On the flip side
House prices fall and jobless claims rise - just two of the signs of economic health - but are seen as both inhibitors and stimulants of growth. Vanessa Drucker in New York analyses the two sides of the same coin.
How far is the American economy poised for growth? Flip a coin. In economics, every development is two-sided: gains on the swings lead to losses on the roundabouts. One must examine two sides of the same coin, to weigh the net advantages and drawbacks.
The American Federal Reserve recently voiced increased optimism, revising its growth forecast to 3.4% to 3.9%, up from 3.0% to 3.6%. Yet this article is not concerned with predicting estimates, but rather with the forces behind the growth, or lack of it. It explores a set of plusses and minuses, in ledger form, which constitute the positive and negative drivers for near term American economic expansion, looking out over the next year or two.
”It is always true that confidence causes a recession and growth brings it back”
A discussion of the positive characteristics of the economy begins with confidence levels. Both consumers and businesses appear to be rebuilding morale, after several seasons of discontent. “It is always true that confidence causes a recession and growth brings it back. It may be hard to separate out the cause and effect, but the virtuous spiral helps,” says David Wyss, the chief economist at Standard & Poor’s (S&P).
The American consumer has begun to spend more, demonstrating a willingness to buy even big ticket items. This revived optimism derives from two main sources, the performance of financial markets and some stabilisation in employment. (Cover story continues below)
Both these forces have particularly benefited the higher income segments of the population, who experience the “wealth effect” of rising capital markets, and have also been less severely affected by job losses. According to the Bureau of Labor Statistics, in the last quarter of 2010, university graduates accounted for only 19% of all those unemployed, while a January survey conducted by Harris Interactive, showed employed workers’ concerns about lay-offs had decreased to 17%, down from the third quarter at 20%. In other words, people who are employed are becoming less frightened of losing their jobs.
Business confidence is also manifesting in renewed spending on capital investments. American corporations have amassed troves of cash on their balance sheets, prompted by the traumas they have witnessed in the financial sector. That cash, however, is generating no income, and is beginning to exert an unacceptable drag on earnings, with no return on equity. Cliff Draughn, the president of Savannah-based Excelsia Investment Advisors, points out that many companies prepare their annual budgets in September or October, establishing the year’s plan for evaluating management and allocating resources.
“Once budgets are set, companies are unlikely to change midstream in terms of new equipment or hiring,” Draughn says. According to such a schedule, businesses may not start to deploy their cash for another nine months or so. David Levy of the Jerome Levy Forecasting Center in Mount Kisco in New York, is even more guarded about the timetable for capital spending. He expects investment in fixed capital stocks and overheads to be postponed for at least another couple of years. For instance, despite improved profitability in the airline industry, and some immediate need to replace planes, airlines have been reluctant to add back flights. They would rather run fewer flights to earn higher profits.
Corporate profits, indeed, have been robust in recent quarters, contributing to expanding margins. Part of that vigour is owing to technology, which is constantly advancing, and another aspect to lean management principles.
The most important driver, however, is that companies have learned to manage with fewer workers, which accounts for the rise in productivity. Notwithstanding, note that 40% of those profits from S&P companies originate from foreign operations. “From that perspective, many US companies have not recovered to the same degree,” says Levy.
The foreign arena has proved a net positive, both in terms of overall increased trade and currency movements. Mark Zupan, the dean of the University of Rochester’s Simon School, sees the continued trend of globalisation as a net advantage to America. He interprets it, “as a way of raising our game, much as Japan did in the 1980s”.
The fallacy, in his view, is to regard trade as a zero sum, rather than positive sum game, with direct benefits arising from arbitrage opportunities. Furthermore, by taking a dynamically evolutionary perspective, American companies are likely to reflect hard about the costs of doing business, as they strive for success in a global race.
In the currency markets, the dollar’s decline has proved a blessing for American exporters, which have become a key contributor to the country’s growth. “Two years ago, President Obama promised he would double exports,” Draughn says. “The easiest way to accomplish that is to devalue the currency, which has been achieved, by 25%.” The consequence is that top line revenues for large firms such as MMM, Caterpillar or Boeing increase, even while the volume of sales may remain level. Meanwhile, Asian countries have been diversifying their reserves away from dollars and into euros and yen. That move should help American firms, because it weakens the dollar by spreading foreign investment.
”A misguided focus on the deficit will undermine what little growth we have had”
Currencies still tend to mean revert once they reach unsustainable levels. When and if the dollar changes course, those export benefits could swiftly unravel. Eventually the greenback will stop falling, as there will be no suitable currencies left against which it can decline. The euro, in particular, threatens to weaken against the dollar in the event of an emergency in Europe. That would create a double whammy for American exports. Another freeze in financial markets, triggered by a default crisis in the peripheral European countries, would prompt a flight to quality into the dollar. At the same time, the export market would suffer, given that Europe is America’s number two customer, after Canada.
King Dollar could come under further siege, deficit hawks argue, as the American national debt mounts. The deficit itself is touted as a major impediment to long-term growth. Some more progressive economists, on the other hand, take issue, seeing the stimulus and spending that it enables (the other side, effectively of the same coin) as the most important underpinning for growth.
“Ironically, people have it exactly backward,” Levy insists. “In normal times, we would not want to run up too much government spending, which might overheat the economy. Right now, that’s not a concern.” He argues that there are two appropriate times to run huge deficits: in wartime, when struggling for survival, or when fighting a depression. The American economy is still mired in weak net investment, at a level barely running ahead of depreciation, and offset by what it is leaking through the trade deficit. “Without government support, the system would now collapse into a depression,” Levy maintains.
Ron Baiman, the director of budget and policy analysis at the Center for Tax and Budget Accountability in Illinois, agrees that “a misguided focus on the deficit will undermine what little growth we have had.” Baiman suggests that a theoretical solution such as a financial transactions tax might serve as an alternative method for raising revenue, although he swiftly adds that it is unlikely to materialise, since “the political system is so influenced by Wall Street”.
As today’s economy tentatively regains its footing, pent-up demand is finally unleashing inevitable animal spirits. As a historical example, after years of consumer deprivation during the second world war, a resurgence of fresh demand fuelled exceptional growth in the post-war years.
“People have not been spending for a long time since the recession started, which has built significant potential demand,” says Alan Madian, a senior adviser at the Brattle Group in Washington DC. Some of that demand will be funded by borrowing. Madian adds, “As they get back to employment, people will pay out of their current earnings and use their increased borrowing capacity.” His prediction comes with the caveat that the growth must be sufficient to bolster the jobs market, which requires more than 200,000 new recruits each month or 2.5m a year, just to break even with the number of jobs that have been lost.
On the positive side, historically low interest rates continue to provide a buffer and a platform for growth, by freeing cash. Harlan Platt, a professor at the College of Business Administration at Northeastern University, acknowledges that rates “have come up somewhat, but are still giveaways.” That means that the combination of lower home prices and low interest rates allows more people to buy homes, and thereby reduces the rents they are paying at present. But flip the coin: although the increased liquidity may translate to added consumer debt, it has the converse effect on bank profitability.
As a final positive for homeowners and businesses, natural gas has become cheap and plentiful in the past 24 months. Marcellus, a newly discovered giant field in Pennsylvania, turned out to be fortuitously situated on a pipeline, affording easy shipments to New York and New Jersey. The black shale formation is estimated to contain 4.7 trillion to 14.6 trillion cubic metres of natural gas; that would amply supply, say, New York State, which uses 31 billion cubic metres per year. New fracking technologies have also improved natural gas extraction. Since shale gas exists in a tight formation, injecting fluids underground helps to break up the structure. “Natural gas is a much cleaner fuel, and many industries and homeowners have already converted from oil, or are planning to. Conversion provides them with a rebate, since gas prices are so low,” says Platt.
”People have not been spending for a long time since the recession started, which has built significant potential demand”
Now let us review the negative side of the economic coin. If abundant, inexpensive natural gas is providing a welcome tailwind, then commodity inflation is widely perceived as a lurking impediment to economic growth. Kenneth Lehrer, who manages Lehrer Financial and Economic Advisory Services in Houston, focuses on supply constraints across a range of raw materials, especially petroleum. “We’ve used up the cheap stuff,” he says. “We have to drill deeper for oil, and for logging we look to Canada for extra timber. We used to fish close to shore, but we have to go out 300 miles.”
The controversy over incipient American inflation has split economists’ ranks. On one side, Ben Bernanke, with the backing of fellow Federal Reserve members, still perceives little evidence of it. The central bank’s most recent minutes, published on February 16, reveal the Fed’s inflation forecast as essentially unchanged at 1.3% to 1.7%. Reporting that underlying consumer price inflation continues to be tame, the minutes added some granular detail: “Despite the steep run-up in agricultural commodity prices over the second half of last year, increases in retail food prices remained modest. However, consumer energy prices moved up sharply in December, and prices of most types of crude oil increased during December and into January. The prices of nonfuel industrial commodities also continued to rise over the intermeeting period.” Yet more recently, since those deliberations were published, Middle Eastern unrest has pushed up crude prices substantially, and that rise has already fed through to American gas pumps.
Many remain unconvinced that inflation is low. Draughn describes how the consumer prices index, first compiled in 1911, has been recalculated five times since then. The last time, in 1995, then Treasury Secretary Robert Rubin persuaded Congress to remove food and energy from the list of components, citing their month-to-month volatility. For those who choose to compute inflation according to a pre-1995 measure, today’s reading would come in at a more alarming 7.3% to 7.4%.
While economists spar over the hazards of present inflation, all agree that the dismal employment picture creates a high hurdle. Ronald Reagan once darkly quipped that, “a recession is when your neighbor loses his job; a depression is when you lose yours.”
Strictly speaking, unemployment, although a huge social negative, in itself does not necessarily impinge on growth. “But it does stress the financial infrastructure, by having more people out of work and unable to service their debts,” Levy notes. He expects employment to improve over the next six months, but “even making good progress will not be enough”.
Basically, a powerful boom would be needed, to create the 200,000 jobs required for breakeven. Bear in mind that since the recession, more than a million people have dropped out of the labour force, and are no longer counted as unemployed. As the economy gains traction, those will be returning, not to mention a huge workforce of illegal aliens, who will be casting about for work in areas like construction.
Alongside unemployment north of 9%, extreme income disparity is undermining the ability of the economy to grow without asset bubbles, in Baiman’s view. Looking back, from 1947-79, during an epoch of higher tax rates in upper income ranges, the top decile of the American population enjoyed 34% of income growth, with the remaining 66% flowing to the bottom 90%. From 1979-2007, that pattern was exactly reversed, according to Thomas Piketty and Emmanuel Saez, two academics. In the most dramatic shift, from 2002-07, the top 1% earned 62% of income, in a massive wealth transfer.
The yawning gap, at its widest since 1929, interferes with sustainable growth and misallocates resources. Or, as Lehrer bluntly puts it, “when the unemployment rate and the price of Tiffany’s stock hit new highs simultaneously, something is wrong.”
An important factor behind growing income disparity can be traced to the neglect of primary and secondary education. On the bright side, American university education “is the envy of the world,” says Zupan. It spawns entire industries, generating concepts like Google and Facebook in college settings. Secondary schools, he sighs, “tell a different story.”
”It is likely that home prices will continue to fall, which will hold adverse consequences for exposed financial institutions, as well as mortgage backed securities investors”
According to the rankings from the Organisation for Economic Cooperaton and Development, American schools are placed only 18th, among the 36 nations examined. “The system has been bureaucratised, with as many people employed in central offices as in classrooms,” Madian observes. He compares American high school teachers with those in countries such as Japan, Singapore and Finland, where “they earn more in compensation, and enjoy higher prestige and respect.”
Employment goes hand in hand with the vigour or softness of the housing market. While the rot in the mortgage derivative market has been tackled, the spectre of loan defaults still looms large. As prices fall, it will become increasingly difficult even to foreclose as the scale grows. In recent months, homeowners have rallied back to fight evictions, pointing to automated “robo loans” and improper paperwork. Levy warns of a scenario, like that in Japan, where for a decade banks baulked at writing off their problem loans, and thereby failed to let the market clear. That stalemate further curbed their lending.
Home price deflation threatens both the financial wellbeing of households and the condition of the American banking sector. “It is likely that home prices will continue to fall, which will hold adverse consequences for exposed financial institutions, as well as mortgage backed securities investors,” predicts Madian. He foresees further unraveling, describing how, “as those assets are written down, it will impact bank capital and banks’ earnings, ultimately affecting both shareholders and banks’ ability to lend.”
Lastly, on the negative side of the ledger, we see the culmination of a long process, which dates back more than 30 years, during which the American manufacturing base has eroded. An economy that does not produce tradable goods, has less to export, which puts constant pressure on the trade deficit. Although entrepreneurship and venture capital may still flourish in areas like Silicon Valley, the number of American jobs generated has declined by many factors; in California, technology firms just do the prototype research and scale up production elsewhere.
For heavier manufacturing, it takes substantial time to gear up and build facilities. Madian hopes that subsidies and loan guarantees will encourage Americans to build half a dozen nuclear plants this decade, but warns that, in the meantime, the Chinese will be constructing 50 state-of-the-art plants of their own. Last year offered a lesson in preparedness, when the Chinese, who had monopolised the rare earths industry, suddenly tightened export limits.
It may not be too late for America to kick-start industrial capacity. Policymakers have gained a better understanding of the new patterns of supply and demand, especially regarding the explosive growth of China, than they possessed five years ago. They recognise that if they do not anticipate and address the new order of market signals, they may find themselves in some peril and facing excess costs. While those brakes on growth may not be showing quite yet, before we know it, the future will be upon us.
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