Volume 62, Number 9
It is a quiet first week of the month with no employment report, so we have decided to take a step back and focus on some big picture issues. We begin with the observation that we are neither Keynesian, Monetarist nor even Austrian, but essentially Institutionalist. That is, we are as concerned about the efficiency of the systems that carry out policies as we are about the policies themselves. At present, our focus is on the damage to the US financial system post-Lehman, where banks, fearful of declining real estate collateral, refuse to lend. In a fiat money system, it is banks which control the growth of nominal GDP by making loans with the reserves the central bank creates for them. If they do not lend – even at near zero borrowing costs – the economy loses it potential for strong upside surges fueled by optimistic consumers and investors who want to invest in the real economy via housing, or autos, or education, or capital equipment, but need credit. Liquidity injections spike the assets markets, but the trickle down is limited unless the winners hire and invest – but that activity has been limited so far in this recovery.
We do not believe the US is headed for a recession, but rather that it is stuck at roughly 4% nominal growth. If inflation is high, due to energy or food or other reasons, real growth suffers. And when inflation abates, due to a mild winter or whatever, growth shines through. Over the past six quarter, after the 2009 stimulus wore off, nominal GDP has averaged 3.9% — and with relatively little volatility. Meanwhile, real growth has been as low as 0.4% and as high as 3.0%, while inflation (as measured by the GDP deflator) has ranged from 0.6% to 2.7%. Yet, over this six quarter period, inflation has averaged 2.0%, consistent with the Federal Reserve’s long run target rate, while real growth has limped along at a 1.9% annual rate. Given the Federal Reserve has dedicated itself to not allowing consumer inflation to slip below 1% or over 2%, for real growth to break out on the high side will require more lending than the banks seem willing to undertake.
Remaining at 4% nominal growth may be difficult, as it appears to be below the economy’s stall speed leaving the cycle exposed to downside risks. Corporate revenues have grown faster than overall GDP growth as the government sector retreats, but over the past two quarters profit growth has ground to a halt as compensation growth has risen. Compensation was up 4.6% in January compared with a year ago – a solid reading – but higher taxes and lower transfers resulted in per capita real disposable income falling -0.1% for the year. A shrinking government deficit is what we want, but it comes at the expense of current spending. In January, transfers fell by -$3.6 billion despite $30.2 billion in cost of living adjustments for social security and other programs. The drop was the result of ongoing reductions in medical transfers (Medicare and Medicaid) which fell $9.2 billion, the end of the “Making work pay” tax credits, and more workers rolling off the unemployment rolls (often onto social security or disability, rather than to a job). Also, taxes jumped 1.9% or $23.2 billion as governments finally are following Lord Keynes injunction that they should increase revenues at the top of the cycle. Bottom line, fiscal austerity has offset corporate largess, and the 70% of the economy controlled by the consumer is seeing no increase in spending power beyond population growth.
The outlook for business investments is also shaky due to the lack of profit growth and the end of 100% expensing. In January, new orders for non-defense capital goods excluding aircraft fell a much larger than expected -4.5%, more than offsetting the 3.4% gain in December. We expect business equipment to slow in early 2011 due to the reduction in expensing from 100% to 50%. Indeed, equipment investment has been slowing steadily over the year and a half since the stimulus peaked. The current three month average is only 5.9% higher than a year ago, only slightly better than overall nominal growth. The current three month average is -3.7% lower at an annual rate than the previous three months. Without a strong rebound in February and March, equipment will be a drag on GDP in early 2012.
We have been clear in recent newsletters that the strength in the economy this winter appeared to be weather related – and given that view the January construction data are particularly disappointing. Nominal construction outlays fell -0.1%, as a -0.8% drop in non-residential activity offset the strong 1.6% surge in residential building. Nonresidential building had been responsible for a large part of the upward revision in nominal GDP for the fourth quarter from 3.2% to 3.9%. Now despite very mild weather in January, building activity has failed to meet, never mind outperform, general economic growth.
Similarly, the strength in February motor vehicle sales – as in January – appears to have been substantially boosted by fleet sales. February sales were at a hefty 15.0 million unit annual rate, up from a 14.1 million unit rate in January and a 13.4 million unit pace in the fourth quarter. Industry sources have confirmed that much of the January rise was in fleet sales. The give-away in February is that surging sales of Chrysler 200s and 300s led the way. Both have traditionally been fleet favorites, and Chrysler has relied far more heavily on fleet sales than other manufacturers. Looking at the non-seasonally adjusted data is also important since leap year has so profound an effect on February, with the extra day alone lifting year on year comparisons by 3.6%. In January, unadjusted sales of trucks and imported cars rose 3.6%. Neither is traditionally heavy in fleet sales. Meanwhile, domestic car sales were up 28.7% flashing a strong fleet signal. In February, trucks and imported cars rose 9.1%, but adjusting for the extra day only 5.5%, slightly better than in January. Remember, February weather last year was about the worst ever. Meanwhile, domestic cars sales were again up 28.7% (or 25.1% adjusting for the extra day) in February. We worry that fleet sales and weather will both disappear from the data at the same time in spring.
Do Policies Matter?
While cogitating about the impact of living with a damaged banking system, we were driven to evaluate the growth experience in Japan – and were fairly shocked at the results. Data on real per capita GDP (prepared by Dr. Matthew Shane at the USDA Economic Research Service) indicate that the US and Japan have grown at almost precisely the same pace over the past eleven years (since the cyclical top in 1999.) Perhaps even more surprisingly, so has the EU15. All three parts of the developed world have experienced five year growth rates that vary only slightly during the last expansion and the subsequent crash – the US and Japan both saw real per capita GDP rise 10% from 1999 to 2011, while the EU15 saw a slightly stronger 13%. Indeed, during the 29 years since 1982 (the last major down cycle) real per capita GDP growth in the US grew 68%, in Japan by 65% and for the EU15 61% — all almost precisely the same annual rate of approximately 1.7%. This suggests that regardless of a nation’s individual policies, given free and open markets, productivity growth differentials are smoothed out over the very long run by movements in exchange rates, interest rates, domestic and import prices, and reactive trade and domestic policies.
We note that before the 1982 recession, Europe and Japan both significantly outgrew the US as they were still in a post war catch-up phase. The similarity in growth, particularly between the US and EU15, since that time suggests that the retooling as the result of higher energy costs in the 1970s resulted in similar industrial bases. Europe’s growth cycle has lagged slightly behind the US since then, as reflected in their recent crisis. Meanwhile, Japanese per capita GDP growth was well above US and European rates during the 1980s, but crashed to earth on a super strong yen in the 1990s – and fell in step over the past decade. The EU15’s real per capita GDP has remained in a band between 75% and 81% of the US level since 1970, while Japan went from 69% in 1969, to parity in 1991, back to 85% now. It is an object lesson for the Eurozone that free and open markets did not narrow the differential between the US and Europe over a forty year period. The gap between the Northern and Southern tier of Europe may never narrow either.
One conclusion that is glaringly clear is that population growth accounts for far more of a developed nation’s overall economic power than productivity differentials. Here the US has a clear advantage as even now US population is growing at 0.7% a year, while it is flat in Europe and declining in Japan. It is partially slower population growth that has Europe looking to the East, and a declining work force that forced Japan to shift productive capacity to the Newly Industrialized Countries and then China. Even China is now faced with no population growth which offsets some of its catch-up growth momentum. Bottom line, immigration policy may have more of an impact on a nation’s economic dominance over the long run than monetary policy, fiscal policy, exchange rate intervention, or trade agreements.