2% zone because of the cumulative residual GDP “gap” between actual and potential output of goods and services; the chronic current account deficit gradually will increase; existing and potential fiscal actions will create another federal budget deficit in the $11/2 trillion zone; and, monetary officials will maintain their “zero boundary” policy interest rate target until employment prospects clearly improve while most of the unconventional quantitative easing programs designed to stabilize financial markets by providing huge liquidity transfusions and preferential bail-outs for selected institutions gradually are phased out to help neutralize inflation expectations. (Somewhere Over The Rainbow, February 13, 2010, p. 1)
Advance GDP figures indicate that during 2010 the output of goods and services increased 2.8% (measured 4th to 4th quarters). The year began with solid growth based on positive inventory spending and government outlays and tax relief. A sharp slowdown of activity occurred during the summer but consumer and business spending accelerated during the fall and a second round of monetary and fiscal stimulus was announced.
Baseline 2010 Forecast Summary and Third Estimate of Results
(Percent Change; Fourth to Fourth Quarters; Real Chained [2005] Dollar Basis)
Sector 2010 Forecast Third Estimate*
Gross Domestic Product 21/2 2.8
Personal Consumption Expenditures 11/2 2.6
Business Fixed Investment 5 10.6
Residential Construction Investment 71/2 - 4.6
Federal Government Outlays 5 4.8
State & Local Government Outlays 0 - 1.3
Inventories (contribution to GDP) Increase 0.4
Net Exports (contribution to GDP) Larger Deficit - 0.6
Unemployment Rate Annual Average 10 (10.5 high) 9.6
Headline CPI (December/December) 2 zone 1.5
Core CPI (December/December) 2 zone 0.8
FY 2010 Federal Budget Deficit $1.349 trillion $1.294 trillion
Federal Funds Rate Target Zero Boundary Zero Boundary
* Third GDP figures released on March 25, 2011; figures will be revised in July.
A third estimate of real GDP growth during 2010 is close to my baseline forecast but there were surprises as usual. Personal consumption expenditures increased much faster than expected and contributed 1.8 percentage point to the 2.8% GDP growth rate. This was an impressive turnaround from the negative figures reported during the severe recession. During the last quarter of 2010, spending surged at a 4.0% annual rate led by sales of consumer durable goods, which rose at a 21.1% annual pace (motor vehicles and parts, household furnishings and equipment, recreational goods and vehicles, and other goods). Nondurable goods (food and beverages, clothing and footwear, gasoline and energy goods, and other goods) and services also recorded solid gains. Personal consumption represents 70% of the total GDP. The ability of households to spend was enhanced by payroll job gains and a small uptick in total personal income from $12,239 billion to $12,724 billion during the year. Employee compensation increased and government personal transfer payments continued to rise. My cautious forecast about the willingness of consumers to spend was wrong. Households did not “deleverage” their balance sheets by reducing record level personal debt and increasing personal saving. Consumer debt did fall 4.4% in 2009 and 1.6% in 2010, but quickly increased again when personal spending accelerated in the fall. Revolving consumer credit was cut from $958 billion in 2008 to $801 billion by December 2010, but nonrevolving loans for automobiles, mobile homes, education, boats, trailers, and vacations began rising again during the third quarter of last year and were back to a record high of $1,610 billion by December 2010. The personal saving rate (as a percent of disposable personal income) increased to 5.9% in 2009 and 5.8% in 2010. These figures are higher than the average level of 2.7% reported from 1999 to 2008, but well below the average figure of 8.1% from 1960 through 1998. The improved consumer confidence, booming stock market rally, stabilization of falling house prices, continued moderate inflation, modest employment and income gains, and broad “austerity fatigue” combined to create a surge of consumer spending above the forecast by yearend 2010.
Residential construction investment subtracted 0.1 percentage point from the GDP growth rate rather than making a positive contribution as my baseline forecast predicted.
The erroneous forecast assumed investment would increase 7½% based on the favorable affordability index ratio of average house price payments to personal incomes, very low mortgage interest rates, government programs, predicted small gains in house prices, and pent-up demand after three years of new starts at about one fourth of the cyclical peak of 2.1 million new units in 2005. Residential construction actually declined 4.6% and only 588,000 new units were started. New construction and sales did improve at the beginning of the year, but faded after the expiration of the temporary tax credit in April and a surge of delinquent and foreclosure mortgages created a huge inventory of houses for sale. The S&P/Case-Shiller index of house prices in 20 metropolitan cities continued to fall during the second half of the year and is now about one third below its mid-2006 cyclical peak. Household concerns about income and employment prospects and the large inventory of unsold houses have created pervasive pessimism in this sector.
Business capital investment surged in 2010 contributing 0.97 percentage point to the GDP growth rate. Spending for equipment and software increased 16.9% after declining 4.9% in 2009. Investment in structures -- plants, office buildings, shopping centers, and utilities -- declined 4.0% for the entire year, but this was a major improvement over the 26.5% deterioration in 2009 and modest growth during the last three months of 2010 was a surprise after nine consecutive quarters of poor results. The turnaround in investment was the result of strong profits, large cash balances, improved access to credit at very low interest rates, rising capacity utilization rates, and the rapid revival of business optimism.
Cautious inventory spending contributed 0.41 percentage point to the GDP growth rate last year. The transition from rapid liquidation of stocks at the bottom of the recession to restocking as the recovery gained traction during the last six months of 2009 and early months of 2010 was a key variable in the cyclical turnaround. The sharp acceleration of final sales during the final quarter of 2010 will encourage additional inventory spending.
The net exports of goods and services subtracted 0.6 percentage point from the GDP growth rate during 2010. Exports increased 9.0% but imports rose 11.0% from a higher base level. U.S. imports rise faster than exports during cyclical expansions. There was a sharp drop in imports during the fourth quarter, at a 12.6% annual rate, but the trade gap for the entire year increased the current account deficit to 3.2% of GDP. Global financial imbalances continue even though recent U.S. deficits are well below the level of 6% of GDP reported prior to the global economic crisis. There is consensus agreement that the U.S. deficits are unsustainable and require a reorientation of national economic priorities to emphasize investment and exports rather than immediate consumption and housing.
Federal government spending contributed 0.4 percentage point to the GDP growth rate during 2010. Total defense spending increased 3.4% and nondefense outlays rose 7.7%.
The rapid growth of federal spending was caused by the momentum of established budget programs and unpredictable shocks, such as wars in Iraq and Afghanistan and the severe economic recession. The emergency spending authorized by the American Recovery and Reinvestment Act of February 2009 increased the FY 2009 through FY 2011 budgets.
The decline in state & local government outlays subtracted 0.16 percentage point from the GDP growth rate. This sector usually contributes to overall growth, but a fiscal crisis forced governments to cut spending, raise taxes and fees, and tap special reserves to meet statutory balanced budget requirements. Federal assistance for Medicaid, education, and infrastructure programs filled part of the gap, but that emergency cyclical help is phasing out and there are very few options as retirement benefits and health care costs increase.
The average unemployment rate in 2010 was 9.6% and a broader measure, that includes those working part-time for economic reasons and those with marginal attachment to the labor force, was 16.8%. The base rate did not temporarily surge above 10%, as projected in my baseline forecast, because the participation rate fell to only 64.3% (civilian labor force as a percent of civilian noninstitutional population) and monthly payroll job figures slowly improved. However, the “jobless recovery” slow growth rate did not reduce the unemployment rate much below the peak of 10.1% reported in October 2009. The tragic consequences of long-term unemployment in excess of 26 weeks, which included 44% of the unemployed group in December 2010, caused Congress to expand the unemployment insurance program coverage to 99 weeks. Consequences of long-term job losses spread