Interview With Andres Carbacho-Burgos: Recovery Won't Accelerate Until 2014 When GDP Growth May Nearly Double

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by: Harlan Levy

Andres Carbacho-Burgos is a senior economist at Moody's Analytics. He currently analyzes the U.S. housing markets and the state of Connecticut. Previously he was an economics professor at Texas State University.

Harlan Levy: The latest economic data - consumer spending down on weak income, plunging bond prices, and mediocre job reports while the U.S. consumer sentiment is at its highest level in nearly six years - looks contradictory. Is the economy actually starting to improve after five years of awfulness?

Andres Carbacho-Burgos: In some areas, yes. But you get the usual imbalance effect where some indicators lag while others move ahead faster.

The perceptible areas of improvement are, first, house prices have started to increase across the country. So households no longer face that hit to the balance sheet and are in much better shape after three years of paying debt and consuming less. That's why the consumer sentiment index has improved. Consequently, we can now expect that over the coming year or two most local government finances will start to stabilize as the property tax revenues no longer get drained by falling home values.

What still needs to improve is the labor market situation where there's a lot of slack and a high unemployment rate. Also, the employment-to-population ratio is still very low compared to what it was before the recession.

In addition to a loose labor market there are several lagging areas in the U.S. economy. The first is the public sector, where you're going to have both federal and state governments being a drag on growth for at least the coming year. That's due to the sequestration cuts and to the fact that state governments still have to cope with reduced sales tax revenues and greater pension obligations than before the recession.

The other drag in a lot of areas will be simply restoring growth in high-wage industries. For example, Connecticut has a lot of high-wage industries in aerospace, pharmaceuticals, financials such as insurance, and ship-building near the coast. But none of those industries has hired significantly over the past three years. Until the end of last year you have a situation where income growth in Connecticut was not keeping pace with inflation, and that's never a good sign.

That's still happening in a lot of states besides Connecticut. So, while we are in recovery, it's still slow, and it's not going to accelerate until early next year. Because of sequestration and other reasons, we expect Gross Domestic Product growth to be slightly slower in 2013 than in 2012. In 2012 we recorded 2.2 percent real GDP growth, and for 2013 the forecast is for 1.9 percent. But once the public finance situation stabilizes and when sequestration cuts finally recede, we expect GDP growth in 2014 to be about 3.4 percent.

H.L.: What do you see the U.S. jobless rate next year?

A.C.-B.: In 2012 the rate averaged 8.1 percent, and despite slower growth in 2013 we're going to keep bringing that down. We expect 7.7 percent in 2013 and around 7.1 percent in 2014. But that improvement may overstate the situation, because the labor force is smaller than it was before the recession.

In 2007 just before the start of the recession we had an employment-to-population ratio of 45.6 percent. That bottomed in 2010 at about 42 percent, and in 2013 we're expecting a ratio of about 42.8 percent. The percentage difference from 2007 doesn't sound like much, but you're talking about several million workers who are still unemployed or who are not in the labor force but could be employed. That means the labor market recovery from the recession will be long and drawn out and slower than suggested by just looking at the unemployment forecast.

H.L.: Will housing continue its positive trend?

A.C.-B.: Yes. The one qualification is that it will be uneven regionally. We're getting faster house price growth in the Southwest and California and also to some extent in the Western states in general, because they have cleared out their foreclosure inventory. That 's not happening in states with judicial foreclosure proceedings, like the Northeast, the Midwest, and Florida, so those state will experience slower house price growth.

H.L.: Do you think the Federal Reserve will continue buying $85 billion worth of Treasurys and mortgage-backed securities each month?

A.C.-B.: The U.S. economy is starting to recover, so I can definitely see the Fed bringing quantitative easing to a close by the end of 2013. That doesn't necessarily mean that interest rates will start going up at the same time. What will happen is that the Fed will keep a close eye on the U.S. economy, and once it decides that the economy is undergoing self-sustaining growth and has significantly reduced the unemployment rate, then it will start bringing up interest rates. We're not expecting short-term interest rates, such as the rate on Treasury bills, to go up before 2015.

H.L.: Do you see euro zone leaders able to fix the zone's toxic sovereign debt problems, or is the situation just getting worse and dire?

A.C.-B.: Just about any answer that any analyst gives you is going to be wrong. Here's mine: Right now the financial situation in Europe is stable thanks to the guarantees set up by the European Central Bank. The problem is that these guarantees are still conditional on continued austerity in the southern European countries, Spain, Greece, Italy, and Portugal. The situation is particularly bad in Spain, Greece, and Portugal, which have unemployment rates above 20 percent and much higher for young people.

The question is, first, when will the populations of those countries have had enough and when will there be newly elected governments that say, "Enough. No more austerity." Then the ball is back in the court of the European Central Bank, Germany, and the International Monetary Fund. They could accept a write-down of debts in each of those countries.

Alternative No. 2, which is even less conceivable, is the European Central Bank continues buying up sovereign debt issued by Spain, Greece, and Portugal, which would create expectations of much higher inflation. But the ECB is very allergic to this, so it doesn't have a ghost of a chance of happening -- but it is an alternative.

The third and last alternative is that the European leadership tells any country that rejects austerity, "You're on your own if the private bond market doesn't support creation of further debt, and then you'll have to leave the euro." Depending on how much warning there was and how prepared the European banks were, it could spark another financial crisis. But it would be more likely to just cause a reduction in business confidence and slower growth in Europe.

Let me emphasize that these are all downside risks. Moody's' forecast is that Europe continues to shrink in 2013, has very slow growth in 2014, and only starts to really recover in 2015, and no European countries withdraw from the euro zone.

H.L.: What's happening in Connecticut?

A.C.-B.: Connecticut is actually looking slightly better in the last couple of months than it did in 2012, when job growth was flat and income growth was not quite keeping up with inflation. Not only were most private industries still moving sideways or laying off people, government was creating a significant drag, mainly through county and municipal layoffs.

That's starting to look better in the first months of 2013. Through April Connecticut has had slightly positive job growth, led by healthcare and lower-paying industries like retail, tourism, and hospitality.

Another piece of good news is that for the first four months of 2013 local government payrolls have stabilized. Connecticut appears less likely now to go into a double-dip recession than it did at the end of 2012. The state is still lagging behind the U.S. and still has significant downside risk.

Among the problems Connecticut faces, first, the aerospace industry, the key U.S. manufacturing industry, faces defense cuts and reduced demand from Europe. I doubt that growth in industrial production will be very fast, and I doubt that manufacturers will do anything more than keep current payrolls.

Secondly, the financial industries are still retrenching, in part because even though the stock market has gone up, interest rates are still very low, and rock-bottom interest rates have drastically reduced the profitability of financial firm portfolios. That's why even now the insurance industry in Hartford hasn't halted the downward trend in employment. Also, financial firms are moving as many support and back-office jobs as they can to lower-cost parts of the country.

The third drag is that state government will not be able to increase expenditures, first because there's no political or economic room to raise taxes, and secondly because it still has a very critical situation with pensions. For the next couple of years, the state is going to need to increase funding for its pensions, which means it will have to reduce spending on other areas.

Our baseline outlook adds up to Connecticut lagging behind the U.S. recovery but does not add up to another recession in the state. It's not really a doom-and-gloom forecast, because Connecticut still has some high-paying industries and a high per-capita income. So, it will be fine, even with slower growth than the U.S. average over the next three to four years.

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