Thursday, December 10, 2009

In the Xinhua News

U.S. economy to see modest growth but high unemployment 2009-12-10 17:24:00

LOS ANGELES, Dec. 9 (Xinhua) -- The U.S. economy is on a "modest growth path that will be accompanied by extraordinarily high rates of unemployment," according to the University of California, Los Angeles (UCLA) Anderson Forecast released Wednesday.
The UCLA Anderson Forecast is one of the most widely watched and often-cited economic outlooks for California and the United States.
The Forecast says this slow growth reflects the lagged effects of the implosion of consumer balance sheets and is a result of the transition from an import-oriented, low-savings economy to a more export-oriented, higher-savings one.
Fueling the transition is the Obama administration's "weak dollar policy," which encourages exports and discourages the consumption of imports, the Forecast says.
The combined effect will cause real consumer spending to grow at a modest 2 percent rate, far below the historical 3-3.5 percent rate, the Forecast predicts.
UCLA Anderson Forecast senior economist David Shulman noted in a report titled "Lost and Found" that the recession established postwar records for declines in stock prices, home prices and employment and that, over the past decade, the unemployment rate had more than doubled while real wages rose by a modest 6.5 percent.
There were now a half-million fewer people on the non-farm payroll than there were 10 years ago, said Shulman.
With most of the recession's damage done, Shulman predicts slow growth for the U.S. economy.
He forecasts that, after growing at a rate of 2.8 percent in the most recent quarter, real gross domestic product in the United States will settle into a 2 percent growth rate for 2010 before rising to about 3 percent in 2011.
The unemployment rate will likely peak at 10.5 percent in the first quarter of 2010, then settle at or above 10 percent for the rest of the year, according to Shulman.
"We hypothesize that one reason for the high rate of unemployment is that business firms who hitherto viewed office overhead costs as fixed now view them as variable," said Shulman.
"Where in prior recessions much of the marketing, finance, research and administrative employees were generally immune from layoffs, the new management regimes have made those functions vulnerable to severe cutbacks," he added.
Shulman also noted in his report that government policymakers were "highly medicating" the economy with record federal deficits and a zero interest-rate policy from the Federal Reserve. While necessary to avoid an economic free-fall, Shulman asserts that these policies are not sustainable in the long run.
UCLA Anderson Forecast director Edward Leamer examined past economic recoveries and attempted to forecast how the current recovery would play out.
Leamer said that, unlike in the past, consumers, who had "already spent income we are never going to earn" and who were now more focused on savings, could not be counted on to spend the economy into recovery.
In his opinion, U.S. exports are the potential driver of a successful economic recovery. He even metaphorically suggests that "we will need to turn our shopping malls into factories."
For California, UCLA Anderson Forecast senior economist Jerry Nickelsburg said the outlook for the rest of the year involved little or no growth.
He said the golden state's economy would begin to pick up slightly in the beginning of 2011 and, by the middle of 2011, begin to grow at more normal levels.
Nickelsburg said the keys to California's recovery were exports of manufactured and agricultural goods, increased public works construction, and increased investment in business equipment and software.
The Forecast predicts total employment in the state will contract by 4.3 percent in 2009 and that no new jobs will be generated in 2010.
Unemployment will get worse, rising to 12.7 percent in the fourth quarter of 2009, according to the Forecast.
But once growth returns in 2011, employment will begin to grow faster than the labor force, at a 1.7-percent rate, and the unemployment rate will begin to fall, but the economy will not be generating enough jobs to drive the unemployment rate below double digits until 2012, according to the Forecast.
Real personal income growth will be a negative 2.7 percent in 2009 before returning to positive growth of 0.4 percent in 2010 and 2.8 percent in 2011, according to Shulman.

Full URL,

Wednesday, December 9, 2009

"Lost and Found," UCLA Anderson Forecast, December 2009

“Many shall be restored that now are fallen, and many shall fall that now are in honor.” Horace – Ars Poetica[i]

The first decade of the 21st Century is over. Good riddance! It has truly been a lost decade for labor and capital. In stunning contrast with the ebullience of late 1999 there are now a half million fewer people on nonfarm payrolls than at the start of the decade. To be sure late 1999 represented a business cycle peak while late 2009 represented a trough, but make no mistake the recent recession established postwar records for declines in employment, home and stock prices. Over the decade the unemployment rate has more than doubled and real wages rose by a very modest 6.5%. Concomitantly the federal budget swung from a $91 billion surplus in FY 1999 to a record $1.4 trillion deficit in FY 2009. All of the gory details are presented in Figure 1.

Despite the 64% stock market rally off the March lows, both nominal and real stock prices are far off their yearend 1999 levels by 26% and 42%, respectively. Needless to say this poor performance is a far cry from the wild-eyed bullishness of the dot com era and it perhaps fitting that the early 2000 signature AOL-Time Warner merger became undone this month with Time Warner spinning off the remnants of AOL.

In sharp distinction oil, gold and of all things, very staid U.S. Treasury bonds enjoyed spectacular bull markets during the decade. Gold and oil prices nearly tripled and quadrupled, respectively and long term U.S Treasury bonds that offered current yields just above 6.5% advanced by 34% during the decade. Along the way the trade-weighted foreign exchange value of the U.S. dollar declined by 24%. Median existing home prices, after soaring earlier in the decade, went into free fall after 2006 and ended up a modest 22% in nominal terms and actually declined by 5% in real terms.

Thus the overall performance of the labor, capital, housing and commodity markets during the decade, hardly of which were any of it forecast, gives rise to great deal of humility when forecasting the economic outlook for the next few years. Nevertheless, in the spirit of “often wrong, never in doubt,” we trudge on and we trust by the time 2020 rolls around much of the current pessimism will give way to a more hopeful environment. Simply put the economy is in a painful period of transition. Thus, we would like to think that the next decade is the mirror image of the last where we start from a cyclical trough and end at a peak.

Figure 1. Selected Economic Indicators Late 2009 vs. Late 1999

The Near-Term Outlook

Similar to last quarter we continue to believe that the economy is on a modest growth path that will be accompanied by extraordinarily high rates of unemployment.[ii] Specifically we forecast that after growing at 2.8% in the most recent and current quarters, real GDP growth will settle into a 2% growth path for much of 2010 and be closer to 3% in 2011. (See Figure 2) With such sluggish growth the unemployment rate will likely peak at 10.5% in the first quarter and remain at or above 10% for almost all of next year. (See Figure 3)

We hypothesize that one reason for the high rate of unemployment is that business firms who hitherto viewed office overhead costs as fixed now view them as variable. Thus where in prior recessions much of the marketing, finance, research and administrative employees were generally immune from lay-offs, the new management regime has made those functions vulnerable to severe cutbacks. Indeed such previously recession resistant industries such as finance, advertising and media have witnessed an unprecedented amount of job cuts. Further exacerbating the employment situation is uncertainty about tax, healthcare and energy policies coming out of Washington.

Figure 2. Real GDP Growth 2000:Q1 – 2011:Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2000:Q1 – 2011Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

The slow growth outlook reflects the lagged effects of the implosion of consumer balance sheets and is a result of the economy in transition from being an import oriented low savings rate one to a more export and higher savings oriented one. (See Figures 4 and 5) That transition is being pushed along by the administration’s weak dollar policy which encourages exports and discourages the consumption of imports. The combined effect will cause real consumer spending to grow at a modest 2% rate, well below the more historical 3-3.5% rate. (See Figure 6) Nevertheless the savings rate won’t rise in a straight line. For example the scheduled increase in income taxation for high income earners in 2011 will depress savings for that year.

Figure 4. Growth in Real Imports and Exports, 2000:Q1 – 2011:Q4F
Source: Department of Commerce, UCLA Anderson Forecast

Figure 5. Savings Rate, 2000:Q1 – 2011Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Consumption Growth, 2000-2011F

Source: Department of Commerce and UCLA Anderson Forecast

We would be remiss if do not discuss the current controversy with respect to housing activity. In terms of prices and home sales it appears that housing is finally on the road to recovery. To be sure with 23% of the nation’s houses with mortgages underwater, foreclosures continue to rise; but we believe that is already factored into the decision making process of both buyers and sellers. Thus given mortgage rates below 5%, affordable prices and demographically driven pent-up demand we, like most macroeconomic forecasters, believe that housing starts will rise to around 850,000 units in 2010, up from an estimated 574,000 in 2009. (See Figure 7) We also allow for the gradual winding down of the Fed’s mortgage backed securities purchase program. However, analysts who are much closer to the ground, like our friend Ivy Zelman of Zelman & Associates, believe that housing starts next year will be in 600,000 – 700,000 range because of the lack of construction and development financing. Should that be the case, our 2010 view for the economy as a whole would necessarily be marked down.

Figure 7. Housing Starts, 2000 -2011F

Sources; Department of the Census and UCLA Anderson Forecast

The Highly Medicated Economy

Let’s be clear, policy makers are highly medicating the economy with record federal deficits and a zero interest rate policy coming from the Federal Reserve. (See Figures 8 and 9) While necessary to abate the free fall in the economy that took place in late 2008 and early 2009, both fiscal and the monetary policies are not sustainable in the long run. Deficits will have to be reduced and interest rates will return to more normal levels. In fact the deficit projections below do not include another stimulus package and the inevitable cost-overruns associated with the healthcare package now moving through the Congress. The “never-never land” world of financing the deficit at a near zero interest rates will soon be looked upon as the very low teaser rates offered to homeowners a few years ago as the cost of financing the national debt explodes.

Thus we do not really know whether or not the signs of economic revival are the temporary result of the medicine being applied or the result of a healing process that will put the economy on the road to a self sustaining recovery. We suspect that it is a little of both and that is why we do not anticipate that the Fed will tighten policy until late in 2010 nor will tax hikes be enacted, except for healthcare, beyond what are already scheduled to take place in 2013.

Figure 8. Federal Deficit, Unified Budget, FY 2000 – FY2019F
Sources: Bureau of the Budget and UCLA Anderson Forecast

Figure 9. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2000Q1 – 2011:Q4F
Sources: Federal Reserve Board, UCLA Anderson Forecast

Nonetheless there are many permanent aspects to the current policy regime. Homeowners and businesses are using the current low rate environment to refinance high cost debt. Indeed the high yield corporate bond market has just experienced its greatest rally in history. (See Figure 10) Furthermore, although far from ideal, consumer balance sheets are being improved by the wave of foreclosures and mortgage modifications. How so? Simply put, debt is being extinguished at the expense of losses in the financial system. We know it is not pretty, but that is how the process works with respect to business bankruptcies.

Figure 10. High Yield Corporate Bonds vs. Treasuries, July 06 –October 09.

With all of the stimulative “medication” in the system it would be logical to assume that the most likely side effect would be a ramp up in inflation. Indeed we believed that is the message coming out of the foreign exchange and gold markets. Nevertheless with so much excess capacity in labor and product markets, we believe that inflation will not manifest itself within the 2011 forecast horizon. Indeed we are forecasting consumer price inflation to average a modest 2% over the next two years.

The Fiscal Crisis of the States

From New York and New Jersey in the east, to Michigan and Illinois in the mid-west, to Florida in the south and to California and Oregon in the west, state and local governments are enduring their worst fiscal crisis since the Great Depression. While the private sector has dramatically cutback employment by 4.6% in the twelve months ending October, state and local employment declined a modest 0.8% while state tax receipts plummeted 10.7%. (See Figure 11) Public employment is being sustained by massive infusions of Federal cash, but that cash will run out at the end of 2010. Perhaps there will be another stimulus package, but the inevitable restructuring of state and local government lies ahead of us. Remember the decline in share prices this decade noted at the start of this essay has decimated public pension plans. Put bluntly, state and local pension plans have made promises that the taxpayers can’t keep. As a result state and local purchases will be flat at best for several years to come. (See Figure 12)

Figure 11. State and Local Tax Collections, 2006Q3-2009:Q3

Source: Nelson A. Rockefeller Institute of Government

Figure 12. Real State and Local Spending, 2000 – 2011F
Sources: Department of Commerce and UCLA Anderson Forecast


When economic historians look back on the recent recession and the sluggish recovery we are forecasting, we believe they will note that the 2007 -201? Era signaled that the U.S. economy entered a period of transition. The characteristic of the period involves the inability of export growth to completely offset growth declines in consumer spending and state and local spending. Over time the savings rate will increase and once it stabilizes in the 5-7% range, consumption will once again grow with the economy. Meantime, after a modicum of restructuring takes place in the state and local government, that sector once again will be a source of modest growth. By mid-decade 3-4% economic growth accompanied by mid-single digit unemployment rates will once again become the norm. Thus instead of being a lost decade, we will once again find our way back to the economy’s historical growth path. Therefore we are not in the “new normal” camp for the entire decade.

[i] Opening quotation in Graham, Benjamin and David L. Dodd, “Security Analysis,” 6th Ed., (New York: McGraw Hill, 2008, originally published in 1934).
[ii] See Shulman, David, “The Long Goodbye,” UCLA Anderson Forecast, September 2009.

Friday, November 6, 2009

Letter to The Wall Street Journal, Nov. 6

Don't Follow Failed Japanese Example

The new regulations allowing banks to classify underwater commercial real-estate loans as "performing" will create "zombie" banks that will plague our economy well into the next decade ("Banks Get New Rules on Property," Money & Investing, Oct. 31). These regulations mimic the failed Japanese approach of the 1990s and will, unfortunately, have the same effect. Simply put, weighed down with bad loans "zombie" banks don't lend.
Instead of restructuring real-estate loans, the underlying banks should be restructured through equity infusions from the public or with TARP funds, with the underlying real estate sold into the marketplace. Broadly speaking, that was the Resolution Trust Corp. solution of the early 1990s.
David Shulman
Berkeley Heights, N.J.
Mr. Shulman was head of real-estate research at Salomon Brothers from 1986 to 1991 and was senior REIT analyst at Lehman Brothers from 2000 to 2005.

Tuesday, November 3, 2009

In the Dow Jones Newswire, "Wells Fargo Defers Reckoning On Troubled Mortgage Balances," Nov.3

Because of troubled borrowers like Annan, Wells Fargo risks tethering itself to what former Wall Street executive David Shulman terms "wasting assets," since borrowers facing years of negative home equity have little incentive to maintain or improve their homes. "You've got to give the homeowner incentive," says Shulman, now a senior economist at UCLA Anderson Forecast. "Otherwise, they're sitting there as a tenant."

Saturday, October 31, 2009

Letter to the Star-Ledger, Nov. 1

Can’t spend anymore
Is Tom Moran out of his mind ("More state debt or more open space, what’s a voter to do?" Oct. 28)? A "No" vote on open-space bonds is a no-brainer. New Jersey, by any common sense definition, is bankrupt. We are California without the climate. Thanks to the combined efforts of past and present governors, the state is no position to borrow another nickel, much less $400 million.
Sorry folks, Trenton’s big spending party is over.

Thursday, October 29, 2009

Stock Analysts Blow it Again

As a former analyst it never ceases to amaze me to see all of the hype associated with companies beating their typically low-balled earnings estimates. For example, according to one of my buddies at Goldman Sachs, 80% of the first 260 S&P 500 companies reporting earning this quarter exceeded consensus estimates, well above the more typical 65%. Indeed only 13% of the companies missed their consensus estimate, compared to a more normal 20-25%.

What gives? They blow it every quarter! The current quarter more so. It reminds me of what the late Howard Cosell would say when the Dallas Cowboys were having a particularly bad night, "never have I seen such continuing ineptitude." It seems to me that there is absolutely no adaptive learning in the Wall Street analytical community. The reason for this piss-poor behaviour is that most analysts suck up to company management and strive to keep their estimates in line with what they know is low-balled company guidance. In order to be in the flow of information and have access to company management they have to play ball.

The managements of Wall Street firms understand this and they do NOT compensate analysts on the basis of the accuracy of their earnings estimates. If they did, analyst salaries would be alot closer to the minimum wage than seven figures a year. Everybody in the institutional community knows the game. Unfortunately the public doesn't and it is a disgrace of the business press and especially CNBC for not informing the public the fraud that is being perpetrated on them.

As a final point a 12 year old could beat Wall Street analysts every time by taking the midpoint of a given company's earnings guidance and add 5% to it!

Wednesday, October 28, 2009

In the Washington Post, "Economy is kick-started, but can it motor ahead?," October 28, 2009

"The patient is out of intensive care, but is still highly medicated," said David Shulman, senior economist at the UCLA Anderson Forecast. "So you don't know how much of this growth is driven by short-term stimulus and how much of it is self-sustaining. My guess is this is going to be the best quarter of growth for a long time."

For full article see,

Monday, October 12, 2009

Tom Friedman's Best Column, Ever

Tom Friedman rightly responded to the Nobel committee's bizarre awarding the Peace Prize to Barack Obama by, in effect, nominating the American soldier as the most important peacekeeper of the last century. I can't do justice to his column, "The Peace (Keepers) Prize," so here is the direct weblink.

Thursday, September 17, 2009

The Long Good-Bye, UCLA Anderson Forecast, September 2009

“But the world is not in a run-of-the mill recession. The turnaround will not be simple. The crisis has left deep scars, which will affect both supply and demand for many years to come.”[i]

Olivier Blanchard, Director, International Monetary Fund Research Department

Although the worst recession in seven decades likely ended in the current quarter, its negative effects will linger well into the next decade. As we noted previously the recession had its origins not so much in imbalances in the real economy, but rather in the over-indebtedness of consumers and businesses that will take time to cure. Simply put it was a balance sheet recession.[ii]

As a result both consumption and investment will be weighed down by the process of deleveraging the balance sheets of consumers, businesses and financial institutions. Not only will financial institutions be less willing to lend, but consumers and businesses will be less willing to borrow. This process differs from normal recoveries where there is a natural inclination to borrow and spend after a period of Fed tightening that induced recession in the first place. Remember the Fed was easing well before the start of the current recession. That is why that even after an extended period of zero official interest rates the economy is only now showing hopeful signs of recovery.

That said, after four quarters of decline, economic growth is resuming. We forecast that real GDP will increase at an annual rate of 2.1% in the current quarter and 2.3% in the fourth quarter. For all of 2010 we forecast quarterly growth to average 2% with noticeable improvement at the end of the year. (See Figure 1) A lion’s share of near-term growth will come from a dramatic reversal in inventories. After plunging at a revised annual rate of $159 billion in the second quarter, real inventories are forecast to increase by $12 billion in the fourth quarter accounting for almost 1 1/2% of real GDP. (See Figure 2) However, once the big swing in inventories is spent, growth will remain very modest for most of 2010. Two other important swing factors are the recovery in exports and the long awaited rebound in residential construction. Exports are being helped along by the rebound in production that is taking place in Germany, France, Japan, China and Southeast Asia. Nonetheless, if our view of sluggish overall growth is close to the mark, the unemployment rate will be above 10% well into next year. (See Figure 3)

Figure 1. Real GDP Growth, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 2. Change in Real Inventories, 2000:Q1 – 2011:Q4, SAAR
Source: Global Insight and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2000:Q1 – 2011Q4F
Source: Global Insight and UCLA Anderson Forecast

Our cautious view of growth rests on the belief that after a two decade consumer spending binge based initially on rising stock prices and then on rising home prices fueled by extraordinarily easy credit has ended. (See Figure 4) Instead of increasing their nest eggs by deferring consumption, households took advantage of the ebullient asset markets to buttress their balance sheets and to over-consume housing and automobiles. Now consumers seeking to accumulate assets will have to do it the old fashioned way, by directly increasing savings through a reduction in consumption. (See Figure 5) Simply put, credit impaired lower income consumers can’t spend the way they used to and wealth impaired affluent consumers won’t. To be sure the stock market has rallied 50% off its March lows and housing prices apparently have made a bottom, but both of these asset classes are trading well below their highs of only two years ago.

Figure 4. Real Consumption Growth, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast.

Figure 5. Saving Rate, 2000 – 2011F, Quarterly Data
Source: Global Insight and UCLA Anderson Forecast.

Fiscal Collateral Damage

Starting with the Bush Administration’s $168 billion stimulus package in 2008 and ending with the Obama Administration’s $787 billion package in 2009, the federal government has gone all out in attempting to mitigate the effects of the recession and to engender economic recovery. Whether or not the programs work as intended will take time to sort out, but it appears that the increase in spending and tax cuts may have put a floor under last winter’s decidedly weak economy. However the stimulus spending along with an increase in baseline spending and the effects of the recession has caused a decided worsening in the long term fiscal outlook. The administration is now projecting cumulative federal deficits of $9 trillion over the next 10 years. (See Figure 6) To call this collateral damage is to put it mildly; it looks more like a fiscal train wreck that international holders of large dollar balances might seek to avoid thereby triggering a significant devaluation of the currency.

Figure 6. Federal Deficit, Unified Budget, FY 2000 – 2019F
Source: Global Insight and UCLA Anderson Forecast

Programmed deficits averaging $900 billion a year over the next decade are a recipe for higher taxes above the increases already scheduled to take place. For example the $180 billion a year hike in income taxes on high earning households will kick in 2011. Given the fiscal outlook this tax increase looks like a drop in the bucket so sooner or later President Obama is going to have give-up on a host of domestic programs and/or go against his campaign pledge not to increase taxes on households earning less than $250,000 a year. Make no mistake, tax increases on the broad middle class are becoming more likely and that will put more stress on consumption spending later in the decade. The arithmetic is simple. The federal government financing itself, in part, with near zero teaser rates interest cost on the debt is running at approximately $250 billion a year. Add $9 trillion dollars in debt and assume a 4% interest rate, interest costs sky rocket to $800 billion a year, nearly 40% of current receipts.

One modest fiscal effort in terms of dollars that caught the public’s attention and not in the original Obama stimulus package was the so called “cash for clunkers” program where the federal government paid consumers $3500-$4500 a car to trade-in and scrap their older vehicles for new ones. Ostensibly the purposes of the program were to get older low mileage vehicles off the road and to replace them with more fuel efficient vehicles and to explicitly subsidize the automobile industry.

This tiny, by federal standards, $3 billion program accounted for the sale of 700,000 vehicles ($14 billion at $20,000/car) in August thereby increasing the estimated automobile sales rate in the third quarter to 11.8 million units compared to 9.6 million units in the second quarter. Of course it will take time to estimate how many of those cars would have been sold absent the program and how many represent the pulling forward of demand from subsequent quarters. Because we believe that much of the sales represented the pulling forward of demand we have modeled in a drop-off in automobile sales over the next few quarters. (See Figure 7)

Figure 7. Motor Vehicle Sales, 2005:Q1 – 2011:Q4
Source: Global Insight and UCLA Anderson Forecast

We did, however, learn an important lesson from the “cash for clunkers” program. It met the threefold test of being temporary, timely and targeted and it did not require a huge spending program to have a big short term impact. The program mopped-up excess automobile inventories triggering increased production and employment for that beleaguered industry. As mentioned above we don’t know whether or not the program will have long term effects outside of reducing the capital stock of automobiles, but in the short run the real psychological effects on the economy were certainly welcome.

Whither the Fed?

Now that Federal Reserve Chairman Ben Bernanke has been re-nominated the focus will return to the substance of Fed policy. The Bernanke central bank has been perhaps the most activist Fed in its nearly 100 year history. Once the financial crisis was in train, the Fed launched a host of very aggressive and in many cases first time measures to relieve the most seized up lending environment since the 1931-3 Great Depression crisis. Bernanke also dusted off Section 13 of the Federal Reserve Act to directly lend to nonbanks in “unusual and exigent circumstances,” a power not used in over 75 years.

Furthermore the Fed took monetary policy to its zero interest rate bound by targeting the Federal Funds rate at between zero and 25 basis points, again reminiscent of the Great Depression and more recently of the Japanese deflation.
Along the way the Fed for a time tripled the size of its balance sheet. Simply put, in Bernanke’s words, the policy was “whatever it takes.”[iii]

As difficult as it might have been for both the Fed and the Treasury to engage in their unprecedented interventions in the economy, the hard part is now ahead of them. It is one thing to intervene with the goal of saving the economy and restoring growth, it is quite another to take back the monetary stimulus to fight an incipient inflation in an environment of high unemployment. Market participants know full well that there is more than enough liquidity in the system to ignite a persistent inflation; not today but perhaps within a few years.

In order to deal with this threat we believe that the Fed will gradually shrink its balance sheet and begin to slowly move away from its zero interest rate policy in the third quarter of 2010. To be sure unemployment will still be around 10%, but the economy will have been growing, albeit slowly, for about a year by then. The argument for modest rate hikes will be that the financial emergency is over and that modest rate increases would have a minimal effect on the economy. In fact it could be viewed as a sign of strength in light of the fact the financial markets by that time would have returned to normal.

Indeed in late August the Israeli Central Bank became the first official authority to raise rates after two years of declines. We do note that the Governor of the Bank of Israel is Stanley Fischer, Bernanke’s thesis advisor at M.I.T. Remember that if the Fed doesn’t act, the bond market has the potential to make life very unpleasant for the central bank. (See Figure 8)

Figure 8. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2000:Q1 – 2011:Q4F
Sources: Global Insight and UCLA Anderson Forecast

The H1N1 Wild Card

We would be remiss not to note a potential risk posed by the 2009 version of the H1N1 flu, a lineal descendant of the historic 1918-19 pandemic.[iv] Public health authorities have warned that the 2009 version has the potential to infect half the U.S. population, hospitalize 1.8 million and kill 90,000 people.[v] Although this might be viewed as a worst case estimate, these data indicate that we facing something far worse than the garden variety flu season we face every year where about 36,000 people die.

Obviously if the upcoming flu season is anywhere close to the public health prediction economic activity could suffer from plant and office closings as well as sharp reductions in business and leisure travel, further battering the already hard hit transportation and hospitality industries. We have not modeled in a severe flu season, so we would we would warn that it represents a downside risk to the forecast.

[i] Blanchard, Olivier, “Sustaining a Global Recovery,” F&D Magazine, International Monetary Fund, August 2009.
[ii] See Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008 and Koo, Richard, “The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession,” (Singapore: John Wiley and Sons, 2008)
[iii] Wessel, David, “In Fed we Trust,” (New York; Crown Business, 2009) p.7
[iv] For the best history of the 1918-19 pandemic see, Barry, John M., “The Great Influenza,” (New York: Penquin Group, 2005)
[v] Randall, Tom, Alex Nussbaum, “Swine Flu May Cause 90,000 U.S. Deaths, Report Says,” Bloomberg, August 24, 2009.

Saturday, September 5, 2009

In the Washington Post, "Economic Growth Yet to Hit Job Market," September 5

"We've gone 10 years with zero employment growth," said David Shulman, a senior economist at the UCLA Anderson Forecast. "This has been a lost decade."

For full article see,

Saturday, July 18, 2009

Obama's Bad Bill Syndrome

A disturbing pattern is beginning to emerge with respect to President Obama's relationship with Congress and the American people. It seems that he prefers bad legislation to no legislation, For example he supported the stimulus bill that was weighed down with the Democratic Party's 28 year wish list, but really offered little or no near term stimulus for the economy. He could have exercised leadership, but chose not to. A similar thing happened with the cap and trade energy bill that passed the House. That bill is a long way from an ideal carbon tax and for that matter a pure cap and trade system. Instead of charging for carbon emissions, it mostly gives away licenses to pollute for favored industries and penalizes the unfavored oil refineries. Should it pass in its current form, refineries will close and the U.S. will import even more gasoline and worse it will be a bonanza for Washington lobbyists seeking to bend the permit system in their favor.

Indeed the same syndrome is playing out with the health care bill. As the CBO noted it does nothing for cost control and, in fact, it increases health care costs for both government and the economy as a whole. President Obama surely wants the glory of presiding over national health care legislation, but he fails to realize that a bad bill will soon cause most American to look back with nostalgia at the system we now have. As the good Doctor Hippocrates once said, "do no harm." Bad bills do lots of harm.

Thursday, July 16, 2009

Strange Claims Data Offer Hope of Recession's End

The Labor Department (DOL) reported that new unemployment claims declined to 522k for the week ended July 11 down 47k from the prior week. These data are well below the 650k peak reported in the Spring. DOL noted that the seasonal adjustment factors could be completely out of whack because major auto lay-offs took place in April and May rather than July thereby rendering the seasonals less than accurate. In fact unadjusted claims actually increased by 86k for the week.

Nevertheless with two weeks of claims below 600k it is quite possible that on a GDP basis the recession might have ended this month. In terms of the labor market the recession is still far from over. Although layoffs might be waning, employers remain on strike with respect to hiring.

Friday, July 3, 2009

In the Washington Post, "Job Losses Dampen Hopes for Recovery," July 3

"This sprayed some Round-Up on the green shoots," said David Shulman, a senior economist at the UCLA Anderson Forecast, using a metaphor for signs of economic improvement that Federal Reserve Chairman Ben S. Bernanke popularized in the spring.
"The economy is in the process of bottoming, but that's different from saying it's recovering," Shulman said.

Full story at

Thursday, July 2, 2009

No Shock in Job Numbers

The payroll number was no real surprise. The job losses occurred because there was a slowdown in the seasonal hiring college and high school graduates for summer and full-time employment. As someone who is associated with three universities, it was patently obvious to me that the normal hiring of college graduates did not take place this year. Hence when the data went through the seasonal meat grinder of the BLS it showed up as job losses. See post below.

Thursday, June 18, 2009

Out of Intensive Care, UCLA Anderson Forecast, June 2009

" It's very easy to forget, in your iron indignation at the failure of the market, where the true mainsprings of economic growth lie. The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from the private sector, not from the state.” Niall Ferguson[i]

The economy is out of intensive care, but make no mistake, it is still very sick. The free fall stage of the recession appears to be over and in fact we anticipate that the economy will record positive, albeit minimal, growth as early as the third quarter. (See Figure 1) After declining by an estimated 2.9% in the current quarter we forecast that real GDP growth will be zero in the third quarter and 0.6% in the fourth quarter or 2009 and the first quarter of 2010. Thereafter we forecast growth will be in the very modest 2-3% range.

Figure 1. Real GDP Growth, 2000Q:1-2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

However, with the economy growing at such a tepid pace, the unemployment rate will continue to climb well into 2010 where we expect it to peak at a 10.4%. (See Figure 2) Job losses will likely continue for the remainder of the year and we would not be surprised to see the worst data of recession arriving with the June employment report to be released in early July. Why? The seasonal adjustment factors used by the bureau of Labor Statistics look for a large increase in college/high school graduate hiring along with a rise in vacation oriented employment. Because the economy has been so weak the hiring of new graduates has been unusually soft this year. Thus the data will likely show a large decline in seasonally adjusted employment.

Figure 2. Unemployment Rate, 2000:Q1 -2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

As bad as the U.S. Economy has been, the rest of the world has been doing much worse. As we noted last quarter, we are in a truly global slump.[ii] The 5.7% decline in U.S. output in the first quarter pales in comparison to the 25% decline in Singapore, the 22% decline in Mexico, the 15% decline in Japan and the 14% decline in Germany. These depression-like declines were caused in large part by a 30% collapse in year-over-year exports for the 15 largest economies. Because the weakness in trade was exacerbated by the lack of financing, going forward the healing of the financial system will work to mitigate the decline.

The Financial System Heals

Despite all of the controversy, the host of Federal Reserve and Treasury actions to provide liquidity and capital to a severely wounded financial system suffering from the worst crisis since the 1930s appear to be working. In the inter-bank market the three month LIBOR rate has decline from 4.85% in early October to .65% in May. The seized-up commercial paper market has reopened and sparked by a record-breaking rally high yield bond spreads have come in 800 basis points since December. (See Figure 3) Along the way we have witnessed a requitization of the major banks and the real estate investment trust industry.

Figure 3. High Yield Bonds vs. Treasuries Mar 200 – May 2009 (Daily Data)

Source: Barclays Capital

Stocks too have bounced 40% off their March lows and the VIX Index (a measure of stock market volatility) has been reduced from 85% to 30%. (See Figure 4) An improved financial sector alone does not make a recovery, but it is a precondition for recovery.

Figure 4. S&P 500, 2000-29 May 2009, Weekly Data
Source: Global Insight

Housing Bottoming, Commercial construction in Free Fall

The long agonizing decline in the housing market is in the process of ending. To be sure prices already down 31% from the peak are still falling, but the lion’s share of the decline is behind us. (See Figure 5) Indeed house prices have now returned to where they were in late 2002. We are modeling in an end to the price decline late this year or early in 2010. At the end of the day with the Housing Affordability Index improving from 100 mid-decade to 170 recently and an end to employment declines should enable house prices to put in a bottom. Nevertheless because house price bear markets tend to have “long tails” do not expect any swift rise in prices over the next several years. Indeed there are still more “shoes to drop” as a new round of Alt-A mortgage resets hits the market in 2010-11 and foreclosures rise on prime mortgages weighed down by high unemployment.

Figure 5. S&P Case-Shiller Home Price Indices, 1988-March 2009, Percent Change Year Ago.

In terms of activity housing starts likely bottomed in the current quarter at an annual rate just below 500,000, down almost 80% from the peak. (See Figure 6) The recently enacted $8,000 new home buyer credit should help over the balance of the year. Because housing activity will come off a very low base, the recovery we envisage will look steep, but in reality the 1.25 million starts we forecast for 2011 will still be 40% below the 2.07 million units recorded in 2005.

Figure 6. Housing Starts, 2000:Q1 – 2011Q4F, SAAR
Source: Global Insight and UCLA Anderson Forecast

In sharp contrast to residential construction, the decline in commercial construction is only halfway through it contraction. (See Figure 7) Although the bull market in the housing market received most of the press in the mid-2000s, a parallel bull market was taking place in commercial real estate. Paced by over-generous lending standards commercial real estate prices more than doubled from 2000-07. However the onset of the credit crisis in August 2007 quickly and decisively triggered a bear market in commercial real estate. In fact, since 2006 the $250 billion/year issuance market for commercial mortgage backed securities (CMBS) market all but disappeared. It is for that reason the Fed made highly rated CMBS securities eligible collateral for the TALF program. However with rating downgrades in train, the dollar amount of eligible collateral will be severely reduced.

Figure 7.Real Commercial Construction Spending, 2000:Q1 – 2011:Q4F, SAAR
Source: Global Insight and UCLA Anderson Forecast

Furthermore, commercial real estate is plagued by more than a shortage of credit. The onset of the recession brought with it huge declines in office employment and consumer spending, the leading economic drivers of commercial real estate. With that vacancies have increased and rents have fallen. All-in commercial real estate prices are estimated to be off by 30-40% and are likely to fall further.

The Shape of the Recovery

What we are perhaps most concerned about is not the timing of the recession’s end, but rather the shape of the recovery to come. We are forecasting the weakest economic recovery of the postwar era with real growth on the order of 2- 3%. Indeed the unemployment rate could very well be close to 10% by the end of 2011. Simply put, we believe that the economy will be weighed down by newly chastened consumers attempting to increase their saving rate and a wrenching structural adjustment in the financial services, automotive and retail industries. These adjustments are even before we get to energy and healthcare.

Recovery will be inhibited by the legacy of the financial excesses of 2003-07 in the form of millions of foreclosed houses and even more plagued with “underwater” mortgages”, a nationalized domestic automobile industry and a partially nationalized banking system. This legacy is in sharp contrast to the roaring 1920s boom where the economy created such productivity enhancing investments as the national electrical grid, a giant automotive industry, unit-drive motors in factories and witnessed the emergence of electronic technology in the form of radios. Similarly the late 1990s bubble bequeathed to the economy the world-wide web and the flowering of wireless communications.

The rise in savings is being caused by the need of consumers to replenish their tattered balance sheets ravaged by the bear market in housing and stocks and the new lending standards that will make it harder to borrow. For example the quaint 20th century notion of consumers saving money to make down payments on houses will come back into vogue. To be sure the saving rate recently popped to 5%, but a good part of that is a result of the decline in automobile sales. Once automobile sales start to recover the saving rate will naturally drop.

Moreover there will be downward pressure on consumer savings coming from the tax increases on high income individuals scheduled to take effect in the beginning of 2011. Nevertheless by the end of 2011 we forecast that the saving rate will be running at a sustainable 3% rate and rising; a far cry from the zero rate experience a few years ago. (See Figure 8) As a result real consumption spending will increase at a very low 1% rate in 2010 and 2011 compared to the historic 3% increases. (See Figure 9)

Figure 8. Saving Rate, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 9. Real Consumption Growth, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast

Although both monetary and fiscal policy put a floor under the economy, no mean feat, it is also likely that the policies now being put into place may put a ceiling on it as well. How so? First the Fed will likely take away a good part of the monetary stimulus injected into the economy. Failure to do so would run the risk of a substantial inflation a few years out. The removal of the monetary stimulus along with modest economic growth will work to return interest rates to more normal levels. In fact this is the message of the recent run-up in 10 year U.S. Treasury yields from 3% to 3.9%.

In terms of fiscal policy the economy will be faced with trillion and near trillion dollar deficits for as far as the eye can see. With government spending(NIPA basis) estimated to peak out at a postwar record of 24.2% of GDP in 2010, the transfer of resources out of the private to the government sector will be hardly conducive the economic growth. (See Figure 10) Furthermore a new regulatory regime with respect to finance, energy, environment and healthcare will be hardly be a motivator for investment, at least, while the transition is taking place. Thus do not expect the recovery to look like those of 1991-99 and 2003-2007. But then again living without bubble-induced growth will be a new experience.

Figure 10. Government Spending as Share of GDP, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast

[i] New York Review of Books, June 11, 2009.
[ii] Shulman, David, “The Global Slump,” UCLA Anderson Forecast, March 2009.

Thursday, May 28, 2009

Comment: Meyerson's, "How the Golden State Got Tarnished," Washington Post, May 28

Like all liberals, Meyerson goes back to Proposition 13 as California's original fiscal sin. To be sure Proposition 13 has a boatload of problems, but the real sin in California is an electorate that wants to spend big bucks on every social program under the sun, while being unwilling to tax itself to pay for them. Like a good friend of mine says, "they want all the lovin without the heartache." The road back for California involves drastic budget cuts to bring spending into line with revenues. Let every constituency scream, and we'll then know whether the California electorate really wants the all the government it is now paying and borrowing for.

I suspect that if every Californian has to bear the burden, they will vote for less government. One last point Meyerson incorrectly notes that California's poor pay more in taxes than California's rich. That is a canard because it assumes that poor renters pay property taxes through their rents. They do not; the property owner bears the property tax burden. This is evidenced by the fact that rents did not go down after Prop. 13 passed; they went up!!

Wednesday, May 13, 2009

Spraying Round-Up on the Green Shoots of Recovery

Today the Commerce Department reported that April retail sales declined by 0.4% which followed a downward revised 1.3% drop in March. The data signalled that the consumer rebound of January and February was ephemeral and that despite optimism about the stimulus package and the Obama Administration, consumer spending is being weighed down by rising unemployment and falling asset prices. Put bluntly the data sprayed the weed killer Round-Up on the emerging green shoots of recovery.

As a result real consumption after rising by 2.2% in the first quarter will likely decline in the second quarter thereby marking down GDP projections. Thus it is no surprise that stocks are down about 2% as of 3:00 PM today.

Saturday, May 9, 2009

Too Soon to Break Out the Champagne

From Washington, D.C. to Wall Street too many economists broke out the champagne and toasted the better-than-expected decrease in April payroll employment of 539,000 jobs and smallest monthly drop since October. Almost lost in the apparent glee was a total 66,000 downward revision to the February and March job counts and the fact the the April data was enhanced by the hiring of 62,000 new 2010 census workers. Although there will be more census jobs to come and they are certainly "real," it goes without saying that these jobs are temporary. Thus a better measure of the "true" run rate of job losses in the economy is in excess of 600,000. To be sure the second derivative of the employment decline is negative(falling at a lesser rate), the 5.7 million job losses recorded since the start of the recession in December 2007 remains well on the road to 7.5 million.

Indeed the data for June, which will be reported in early July, could very well be the worst since the recession started. How so? Part of the answer is technical and part of it is certainly real. It is obvious to all that the college hiring season this year was the worst in memory. Meantime the seasonal adjustment factors used by the BLS look for a big increase in employment by new entrants to the workforce. This year it is highly likely that the increase in employment coming from new college and high school graduates will be de minimus. Hence the data could very well show a big drop off in jobs perhaps as high as 750,000.

From a qualitative standpoint our sources tell us that the pasta business is booming. For example the Ragu tomato sauce factory in Owingsboro, Kentucky is running 24/7 and still cannot meet the demand. If this recession has a culinary theme, it is back to cheap comfort food with a high carbohydrate content. Thus we were not surprised to see that only industry in manufacturing that increased employment last month was processed foods.

In the Washington Post, "In Poor Job Numbers, Hints of Improvement," May 9

"The financial system is healing ahead of the economy," said David Shulman, senior economist with the UCLA Anderson Forecast. "The financial system is in the seventh inning, while the economy is still in the fourth inning."

Saturday, May 2, 2009

In Barron's Cover Story, "The Other Shoe," May 4

The vicious REIT selloff over the past 1½ years has brought belated vindication to former bear David Shulman, a REIT analyst at Lehman Brothers from 2000 to 2005. After his departure from the investment house, Shulman was mocked by Steve Roth, Vornado's longtime CEO, for having "a three-year sell on Vornado with a $43 average target" at a time when the stock was in the 80s. Vornado peaked at $133 in 2007, but plunged as low as $29 in March and now is in the high 40s. It recently sold $741 million of common stock at $43, Shulman's old price target. Roth hasn't apologized in print.
"REITs are a lot more attractive now than they were at the highs in 2007," Shulman said last week from his New Jersey home. "But compared with the rest of the stock market, they don't look so cheap." He notes that most real-estate investment trusts change hands at 10 to 16 times pretax cash flow, while a quality stock such as Johnson & Johnson, which has a triple-A credit rating, fetches 12 times after-tax earnings and seven times pretax cash flow.

Wednesday, April 8, 2009

Pulte/Centex Merger: Dinosaurs Mating

The stock for stock merger between Pulte Homes and Centex to giant home builders, announced today represents a continuation of the death spiral the home building industry is in. Simply put the merger these two behemoths is very much akin to dinosaurs mating. Nothing much will come of it as they are on the downside of the evolutionary curve.

A far better strategy would be chop each company up into smaller more focused units. In that way each unit would be less of a slave to Wall Street earnings projections and instead focus on profitability rather than growth. Afterall it was the search for growth at any price that led to the buying huge tracts of land at the top of the market.

Wednesday, March 25, 2009

The Global Slump, UCLA Anderson Forecast, March 2009

“By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

Warren Buffett, Berkshire Hathaway Annual Shareholder Letter, February 2009

From New York on the Atlantic to Tokyo on the Pacific a global economic slump has engulfed the industrialized world. The ancient financial markets of London, Paris and Frankfurt along with the emerging ones of Shanghai, Singapore, Dubai and Mumbai are suffering under the weight of bad loans and a free fall in stock prices with 50+% declines being the order of the day.[i] (See Figure 1) With economic output falling virtually everywhere, the mid-decade global boom has given way to the worst global bust since the 1930s. (See Figure 2)

Figure 1. Global Stock Prices, Recent Peak to March 10, 2009

Sources: Factset and Bloomberg

Figure 2. Global Economic Growth 2007 – 2010F, Annual Percent Change in Real GDP

Most troubling about the global decline in economic activity has been the collapse in international trade. For example in the fourth quarter U.S. real imports to the United States declined at an annual rate of 16%, while real exports declined by an even greater 24%. (See Figure 3) These 20+% or so declines in the real trade accounts are reminiscent of the 27% compounded rate of decline in nominal global trade that occurred from 1929-32.[ii] Thus at least two of the elements necessary for a recovery in economic output will be a revival in world trade and the recognition that national solutions alone will not be sufficient to restore economic growth. Global solutions are essential. Action from Washington will be necessary, but not sufficient. In that light the stimulus packages announced and/or put in place by Europe, Japan and China are certainly helpful as well as the unprecedented quantitative easings by most of the world’s central banks. Thus the outcome of the upcoming London G-20 meeting in early April could very well be critical for the economic outlook for the remainder of the year.

Figure 3. Real Exports and Imports, 2000:Q1-2011:Q4F
Sources: Global insight and UCLA Anderson Forecast

The U.S. Outlook

The economic outlook remains bleak. After declining at a revised 6.1% annual rate in the fourth quarter of 2008, we forecast real GDP to decline a further 6.8%, 4.5% and 1.7% in the first, second and third quarters, respectively. (See Figure 4) Thus, if our forecast is close to the mark, the current recession will last between 19-24 months exceeding the 16 month 1981-82 recession, the longest of the postwar era until now. Nevertheless we do forecast that by the end of 2009 most of the contractionary forces will have been spent and the fiscal and monetary policies discussed below will begin to work leading to average quarterly growth in 2010 on the order of 2.7% and a more robust 4.1% in 2011.

Figure 4. Real GDP Growth, 2000:Q1-2011:Q4F
Global Insight, UCLA Forecast

As a result of the prolonged contraction, the economy will likely lose 7.5 million jobs peak to trough and unemployment will soar. We now forecast that the unemployment rate will peak at 10.5% in mid-2010 versus the 8.1% rate recorded in February. (See Figure 5) Unfortunately, just as the initial recoveries from the 1990-91 and 2000-01 recessions were “jobless”, the employment recovery from the 2007-09 recession will be long and arduous. For example by the end of 2011 total nonfarm employment will likely be four million below the 2007 peak and the unemployment rate will remain above 9% at that time.

Figure 5. Unemployment Rate, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast
Fiscal and Monetary Policy to the Rescue?

As we have noted in previous forecasts, the Federal Reserve has been engaging in an extraordinary policy of monetary easing by dramatically expanding its balance sheet, purchasing a boatload of private( and risky) assets and bringing the Federal Funds rate down to near zero. These actions along with the TARP program in all likelihood saved the payments system from collapse and reopened the credit channel for high quality borrowers. However, it did not prevent the onset of the worst recession of the postwar era. Over the longer term the Fed’s zero-interest rate policy will enable the banking system to restore its profitability enabling a broad increase in bank lending. Such was the policy during the 1991-93 time period.

Although the Fed’s actions initially had a limited impact on the monetary aggregates, the money supply is now expanding rapidly. M2, a measure of the broad money supply, is now growing at a near 9% annual rate, and if history is any guide that increase will soon be translated to an increase in real economic activity. (See Figure 6) To be sure the velocity of money has collapsed as businesses and consumers have pulled back as the “shadow banking system” based on asset securitization all but disappeared. Nevertheless the expected surge in government spending should ultimately halt the decline in the income velocity of money. (See Figure 7)

Figure 6. M2 Growth, 2000:Q1 – 2011:Q11F
Sources: Global Insight and UCLA Anderson Forecast

Figure 7. Income Velocity of Money, 2000:Q1 – 2011:Q4F
Sources: Global Insight and UCLA Anderson Forecast

Along with the Fed, the Obama Administration, with its $787 billion stimulus package and its near $2 trillion deficit for fiscal year 2010, has adopted an “all-in” fiscal policy. With it comes a 14% federal budget deficit share of GDP, which is on track to be the highest since World War II. (See Figure 8) A feature of the plan is that tax cuts and spending increases come early while tax increases on high income earners and energy come later in 2011 and 2012.

Figure 8. Federal Budget Deficit as a Percent of GDP, 1980- 2011F

Sources: Global Insight and UCLA Anderson Forecast

The Balance Sheet Recession

All of these unprecedented monetary and fiscal policies are designed to overcome what we characterized last quarter as the balance sheet recession.[iii] The economy is being weighed down by the biggest decline in stock and home prices since the early 1930s, a wounded financial system and record high credit spreads. (See Figures 9, 10 and 11) Simply put consumers have lost a total of $14.5 trillion in wealth, $9 trillion in stocks and about $5.5 trillion in home values. Furthermore the S&P 500 Index recently traded at a 12 year low and as of December 2008 stocks recorded their lowest total return for a 10 year period since the late 1930s. In fact a 12 year low in the Dow Jones Industrial Average has only occurred two other times in history (1932 and 1974).

This hit to consumer net worth along with a severe decline in employment has caused consumption to seize up and the savings rate to soar from near zero to over 5%. (See Figure 12) Indeed against this backdrop, the $787 billion stimulus package, although helpful, looks like a drop in the bucket. Thus the recovery we are forecasting will be tepid. It will take time for consumer balance sheets to heal.

Figure 9. S&P 500, 1990-March 2009, Monthly Data
Source: Global Insight

Figure 10. Home Prices, 2000-2008, Case-Shiller 20 City Index

Source: Standard & Poor’s

Figure 11. High Yield Bond Spread vs. Treasuries, 1999 – Feb 2009, Daily Data

Source: Barclays Capital

Figure 12. Savings Rate, 2000:Q1-2011:Q4F
Sources: Global Insight, UCLA Anderson Forecast

Questions About Fiscal Policy

Make no mistake we have our doubts about the full efficacy of the Administration’s policies. To be sure the front loading the stimulus helps “stop the bleeding” in the short run, but individuals and business who tend to think longer term could very well be dissuaded from making purchases and investments today with the full knowledge that their taxes will be higher in the future. A simple example of this phenomenon is the proposal to cut the effective value of top bracket tax deductions to 28% from the proposed 39.6% top rate. Obviously such a change in the tax code would impact the willingness of high income earners to purchase new homes where the tax deductions associated with home ownership would be lower. Moreover a tax increase of this type can hardly be characterized as a shot in the arm for the beleaguered housing industry. Add to this all of the uncertainties associated with healthcare reform, $80 billion a year in implicit energy taxes resulting from the proposed “cap and trade” system for regulating carbon emissions, an end to the deferral of U.S. corporate income taxes on foreign source income and a potential wholesale rewrite of the labor laws, you have a recipe for a very sluggish corporate investment environment.

Moreover, both the Fed and the Bush/Obama Administrations have zigzagged so much on economic policy in recent months, that they have introduced a host of new uncertainties into an already troubled economy. To be sure health and energy policy changes are important to the long term success of the U.S. economy, but the uncertainty associated with the nature and scope of the policies being proposed by the Obama Administration are hardly conducive to making long term investments.

Over the longer term we question the whole consumption orientation of the Obama proposals. The fundamental imbalances of the U.S. economy were characterized by excessive consumption and a large external deficit. In tandem with maintaining global imbalances China’s stimulus package is encouraging investment where it should be encouraging consumption. To correct the imbalances in the U.S. a long term cure would come from a declining consumption share of GDP as evidenced by a higher savings rate and increased exports. In order to achieve that macroeconomic policy should focus on increased exports and improving the competitiveness of import-competing industries. To be sure investments in alternative energy projects and human capital make sense, but perhaps more effective would be a broad investment focused strategy on manufacturing. For example a policy of lower corporate income taxes and some form of investment tax credit would deliver far more benefits than the income transfer elements of the Obama program.

That said we still forecast a tepid recovery in 2010 as the contractionary forces become spent (i.e. housing can’t get much lower) and the near term positive impacts of monetary and fiscal policy take hold. We know that many observers, among them Warren Buffett, have expressed
concern about the long term inflationary consequences of both Fed and fiscal policies. They could very well be right, but for us, if inflation is a problem, it will be late in or after our 2011 forecast horizon.
[i] With apologies to Winston Churchill.
[ii] Calculated from Kindleberger, Charles P., “The World in Depression,” (Berkeley: University of California Press, 1973) p. 172.
[iii] Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008

Thursday, March 19, 2009

Wall St. Bonus Tax: Where are the Civil Libertarians?

"No Bill of Attainder or ex post facto Law will be passed." Article I, Section 9, Para 3, U.S. Constitution

This afternoon the House of Representatives passed a bill imposing a 90% excise tax on income in excess of $250000 for employees of firms receiving in excess of $5 billion in TARP funds. First to note, I have no dogs in this hunt. What House just did was pass a Bill of Attainder (a law singling out an individual or group for punishment without trial) on an ex post facto basis. A twofer violation of the Constitution.

My question is: where are the civil libertarians? What if Congress passed a law taxing the excess incomes of college professors who work at an institution that received federal money? There would howls of protest from civil libertarians. Trust me, this a big deal civil liberties issue. Today the Wall Street bonus babies, tomorrow who knows. Our forebears fought and won a revolution over this issue!!

Tuesday, March 17, 2009

NJ-Budget/Star Ledger Letter 3/17

I rise to Treasurer Rousseau's challenge ("Treasurer dares budget critics to offer better plan," Mar 12, p. 1) .Put together with scissors, paste and bailing wire, the governor' budget will not survive the year. The gale force winds of the global economic crisis will render current and out year revenue forecasts as way too optimistic. Indeed it has worsened the long term structural problems facing the budget especially with respect to pensions.

What is needed is a structural change in the budget. In case you have forgotten the governor was very clear about that last year with his "dog and pony" show promoting securitization of our toll roads. My proposals are simple: 1)the governor has to sit down with his buddies in the public employee unions and renegotiate all of the pension plans covering state and local employees and 2) radically change the Abott v. Burke school funding formula. If that means a constitutional amendment redefining "thorough and efficient", so be it.

My proposals may sound radical, but there is no other long term alternative.

Sunday, March 15, 2009

Comments on CNBC/Jon Stewart

1.Stop the cheer leading. Stop the cheer leading. Stop the cheer leading. 2. More reporting and less commentary. 3. In that spirit fire Cramer and Kudlow. 4.More screening of advertisers. Keep the slimeball gold and mortgage ads off the air. 5. Question interviewees in the same manner Jon Stewart questioned Cramer. 6. Screen guests more carefully and keep the obvious jerks off the air.

Sunday, March 8, 2009

The Balance Sheet Recession, UCLA Anderson Forecast, Dec. 08

“The year under review has been one of dramatic occurrences in the whole field
of international finance, credit, monetary stability and capital movements, both
public and private.”

Bank for International Settlements, Second Annual Report, May 1932

The news from the economy is bad. The recession that we had previously hoped to avoid is now with us in full gale force. We now expect that real GDP will decline by 4.1% in the current quarter and decline by another 3.4% and 0.8% in the first and second quarters of 2009, respectively. (See Figures 1 and 2) Because Europe and Japan are already in recession and China and India are suffering from a significant slowdown in growth, the export boom of the past few years will wane. Make no mistake the global economy is in its first synchronized recession since the early 1990s. Moreover with tepid post-recession growth of around 3% the unemployment rate is forecast to rise from October’s 6.5% to 8.5% by late 2009 or early 2010. (See Figure 2) Concomitant with the rise in the unemployment rate will be the loss of an additional two million jobs over the next year.

Figure 1. Real GDP Growth, 2000:Q1 – 2010:Q4F

Source: Global Insight and UCLA Anderson Forecast

Figure 2. Unemployment Rate, 2000:Q1 – 2010:Q4F
Source: Global Insight and UCLA Anderson Forecast

The Financial Crisis of 2007-08

Unlike most recessions whose origins arise from the impact of Federal Reserve tightening on consumer and business spending, this downturn has its origins in a severe asset price deflation that has imperiled the balance sheets of consumers, financial institutions and over-leveraged business entities. The deflation which first manifested itself as a liquidity crisis in the short term money market in August 2007 quickly metastasized into a full-fledged financial panic.

The asset price deflation was triggered by a collapse in the housing market that triggered increased defaults in the mortgage market which in turn threatened first the liquidity and then the solvency of a financial system that grew increasingly dependent upon the easy flow of mortgage credit. From there it enveloped the high yield corporate bond market shooting up credit spreads to an unprecedented 1800 basis points over treasuries (See figure 3) Later investment grade corporate bonds fell under its sway where credit spreads rose to their highest levels since the early 1930s. (See Figure 4) With credit seizing up the $800 billion commercial mortgage securities market ground to a halt further imperiling the value of all commercial real estate, a market that has already declined by 30%. A contributing factor to the mortgage meltdown was Secretary of the Treasury Paulson’s remark on November 12th that the Troubled Asset Recovery Program (TARP) would not buy illiquid mortgage securities as originally contemplated. Within eight days the value of a key commercial mortgage derivative dropped by 24% implying a 17% yield for the “super” AAA tranche.[i]

Figure 3. High Yield Bond Spread vs. Treasuries, Daily Data, Aug 15, 2000 – Nov. 21, 2008
Source: Barclays Capital Markets
Figure 4. Moody’s Baa Bond Spread vs. Treasuries, 1925-Nov 2008, Monthly Data
Source: Federal Reserve Board

In the wake of the financial crisis such hitherto stalwarts as Fannie Mae, Freddie Mac, AIG, Washington Mutual, and Lehman Brothers have either failed or are under Federal supervision. Investment banker Merrill Lynch was forced into a merger agreement with Bank of America and both Goldman Sachs and Morgan Stanley became bank holding companies. Indeed bank shares lead by Citicorp plunged to multi-year lows. Indeed Citicorp had to be rescued by a $27 billion capital infusion by the Treasury and the creation of a “good bank-bad bank structure accompanied with a $306 billion federal guarantee the purpose of which was to keep “bad” assets from coming on to the market.

Even the credit worthiness of the finance-intensive General Electric Company has been questioned. It seems that everything that was once thought of as solid is now a liquid. As we have argued in prior forecasts we believe that out of the current crisis, as in past crises, a new financial architecture will evolve. Whether the reforms will be accomplished formally with the creation of a new national monetary commission or on an ad hoc basis by legislation and rule making remains to be seen. To be sure there will be an international component to any new financial architecture.

Having never declined since the early 1930s, house prices according to the Case-Shiller Index have fallen by about 22% since their 2006 peak accounting for about a $4.5 trillion wealth loss. Perhaps more astonishingly stock prices are on track to either having their biggest decline in history or, if not that, their worst performance since either 1931 or 1937. As of November 21st the S&P 500 was off 45.5%, worse than the 41.9% decline of 1931 and the 38.6% in 1937. In dollar terms stock prices have declined by $7.4 trillion since their historic high in December 2007. Thus it should surprise no one that consumer spending under the weight of a $12 trillion loss in asset values is now in the tank and will likely to remain soft for quite some time to come.

The carnage in the stock market has been amplified by the fact that real stock never really fully recovered from the bull market euphoria of the late 1990s. In real terms stocks did not make a new high in 2007 and the S&P 500 has now fallen back to where it was trading in August 1995! (See Figure 5)

Figure 5. S&P 500 Stock Index, Nominal vs. Real, 1980 –Nov. 2008, Monthly Data

Source: Global Insight and UCLA Anderson Forecast

Thus it is no accident that the industries linked to the two most durable and most tied to wealth and credit of consumer assets, houses and cars, are suffering. Housing starts are forecast to drop to below a 700,000 unit annual rate, the lowest in the postwar history and automobile sales are now running at a 25 year low. (See Figures 6 and 7)Figure 6. Housing Starts, 2000:Q1 – 2010Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 7. Light Vehicle Sales, 1990-2010F, Annual Data

Source: Global Insight and UCLA Anderson Forecast.

A Whiff of Price Deflation

Where only last quarter we were worried about inflation, we are now worried about its very rare opposite, deflation. The record collapse in oil prices has brought with it welcome relief to motorists throughout the country and an effective tax cut of $440 billion in the form of a lower oil import bill. (See Figure 8) Nevertheless the swift fall in oil prices is now lowering the absolute level of consumer prices and bringing with it likely declines in nominal GDP over the next three quarters. (See Figures 9 and 10) Because nominal GDP rarely declines, it conjures up the image of price deflation where the dollar flow in the economy makes it extremely difficult for workers and firms to earn higher nominal wages and profits. It brings to mind the Japan of the 1990s, not a pretty picture.

Figure 8. Oil Prices, WTI, 2000-Nov 2008, $/barrel, monthly Data
Source: Global Insight
Figure 9. Consumer Price Index, 2000:Q1-2010:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 10. Nominal GDP, 1959:Q1-2010:Q4F
Sources: Global Insight, UCLA Anderson Forecast

The Monetary and Fiscal Response

The Federal Reserve moved swiftly to save the payments system in September by increasing bank deposit insurance and offering to insure money market mutual funds. Those actions prevented a repetition of the 1930s where a cascade of failing banks crippled the economy for a decade. Well before that the Fed embarked on a record setting easing process in terms of timing by lowering the Fed Funds rate by a total of 425 basis points to 1% within a year. We expect another rate cut to a modern era low of 0.5% in December. Indeed the effective rate where Fed Funds are currently trading is already at 0.5%. In all likelihood that will be the floor because at rates below that the nearly four trillion money market mutual fund industry would cease to function. By dramatically cutting rates the Fed has engendered an upwardly sloped yield curve conducive to recovery. (See Figure 11) Of course, if the credit channel remains blocks and banks refuse to lend then the Fed could find itself pushing on the proverbial string.

Figure 11. 3-Month U.S. Treasury Bills vs. 10 Year Treasuries, 2000:Q1 – 2010:Q4F
Source: Global Insight and UCLA Anderson Forecast

Thus rate cutting is only part of the story. The Fed has also created a host of new lending facilities for banks, nonbank banks (i.e. GE Capital) and broker-dealers that more than doubled its balance sheet in two months from $900 billion to $2.2 trillion. (See Figure 12) Perhaps more striking was the Fed’s late November move to make unsterilized (i.e. printing money) purchases of up to $500 billion of agency backed mortgage securities. That action by itself lowered mortgage rates by 50 basis points to 5.5%, thereby breaking the logjam in the mortgage market. The Fed not only holds treasury securities, but it now owns or lends on all kinds of asset-backed securities and commercial paper. The Fed has certainly taken to heart the central bank playbook of lending aggressively in a crisis. Nevertheless the question remains what is to become of these assets, once the crisis has past and what are the long run inflationary consequences of these very aggressive monetary moves?

Figure 12. Federal Reserve Assets, 10 Sept 2008-19 Nov 2008, In Billions, Weekly Data

Source: Federal Reserve Board

On the fiscal side Congress passed a $168 billion stimulus package last winter. The bulk of the package came in the form of $108 billion in refundable tax credits to consumers. It was not effective as much of it was used to pay for higher gasoline prices and reducing debt. What was spent gave a “sugar high” to consumption in the second quarter and was quickly dissipated. For the purposes of our forecast we are assuming a new $200 billion package to pass in the first quarter that would include increased unemployment insurance benefits, food stamps, rebates, aid to state and local governments and infrastructure spending. Of course this could very well be on the low side and a package two or three times higher than what we are now envisioning should not be ruled out. It is also looking more likely that President-Elect Obama’s campaign promise to increase income tax rates to high earning individuals will be deferred until 2010. Remember the economy will already be benefitting to the tune of $440 billion coming from cheaper oil imports. In any event expect that the deficit will exceed $1 trillion in FY 2009. (See Figure 13) Moreover with $7.4 trillion of asset purchases and loan guarantees the deficit represents only the tip of the iceberg.

Figure 13. Federal Surplus/Deficit, FY 2000-2010F
Sources: Global Insight and UCLA Anderson Forecast

After much consternation Congress passed the Treasury’s $700 billion TARP program which was initially designed to purchase illiquid assets from the banking system. That plan quickly metamorphed into the purchase of preferred stock and equity warrants in the largest banking institutions in the country. In essence the banking system was partially nationalized. Whether or not the TARP funding will be sufficient and in what form it will take in the future remain open questions. After all Secretary Paulson has bequeathed $350 billion (subject to Congressional veto) to the new administration.

Not to be outdone by the banking system Detroit appeared on Capitol Hill in search of loan guarantees to fund their massive losses to enable the auto industry to retool. Although bankruptcy maybe the preferred solution and cannot be ruled out, we suspect that given the fragility of the financial system and the politics involved some form of aid will be granted. Remember the domestic auto companies are huge debtors to the financial system and to a host of suppliers.

Although the financial markets have been encouraged by President-Elect Obama’s appointments to his economics team, there are other issues the new administration is pursuing that will affect the economy next year. Two non-fiscal issues loom large over the economy as well. The first is the new Administration’s plan to impose a cap and trade system for carbon emissions which is effectively a large tax on carbon intensive production. The political process alone could create enough investment uncertainty to delay any economic recovery, much less the impact of a new tax burden on the order of $100 billion.

Second is the prospect of new labor legislation that would eliminate the secret ballot in union organizing elections. Under the proposed “Employee Free Choice Act” a union can be formed a given work site with a majority of employees signing cards affirming their desire to join a union. Needless to say this is a major rewrite of existing labor law and, if enacted, it could lead to widespread labor strife. Going back to another 1930s analogy we note that labor strife in 1937-38 after the passage of the National Labor Relations Act of 1935 was one of causes of the industrial collapse of 1937 that practically wrecked the New Deal.


To summarize, we are forecasting a nasty recession that will be characterized by four quarters of declining real GDP and unemployment rising to 8.5% by late 2009. Because of the severe stress on consumer balance sheets, the savings rate will have to increase and by definition consumption growth will be sluggish. Although we are not forecasting that the savings rate will return from the 0.6% in 2007 to a more normal 4-7%, we can see a return to a level of 3-4%. (See Figure 13) As a result trend growth of 3% with very sluggish job growth won’t resume until 2010. Remember both the 1990-91 and 2000-02 recessions were partially based on balance sheet issues and both times subsequent job growth was very sluggish. Furthermore it will take quite some time for the financial system to heal and as we have argued a new financial architecture will emerge out of the current crisis.
[i] Mulholland Sarah and Jody Shen, “Commercial Mortgage Securities Holders Blame Paulson,” Bloomberg News, November 21, 2008.