“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
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