Economic Outlook for 2009: A New Deal for a House of Cards

As an investor and an economist, I am glad to see this year consigned to history. The economy is in as sorry a state as I can remember. It will hold the unenviable record of being the first full year of recession since the Great Depression of 1929. It is also the year in which a financial crisis holds the entire world in its grip. Equities markets have crashed in nearly every country, and bank after bank has lined up with their begging bowls at their governments’ hand-out window.

The outlook for 2009 is also grim. Much of our economy has collapsed like a house of cards. Credit cards, second mortgages, housing prices and complex financial derivatives were stacked on top of each other. They haven’t stopped falling yet, and it looks as if it’s going to be some time before they do. Until then, there can be no talk of recovery.

The good news, such as it is, is that we at least know it is falling. The new Administration that will be taking office next month knows it, too. Since the new President was part of the opposition a short time ago, he has no need to deny the obvious. He is poised to take immediate action as soon as the reins of power are in his hands.

Of the major components of our nation’s income (consumer spending, business spending, government spending and sales to foreigners), the only one pointing up is government. This represents a serious shortfall in aggregate demand and leaves it to Congress and the President to turn to the classic Keynesian prescription of increasing government spending to take up the slack. An increase in government spending will provide a desperately needed stimulus for an eventual economic recovery.

Here is a look at each of the components of our nation’s income:

• 70% of the GDP is derived directly from consumer spending. At this time, however, consumers are being assaulted on several fronts:

Unemployment is high and rising. This means that consumer income will be stretched to its limits, leaving little room for any discretionary spending. We can already see the effects of this development in lower sales of TVs, cars, home improvements, new appliances, and meals at restaurants. The chart below shows the latest unemployment figures available.

Consumer credit is almost frozen. The orgy of lending that characterized banks for the past decade has reversed course, and it now takes sterling credit to get a loan for a car, new appliances, or a new home. In many cases, even good credit can’t persuade banks to take on more debt.

House values are still falling, and most real estate specialists predict that they will continue falling well into 2009 and possibly beyond. This means that one of the major drivers of the economy for the last few years has been halted. Using your home as an ATM machine is no longer an option.

• Business investment is probably at its worst point in half a century.

Corporate profits are down, and businesses are in the process of reducing their production to match the lower levels of sales.

Spending on new plants and equipment is expected to fall along with corporate profits. Their problem now is over-capacity, not new capacity. Overall, capacity utilization has yet to reach bottom. When it does, businesses will be able to calibrate what they will need in the future. For now, we are far from there.

Inventories need to be reduced, not increased. Even if businesses needed to finance new inventory, short-term loans are difficult to arrange.

• Government spending is the one component of GNP that is independent of lagging aggregate demand. There are three primary tools available to government when aggregate demand needs a boost:

Monetary policy involves manipulating the money supply with the aim of reducing short-term interest rates. But, this tool has lost its mojo by being overused for the last few years. With interest rates at 1.5%, how much lower can they go? These are conditions for a liquidity trap—an odd period of economic activity that was postulated by Keynes in 1936. Lower interest rates do not mean that businesses will necessarily want to borrow, especially if they have no need to finance increased production. And, there is nothing in lower interest rates that can force bankers to lend if they don’t have the stomach for it.

Fiscal policy is the tool of choice for today, and it dominates the thinking of both parties in Congress and of the new President elect. Mr. Obama has already spoken of a massive spending program on public services such as roads, bridges, schools, etc. Paul Krugman, this year’s Nobel Prize winner in economics, estimates that fiscal stimulus of 4% of GDP is needed to turn the economy around, and Mr. Obama has signaled that he will do that if necessary. It is easy to see a trillion dollar rescue package coming out of the next Congress.

Tax policy, either in capital gains taxes, business write-offs, or cuts in personal income taxes are all on the table for 2009. Exactly how this will play out is far from certain, but it can be effective, especially as a supplement to a strong fiscal policy.

• Net sales to foreigners, or net exports, as it is called, is not likely to work in our favor. Sales abroad depend on the exchange rate of the dollar with other currencies and demand for American products from foreigners.

With a global recession in progress, it is hard to see how we will have strong foreign demand for American products next year. The World Bank projects world trade for 2009 will decline by 2.1%. World GDP is expected to increase by a mere 0.9%--which represents a decline when the increasing population is considered. Both of these measures for the world output are projected to be the worst since 1982. International cash flows to emerging markets, a big buyer of American products, is projected to decline by 50%!

On exchange rates, the dollar has risen over the last few months, but recently it is flat. The dollar could see a decline against other currencies, but I wouldn’t count on it. Almost all other economies are hurting, so the U.S. financial position is likely to look stronger than that of other countries. Even today, foreign money is flooding the U.S. seeking the safety of U.S. Treasury obligations. This is helping the dollar remain strong, and it is driving the interest rate on short obligations to zero. I do not look for help from a devalued dollar.

What about 2009?

The projections for 2009 are quite diverse. But, among private economists, the outlook by the most optimistic forecasters is for a recovery to begin by mid-year. Others predict it may be as late as the third or even fourth quarter. The deciding factors in determining one’s outlook for next year is how soon the housing market will recover, how soon bank credit will loosen, and how effective the fiscal recovery plan will be.

No one can know any of these magnitudes, but a fourth quarter turnaround is not out of the question. It is, in the view of many, an increasingly likely prospect, given the huge uncertainty that pervades the U.S. and world economies. If the turnaround is that late, then 10% unemployment is likely. If the turnaround comes in June, the unemployment rate might be capped at 7-8%.

As the next year unfolds, recall that the unemployment rate is a lagging indicator. So when the unemployment figures begin to improve, the economy is likely to have already begun its recovery.

The stock market is an inconsistent leading indicator of the economy. If we see a rise in equity prices in December or January, then that would indicate a recovery from five to nine months away. This is not a predictor that you can take to the bank, but it is one of many that might give investors a glimpse of what is to come.

One glimmer of hope for an accelerated recovery lies in a coordinated world-wide fiscal policy. This could lessen the length of the downturn for everyone. With any fiscal policy that calls for increased government spending, there is some leakage from the spending stream lost to foreign sales. But, if all the affected nations do their spending at the same time, this leakage is more than off-set. We have no experience doing this kind of coordinated international fiscal stimulus, but the April meeting of the G-20 in London will offer the members a chance to work together. This is probably a long shot, but it holds some promise as an important new tool in managing the world’s economies.

As to the pace of the recovery, I can’t find any credible source that thinks it will be fast. There are no exact parallels in economic downturns, but deep and wide recessions are typically slow to recover. Let’s hope that this prognosis can be overcome with good fiscal and monetary policies. But, investor confidence has been shaken badly. It is not likely to spring back to life any time soon. My hope is that I can write a mid-year evaluation that is much rosier than today’s outlook. As for 2008, goodbye and good riddance!

Comments

[hanson001:]

"We have no experience doing this kind of coordinated international fiscal stimulus, but the April meeting of the G-20 in London will offer the members a chance to work together. This is probably a long shot, but it holds some promise as an important new tool in managing the world’s economies."

Most everything I learned in economics has been thrown out the window, but I would like to see the affect of a coordinated international fiscal stimulus. It sucks losing money and future expectations during this turmoil but I have to say it is excellent study. One could call it perpetual case study.

2008 Dec 11 11:11 AM

[Ray Hendon:]

We will see something of the effects by the end of next year. Since so many economies of the G-20 are in trouble, most of them will initiate some kind of fiscal stimulus. It will not be formally coordinated, but it will be more or less simultaneous, which will work just about as well.

Best wishes,

Ray

2008 Dec 11 11:39 AM

[BerkeleyBob:]

I am not at all sure what a new international financial restructure would look like, who would benefit and who would be hurt, but I am reasonably sure that the present economic crisis demonstrates a degree of interdependence which has not been anticipated or planned for. On the outgoing administration's watch, the export of fraudulent debt instruments has been permitted with grave consequent damage to America's international reputation.

2008 Dec 11 12:32 PM

[Big-P:]

What a pack of criminals. I think I'll stick em' all in my "Tool Shed."

2008 Dec 12 01:34 AM

[bluesmantoo:]

Fiat Money's not so funny, if you're buying T-Bills,
In the air is a feeling of defeat.
Fed is bailing, Justice jailing, and the country's for sale,
And in every chat corner you hear-
Silver's swell! Silver's swell! It's real money not junkbonds.
Ring-a-Ling, Gold is King! The end of the dollar is near!

2008 Dec 12 02:44 PM