Professional economists have reached a near-consensus for an economic recovery to begin later this year . On May 27 the Associated Press reported that over 90% of the economists who are members of the National Association for Business Economics predicted a turnaround in either the third or fourth quarter of this year. A few thought it might be pushed out until early 2010.
This is good news for those who want to see a healthy economy, but it would be a stretch to say that the beginning of a recovery means a quick return to financial health. The problem lies in the pace of the recovery. If we were to pull out of the downturn quickly, where pre-recession levels of income and production were achieved within a few quarters, then we could begin a serious celebration.
However, this is not the case, at least not in my view or in the views of many others who closely follow the economy. There are headwinds that must be overcome, and if my take on this is correct, our speed ahead is going to be at a snail’s pace. The burdens of our current situation are simply too heavy to allow for a rapid recovery.
There are three primary impediments to a fast recovery:
- Consumer spending is now, and will continue to be, a huge drag.
- The financial sector of America is still in reeling from its previous excesses.
- World demand for goods and services is crippled.
There are two primary subtexts related to a slow recovery of consumer spending, which is usually about 70% of GDP. The first is that most consumer spending originates with household income, and deep and prolonged unemployment has substantially reduced this part of our nation’s income. Most American adults work for a living, and the wages they earn from work constitute their primary source of spending. When they lose their jobs, their cash income declines, and they reduce spending.
Keep in mind that employment is the last thing to recover coming out of a recession. Employment lags other indicators, because businesses are reluctant to put on more payroll or add capacity as their sales gradually recover.
The second factor in restraining consumer spending is that household assets have declined in value with the fall in home prices and the stock market crash. Economists have long studied the “wealth effect” on consumer spending, and it has been firmly established that if one’s wealth is rising, even though it has little to no effect on income, spending tends to rise with it.
So, if you are a homeowner and the selling price of your home is rising rapidly, you “feel” wealthier, and you are likely to spend a higher percentage of your income as a result of that feeling. The same goes for your 401K and other financial investments. If stock prices are rising, the wealth effect stimulates spending, even though you do not tap the increasing value of your investments directly.
Now, reverse the wealth effect, where house prices and stock prices are falling. The wealth effect turns around, and you tend to spend a lower percentage of your income than if prices were stable or rising.
The prognosis for housing is still grim, with many analysts predicting mid to late 2010 before home prices stabilize, and Jeremy Steagall, in a June 7th article in the NY Times, thinks it will be years before house prices stop falling. There won’t be any help there for a long time.
The stock market is showing signs of life lately, so there will likely be some recovery in 401K values, but most investors are far from being made whole. And the spring rally can turn around with the wrong kind of news. This is another reason the wealth effect is likely to be substantially negative for much of next year.
But there is another effect on consumer spending that is also important, and it is entirely psychological. Economic history has shown quite plainly that after a major economic downturn, and our current situation certainly qualifies as major, households increase their savings rate. Adults that lived through the great depression of the 1930s, for example, reduced their spending and increased their savings, even after the recovery was long past. Spending and savings habits of those folks were permanently changed—they saved more and were more frugal in their spending decisions for the rest of their lives.
I don’t know how much this change will affect this generation of income earners, but I suspect that it will constrain future spending for a long time. If this is the case, then the economic recovery will be quite subdued when compared with the relatively mild recessions that we have experienced since the great depression.
Financial Sector Ills
There is a general consensus that another $2 trillion of financial assets will be written off or severely devalued. But, the effects of the coming write-offs in the financial sector may not be as bad as they appear now. The earnings of banks are improving, even for Bank of America and Citibank. In their favor is the traditional spread of interest paid on savings versus interest charged on loans. The spread is well over 3% now: their savings payouts are probably below 1%, and their charge for loans is well over 5%. Higher earnings for banks will make it possible to absorb the losses on the coming write-offs.
This is not the whole story, however. Bank assets are still under pressure, and given their current situation, they are skating on a thin ice of undercapitalization. But, banks are beginning to tap the capital markets to raise additional equity—some are even paying off their TARP loans, so this will probably ease the credit tightness some. Virtually all of the credit indicators (TED spread, LIBOR rate, commercial paper sales, etc.) continue to improve. Things are getting better, but they are not back to normal yet.
Then we have about 100 more banks (mostly smaller, regional banks) that will probably go belly up over the next year or so. This, while never welcome, can be handled by the FDIC. Losses will be absorbed by stockholders and FDIC insurance payouts, and depositor assets will be protected. The failed banks will be merged with healthier ones. Nevertheless, this is not good news. Failing banks hurt consumer confidence and business borrowing. So this, along with the giant banks’ continued troubles, will constitute a drag on our economy for at least the next year, if not longer.
An addition to the financial problem is the size of the American budget deficit. As the bills for bailouts mount up, they simply add to the amount we have to borrow. And we haven’t even remotely addressed the dire straits that many of the state budgets are experiencing. Financing these loans will probably stress the bond market, forcing interest rates up. Although we have plenty of room to accommodate a rise in interest rates, it is not going to help the recovery. How the Federal Reserve and Treasury departments operate to contain this problem has yet to be seen, so the specter of rising borrowing costs is not good for either consumers, businesses, or homeowners.
World demand for American goods and services is expected to be anemic for most of 2009 and well into 2010. Asia, the brightest spot on the map as far as economic health is concerned, will probably generate more than its share of spending on American made goods and services in the coming year, but it will probably not make up for the loss of spending in Europe and Latin America. The top five countries to which we export are: Canada, Mexico, Japan, China and the UK. Only China is experiencing growth this year. All the rest are experiencing serious contraction. Also, we import more from these partners than we sell to them, so expectations for help from the net foreign sector are zilch. There are no knights in shining armor riding to our rescue. When we pull out of this mess, for the most part it will be on our own.
In summary, I believe we will begin a modest recovery before this year is out, but it is going to be long and slow. There are major impediments to be overcome, and most of them are serious enough to be difficult to combat in a hurry. The mood will improve, but exuberance will not be a characteristic of the recovery for some time.
Disclosure: The author is long on SPY and EFA