related materials: The Three Bears Redux! (3/00); The Goldilocks Economy and the 3 Bears (2/00); An Old Talk about Current Events (3/99);
talk to the Loyola Marymount University Executive Strategic Forum, July 17, 2001 (by James Devine) Last revised July 26, 2001.
Two years ago, I filled your ears with all sorts of pessimistic twaddle. (Click here to see my notes from that talk.) I guess I should be happy that a lot of my predictions have come true…
- The predicted recession has happened … though not for the whole economy. It’s incomplete, so it’s not an "official" recession.
- Crucially, the Fed has responded by lowering interest rates drastically – almost in a panicked way – but it hasn’t had a positive effect yet. If it works, it may take a year or more to do so. How long it will take is uncertain, especially since the current slowdown (or incipient recession) is so different from previous ones.
today’s talk –
Now it’s time to pull out the crystal ball and try to figure out what’s happening and what will happen. As usual, I’m not going to bombard you with statistics. Rather, I’m going to try to present the broad contours of what’s happening.
I also reject the standard "forecasts." They are nothing but extrapolations … that are fudged so that they tend to "follow the herd" and predict the same thing.
I’m going to talk about the two-sector economy, two scenarios for the future, two government policies helping to decide how the future works out, two key variables to look at, and two sides to the international equation.
A. the bifurcated economy
Expansionary monetary policies (lower interest rates) have worked on the consumer sector, but they haven’t worked for the industrial sector.
- the industrial economy – including private fixed nonresidential investment – has tanked. (See the industrial production graphs below.) Low interest rates haven’t stimulated recovery yet. Business doesn’t want to invest in factories, machinery, software, or office buildings. High tech, movie theaters, advertising, and telecommunications are four of the major sectors that are in the deepest trouble.
The fall in investment – and its immunity to low interest rats – are because of low profits, unused capacity (similar to previous recessions), corporate debt overhang (click here), and pessimism (partly due to stock market). Capacity utilization is worse than in the 1990-91 recession and as bad as in 1993, the beginning of a recovery period from the 1981-82 recession.
The industrial production and capacity utilization problems of this sector can be seen in Federal Reserve data shown below (from http://www.federalreserve.gov/releases/G17/Current/ipg.gif and http://www.federalreserve.gov/releases/G17/Current/ ).]
- On the other hand, the consumer sector – including investment in new housing and purchase of consumer durables – has been holding up, stimulated by low interest rates. Retail sales are slowing, but in durable goods – such as cars – it’s continued. The demand for consumer services have been holding up. There’s been a wave of mortgage refinancing that’s allowed consumers to lower other debt, to weather the storm so far. Despite high consumer debts compared to incomes – and falling net worth – the consumers continue to buy. Strangely, consumers are pretty optimistic.
B. This split can’t last, since the two sectors affect each other and tend to move together. There are two scenarios.
The Blues: the industrial recession à falling employment and wages à cut-backs in consumer spending (possibly steep, due to debt) à generalized recession à feeds back to intensify the industrial recession.
The Rosy Scenario: consumer prosperity à demand for industrial goods é à industrial recovery à real private non-residential investment é à new hiring, etc. à feeds back to encourage consumer prosperity.
C. We’re at the crossroads. Which scenario will prevail?
1. two policy initiatives encourage the rosy scenario.
- the Fed’s rate cuts
- the Bush tax cut. In the early years, the tax cuts largely go to the majority, who mostly care about current income, encouraging spending. Future cuts raise the expected incomes of the rich, encouraging them to spend. They are the ones who can afford to plan ahead when making consumption decisions.
One problem: many working people will pay more taxes on ESOPs. See the New York Times, July 15, 2001 (front of the business section).
The result of policy also depends on the private economy.
2. In encouraging the "blues," key is the problem of assets relative to consumer debts.
- Consumer debt has been a real problem in recent years, rising steeply relative to personable disposable income (click here). Similarly, consumer debt service is at a very high ratio to after-tax income (click here). (Both graphs are from Doug Henwood's excellent Left Business Observer, number 97, as was the graph above on corporate debt. You can subscribe on-line.) If the economy tanks, this encourages drastic cut-backs in consumer spending (especially on durable goods), which is crucial since consumer spending represents about 70% of total demand.
- But while the economy is not in a full-scale recession, consumer debts are only a problem if assets fall relative to debts. Assets have been falling relative to debts (as net worth has been decreasing), but it's important to remember that having assets allows people to weather milder storms. Further, until recently, the consumer debt explosion has rested on the asset inflation. (Assets used as collateral & something to fall back on.) If assets fall further in value, this could trigger rapid falls in consumer spending. We might have a Japan-type recession on our hands, as the "bubble economy" deflates.
- The possibility of consumer recession is heightened by the fact that some consumer have been borrowing as a way to weather the storm. That is, during the last 7 months or so, there has been an increase in debts that has not corresponded to increases in the value of assets.
3. Signs of possibilities of future debt problems:
- consumer liabilities trending upward relative to assets, with a sharp up-tick in the last year. Click here.
- in the last year, there’s been a reversal of the trend fall (since 1990 or so) in liabilities relative to the value of corporate stock. Click here to see graph.
- liabilities have been rising in value compared to homeowners’ equity since 1983 (click here), while homeowners’ equity has been shrinking as a percent of the value of real estate since then (click here).
(All three of these graphs are based on Federal Reserve flow of funds data.)
The fall in interest rates have been boosting both stocks and housing values, boosting consumer net worth, so that excessive consumer debt isn’t excessive yet. I think that it's quite possible that this is the main way in which monetary policy is working to prevent economic collapse: by boosting home values and stock values, it raises consumer net worth, avoiding cut-backs in consumer spending. (Note that mortgage rates and other long-term interest rates haven't been falling that much, so it's not that much via the encouragement of borrowing.)
4. Thus, there are two key variables to keep an eye on.
if stock prices fall further or housing prices start to fall, this makes the rosy scenario much less likely. Let’s see what the possibilities are.
- the stock market. The price earnings ratio is still pretty high, so that there’s still room for stock prices to fall. It's about twice the historical average; it could fall down to 15 or so, or even over-shoot. Maybe not a lot, if the 2nd order polynomial trend drawn in the graph tells us anything. (That line is an effort to represent the theory that tells us that the "normal" price-earnings ratio has been rising of late.) The stock market’s fall is made worse if earnings fall, too, as is likely in a recession (and as is happening).
- good news: the value of housing relative to the replacement cost has been rising (there’s been asset inflation of late), but it’s still low relative to 1990 or so. So it may not fall again. In fact, it’s on track with the trend shown in the graph. However, if the stock market collapses, along with the rest of the economy, housing prices may fall, too. They may also over-shoot the trend, as it’s done in the past.
D. The Fed’s policy may work, with help from the tax cut. But there are fears about the future:
not inflation, as yet. However, as seen below, international events may encourage inflation.
but since the Fed’s policy encourages the revival of the bubble economy and continuation of consumer debt accumulation, when the economy does tank in a major way, it could end up with a Japan-type recession some day in the future. That is, if the Fed succeeds in preventing or moderating the recession, it may be only delaying the inevitable, while making the future recession worse.
The end of recession (and the possible sudden fall in the value of the dollar) may cause the revival of recession, which would in turn mean that the Fed may want a recession in the future. The "old time religion" – that higher unemployment is the only way to fight inflation – make come back with a vengeance.
E. International dimensions.
1. The balance of trade.
Due to its very large negative balance of trade, the U.S. has been the international "consumer of the last resort," broadcasting prosperity to the rest of the world, preventing a worsening of global stagnation. Now, there’s been role reversal: the U.S. is broadcasting recession to the rest of the world, since the slowdown encourages cut-backs in imports. (Recent declines in the U.S. trade deficit reflect falls in our purchases (imports).)
That moderates the U.S. recession (so far), but the rest of the world is suffering and is thus likely to cut back even more on purchases of U.S. exports. This seems to be happening.
2. The value of the dollar.
- the high dollar persists. So far, it allows us to spend much more on imports than we sell to the rest of the world, so we can enjoy prosperity – on borrowed money. The U.S. balance on the current account is seriously in the negative region, meaning that people outside the US are lending to us or buying our assets in large quantities.
- the high dollar also means that the U.S. can buy foreign products cheaply, so that we can avoid inflation.
- But the rise in the U.S. external debt (a result of the current account deficits) and the fall in U.S. interest rates encourage the dollar to fall. (The graph is courtesy of Doug Henwood.)
- If it does, it encourages an inflationary shock to the U.S. economy, as imports become more expensive and export competition fades away, and also reduces our real living standards.
- The key question: is the dollar going to fall quickly or slowly? If it falls quickly, we’re in big trouble. If it falls gradually, then it’s not a total disaster.
Coda: Interestingly, after I gave this talk, a similar perspective showed up in the Wall Street Journal, on July 19, 2001: "The U.S. economy is at a turning point. It just isn't clear which way it's turning.... Consumer spending has held up surprisingly well, given headline-making layoffs, weak stock prices, surging (until recently) energy prices and post-New Economy depression. Americans are still buying lots of cars. Rising home prices offset the depressing effect of the sinking stocks. The typical house sold for about 6% more this spring than last;...... Raises, productivity bonuses and stock options won't boost income this year, and consumers may not keep borrowing to spend. Already, they spend 14% of each paycheck on debt and interest today, more than at any time in the past 20 years." (David Wessel in "Capital" column, page 1).
James G. Devine
Professor of Economics
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Loyola Marymount University
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