Volume 60 | Number 9
Since our last missive, we have been in Dallas at the National Association for Business Economics and Washington DC at Macroeconomic Advisors Policy Seminar. Our strongest observation is that it is hard to find any optimists out there. Economic outlooks are being ramped down day by day as the data continues to roll in softer than expected. This week, the softer than expected retail sales data, combined with faster than expected CPI inflation, signaled still slower growth in the third quarter – now estimated under 2% (and headed under 1.5%) for real GDP. Even before this latest data (indeed, before this month’s weak employment report), NABE forecasters were lowering their expectations for growth in the second half to 2% and to just 2.3% for 2012. Meanwhile, the EU was revising down its second half growth outlook to just 1.2%. No business economist is telling their boss that now is the time to expand. Rather, the consensus is to hunker down and wait and see what new policy moves might bring – though that well seems pretty dry.
The most optimistic voices on the US were looking for either Operation Twist or for the GSEs (Fannie Mae and Freddie Mac) to allow refinancing of mortgages within their portfolio regardless of loan to value ratio. No one expected much out of the new Obama proposals, though some expressed hope that the super committee would go beyond its minimum mandate. Those with particular knowledge of the defense budget noted that a failure to act by the super-committee would be devastating to the military’s operational budget (since health care costs are rising rapidly there as well.) Most expected at least $900 billion in cuts, with the rest of the $1.5 billion from sequestration (evenly split between defense and non-entitlement spending.) A few optimists expect the grand coalition of tax reform and spending cuts up to $4 trillion. Following the lack of ideas coming out of Europe this weekend, we continue to expect the minimum – unless weakening equities markets and the renewed threat of financial crisis raise the political temperature once more. Unfortunately, the equity markets’ perennial optimism constantly relieves the pressure on Washington, and all we get is kicking the can down the road waiting for an election in fourteen months. We doubt the economy will make the election without further turmoil.
The one area of consistent optimism was for the emerging markets. Though many see China cooling, almost none saw a hard landing. Indeed, many EM analysts see China’s recent woes from inflation as a driver of EM growth as commodities prices to China continue to rise. Latin American analysts were particularly bullish, with the outlook on Brazil basically that they have so much growth that they are stuck with a both a strengthening currency and inflation in the near term as a result. Some expected Indian growth to outstrip China’s over the next several years despite even higher current inflation. Guess where economists are telling their businesses to expand?
It is Still a Housing Problem
After listening to a hundred business economists each preach that the economy would get better if something could be done for their industry, I remain convinced that the central problem remains an imbalance in the housing sector. So long as housing supply exceeds demand, our banking system –based on real estate collateral — will refuse to make new loans. This restriction on new investment robs the economy of its strongest traditional driver. Moreover, by limiting the potential for competition from new entrants, a lack of lending leads to entrenched positions for existing firms. We heard over and over this week of industries that are shrinking to their most productive core, and raising prices as they do so. This process is a massive job killer, as it dramatically reduces the boost to employment that occurs when a new contestant hires workers to pry business away from an existing business. The employment boom of the late 1990s was driven by the creative destruction of internet-enabled online providers competing with established brick and mortar firms. Yes, this ended in recession (a mild one for employment) as ultimately winners were separated from losers. However, the by-product of the winners was greater efficiency and lower costs that allowed other new businesses to flourish from increased spending of freed income. Without competition, monopolists tend to push up finished goods prices while restricting input prices. In a world with limited ability to control commodities prices due to strengthening global demand, it is domestic labor that suffers the brunt of the cost adjustments. Labor thrives from business competition – which tends to lower the share of profits relative to GDP. More lending generates more entry, which generates more jobs. But banks won’t lend if real estate markets won’t clear.
The banks are trying. Some of the largest are adjusting by simply leaving the housing industry altogether. We have noted in the past that banks in the US before WWII were largely lenders to business – as they are still in Europe today. As they once again expand their business lending, entry will become easier. Others are more aggressively clearing up their balance sheets, as we have seen in the August numbers for increased foreclosures. Still, the regulatory authorities are slowing the process by intransigence on allowing new financial institutions to enter the market – preferring to save the existing ones. Meanwhile, the GSEs are hampering the start of what could be a profound refinancing cycle by refusing to allow refis on loans with high LTV ratios – despite the fact they are already at risk on the loans. Again, the attempt to preserve the status quo slows the adjustment.
The US economy is not at risk of a double dip, because it has not built up any new excesses that need to be flushed though a recession. It is at risk of prolonged stagnation, as a lack of risk taking reduces investment and the winners in the current status quo survive by shrinking rather than expanding. Though everyone tells me we are not Japan (and goes on to cite specific differences), I remain unconvinced. At its core, the Japanese malaise was caused by a lack of investment as it refused to let go of the dying keiretsu structure. Investment was increasingly driven by the government, and focused on increasingly useless infrastructure projects. No progress was made on revamping the notoriously inefficient service sector, because the government wanted to preserve jobs and political power. The big firms, as they did recover, invested offshore as they saw no future in a moribund Japan. The US appears headed down the same path. Currently, government selected investment projects are largely directed at rebuilding the worn out infrastructure of yesteryear rather than risking a great leap forward. This is not Kennedy’s Space Race or Reagan’s Star Wars (both of which were spurred by the need to compete with the evil empire). There is too much emphasis on rebuilding and too little on R&D. Private sector investment sees better growth opportunities overseas, where governments are investing in new productivity enhancing infrastructure, not simply repairing the old.
Not Just a US Problem
The Eurozone too is suffering from a lack of competition. While most focus on curing the symptom of heavy indebtedness, that alone will not resolve the Eurozone’s fundamental imbalance. Germany was allowed into the Euro with too cheap a currency valuation, the result of the Deutschemark’s weakness (due to explosive monetary growth) immediately following reunification. As a result, Germany has dominated European growth over the past fifteen years and sustained its position as a major exporter by lending cheaply to the rest of Europe, which effectively borrowed at German rates. The key to the current imbalance is that Germany overproduces relative to the rest of Europe’s ability to consume. As Germany grew, it never invested its earnings in the rest of Europe, denying them any chance of increasing their buying power. Now that system is broken. Either Germany reduces production unilaterally; Germany continues to finance Europe at a loss; non-German Europe has a sharp increase in productivity (through lower unit labor costs); or the Euro must weaken enough for Europe to sell enough outside the Eurozone to be able to sustain excess demand for German goods and services. Of the four, the last is most likely in the short run – but only increased investment in non-German Europe holds a long run solution.
Bottom line, the US has a surplus of housing built during the past decade and Germany has a surplus of excess productive capacity built during the same period. These surpluses are at the heart of the current depression in the developed world – as the US banking system depends on real estate collateral and the European system on German surplus savings. These surpluses are also almost impossible to solve through growing domestic demand whether by monetary or fiscal stimulus. A destruction of capacity is needed. Unfortunately, a program of capacity reduction has no political constituency, so we most likely going to have to do this the hard way. Typically, this was accomplished in past depressions by war or protectionism which excluded foreign producers. Protectionism is more likely today – particularly in the form of competitive currency depreciation or regulatory exclusion of foreign production. Straight protectionism via tariffs would spark global recession and deflation in the near term as global markets contracted. Conversely, emerging market currency appreciation would lift those nations’ ability to buy commodities at discounted prices (relative to the developed world) and be inflationary at least for that sector. Even if emerging markets refuse to appreciate their currencies, the continued lax monetary policy of the developed world would continue to spur rapid EM inflation – reflected particularly in their labor costs. In either case, prices for EM production would rise. Over time, trade balances would shift due to rising EM buying power – but we seem to be only at the very beginning of this process. Bottom line, without innovative new approaches to correcting developed world imbalances, it looks like growth will continue to atrophy here while it continues to outperform in the emerging markets.