Wednesday, September 15, 2010

The Uncertain Economy, UCLA Anderson Forecast, September 2010

““Look at the uncertainty,” said one senior Fed official. “Are we facing
deflation or inflation? Are we up or down? Growing or not?””[i]

Against a backdrop of growing policy uncertainty, the economy stalled in the second quarter with real GDP growing at a revised 1.6% annual rate. Indeed we forecast that the economy will continue to crawl at a 1.4% rate in the current quarter and then grow at a very tepid 2% growth rate for the following four quarters. (See Figure 1) Indeed we don’t visualize a return to trend growth to approach 3% or so until late 2011. In this environment the unemployment rate will remain extraordinarily high ending this year at 9.7% and 2011 at 9.5%. (See Figure 2)

Given the huge decline in output that took place in 2008-09, the economy should be growing at 5-6% annual rate, not the 2% rate that we now envision. What normally happens in a recovery is that the proverbial baton is passed from government spending and inventory restocking to housing, consumer spending and investment. In this recovery somewhere along the way the baton was dropped as housing double-dipped and consumer spending stalled. (See Figures 3 and 5) Although it is hard to visualize the double dip in the quarterly housing start data, it is very evident in the collapse of monthly existing home sales after the expiration of the homebuyer’s tax credit. (See Figure 4) To be sure, equipment and software spending has remained strong, but leading indicators of activity and corporate announcements suggest that it too, will fall from its recent heady pace. (See Figure 6)

Figure 1. Real GDP Growth, 2005Q1 -21012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 2. Unemployment Rate, 2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3. Housing Starts, 2005Q1 – 2012Q4

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

Figure 4. Existing Home Sales, 2005 – July 2010
Source: National Association of Realtors

Figure 5. Real Consumption Expenditures, 2005Q1 -2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Spending on Equipment and Software, 2005Q1 – 2012Q4F

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

What Ails the Economy?

We have two broad explanations as to what is ailing the economy. The first is the balance sheet recession hypothesis we outlined nearly two years ago which is broadly analogous, with the important exception of the U.S. not experiencing a foreign exchange crisis, to the analysis put forward by Carmen Reinhart and Kenneth Rogoff.[ii] In their historical work, “This Time is Different,” they outline the history of eight centuries of financial collapses and come to the conclusion that recoveries from the bursting of debt fueled financial bubbles are invariably slow and are associated with unusually high unemployment rates and an explosion in government debt. Sounds familiar, doesn’t it? Simply put because the imbalances engendered by the prior boom, it takes a long time for an economy to heal from a financial collapse. It certainly doesn’t have to be as bad as the 1930s or Japan’s lost two decades, but in their view a quick recovery to the semblance of the pre-boom normal is not likely.

The recovery from the balance sheet recession is being exacerbated by an extraordinary increase in policy uncertainty which is amplifying the usual economic uncertainties associated with recessions. . As early as December 2008 and almost continually thereafter in the UCLA Anderson Forecast we noted that fiscal, monetary and regulatory policy uncertainties coming out of Washington, D.C. would limit consumption, investment and hiring.[iii] In a way, policy making has become “iatrogenic” in that instead of curing the economic disease it is making it worse.

Policy makers in Washington D.C. don’t seem to understand that the decision of a firm to hire an employee is an investment decision and therefore subject to all of the budgetary criteria that goes into the buying of equipment. And remember there are no health insurance premiums associated with buying a computer. The investment/hiring decision is subject to forecasts on the future of tax, environmental, energy, financial, labor and healthcare policies.

At the present time, business firms can only make the wildest guesses as to what corporate and individual tax rates will be next year and for that matter three years from now, what the cost of healthcare will be, whether or not there will be a revived cap and trade policy with respect to carbon emissions or whether the Environmental Protection Agency will step in with regulations of their own absent a statute and whether it will be easier or more difficult to hedge risks with financial derivatives. Furthermore, it certainly does not help to have the perception, true or not, that the Administration is at best ignorant of business or at worst, hostile to business.

A Late New Deal Analogue

There is a loose historical analogy to the current environment. In the middle of the 1937-38 recession the term “capital strike” entered the political vernacular as several prominent New Dealers, in particular Secretary of the Interior Harold Ickes and Assistant Attorney General Robert Jackson, attacked the business community for “sabotaging” the New Deal.[iv] Of course left out of their theory was the impact of the full implementation of the Wagner National Labor Relations Act and the adoption of a tax on undistributed corporate profits along with a monetary tightening and the tax increases associated with the beginning of the Social Security payroll tax. In light of this history, it would be fair to say, that today's business community doesn't have a clue as to how hostile government policy can be.

Nevertheless, after two national radio speeches on the subject calling for direct controls on the economy by the previously mentioned New Dealers, the subject was dropped like a hot potato as Roosevelt adopted an all-out Keynesian deficit spending policy. With the likelihood of a European war increasing, President Roosevelt became more conciliatory towards business, the tax on undistributed corporate profits was effectively repealed and the full implications of the Social Security program became more widely understood. As a result the economy began to recover well before the advent of rearmament.

A Tax Compromise

Thus it would certainly help if there were at least a perceived truce between the business community and the Obama Administration. Because the drafting and adopting regulations associated with the healthcare and financial reforms will go on well into 2013, a good start would be to compromise on the contentious tax issue. that can actually be accomplished this month! One example of a bipartisan compromise would include permanently setting the tax on dividends and capital gains at 15% compared to the 20% rate for both proposed by the Administration and 39.6% for dividends should the current law lapse, increasing the top rate on ordinary income to 39.6% as contemplated by the Administration and the lapsing of current law, but have the Bush tax cuts remain in force for incomes up to $400,000 for a joint return instead of $250,000 as proposed by the Administration. Add to that setting the inheritance tax exclusion for a family at $7.5 million as proposed by the Administration or $10 million as proposed by some congressional Republicans. And maybe they could throw in the taxing of carried interest capital gains for private equity and hedge funds at ordinary income tax rates.

There you have it, a reasonable compromise where both parties can declare a victory, but can they actually come together and do it? The Obama Administration would get its higher top rate and a step, albeit smaller, toward deficit reduction and the congressional Republicans would get their low taxes on capital. Above all the economy would achieve at least a vestige of certainty with respect to tax policy. One of the worst things that could happen would be a one year extension of the Bush tax cuts. The uncertainty would remain, incentives would be untouched and the economy would have the increased burden of debt. Remember policy makers are playing with fire with respect to the tax issue. A recent article co-authored by former Council of Economic Advisors Chair Christina Romer noted that exogenous increases in taxation have caused severe shocks to economic activity.[v]

Problems Confounding Policy

The Fed has tried practically everything in its policy toolkit to halt the recession and engender recovery. Short-term interest rates have been cut to zero, its balance sheet has exploded, the open market committee has purchased mortgages and long-term treasury bonds with abandon (quantitative easing) and they announced that short-term interest rates will remain low for “an extended period.” Yet unemployment remains high and the recovery is faltering. At the recent Jackson Hole conference, Chairman Bernanke promised he would do whatever it takes to keep the recovery going.[vi] Whether further quantitative easing will work remains to be seen but to the public it is beginning to look like pushing on the proverbial string. After all, record low mortgage rates are not triggering a housing boom, far from it.

Our view is that monetary policy will work with an unusually long lag. We forecast that the Fed’s zero rate policy will remain in place for at least another year and after that the Fed Funds rate will slowly increase. (See Figure 7) Concomitantly long-term interest rates will likely remain unusually low and we anticipate that the yield on 10-Year U.S. Treasury notes won’t exceed 3% until the third quarter of 2011.

Figure 7. Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1 – 2012Q4F,
Source: Federal Reserve Board and UCLA Anderson Forecast

Despite the ongoing policy ease, we expect inflation to remain quiescent during the forecast period. (See Figure 8) Both headline and core inflation will be under control staying below 2% for all of 2011 and the risk of deflation, though nontrivial, remains small. Despite the low rate of inflation, low nominal rates will keep real returns to savers extraordinarily low.

Figure 8. Headline vs. Core Inflation, 2005Q1 – 2012Q4
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

With respect to fiscal policy the Obama Administration is on track to pile up a record decade of deficits. (See Figure 9) Somewhere along the way taxes will have to increase substantially, an inevitable policy uncertainty, and entitlement spending will have to cut radically. In the meantime fiscal policy is not working the way it is supposed to be. Instead of spending with alacrity, consumers are saving and where consumption and investment are rising, a significant portion of it is coming in the form of increased imports. (See Figures 10 and 11) Stimulus in America is turning out to be great news for the exporters of China and Germany.

Figure 9. Federal Surplus/Deficit FY 2000 – FY2010F

Source: Office of Management and Budget and UCLA Anderson Forecast

Figure 10. Personal Saving Rate, 1990Q1 – 2012Q4
Source: Department of Commerce and UCLA Anderson Forecast

Figure 11. Real Imports, 2005Q1 – 2012Q4F, Quarterly Data

Source: Department of Commerce and UCLA Anderson Forecast


In an economy wracked by a post financial bubble environment and living in a theme park of policy uncertainty, we forecast very sluggish growth accompanied by high unemployment. As time passes the economy will naturally heal and the policy uncertainties will resolve themselves to the extent that growth will return to a 3% path and unemployment will begin on its long trajectory downward. We forecast that these more ebullient trends will become noticeable by 2012.

Higher savings and increased imports seem to be one of the key reasons why macroeconomic policy is not working the way the traditional models would have it. Thus if policy is to work it will have to restore the confidence of businesses and consumers to spend and invest in America. A real reduction in policy uncertainty would go a long way toward that end.

[i] Financial Times, August 19, 2010, p.1.
[ii] Reinhart, Carmen M. and Kenneth S. Rogoff, “This Time is Different,” Princeton; Princeton University Press, 2009.
[iii] See Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008
[iv] See Brinkley, Alan, “The End of Reform,” New York: Knopf, 1995, pp. 56,57
[v] See Romer, Christina D. and David H. Romer, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, 100, June 2010, pp.763-801.
[vi] See Bernanke, Ben S., “The Economic Outlook and Monetary Policy,” August 27, 2010.