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.