Friday, December 9, 2011

The Long Slump, UCLA Anderson Forecast, December 2011

“But for a lot of people, I know it doesn’t feel like the recession ever ended. The unemployment rate remains
painfully high, and more than two-fifths of the unemployed have been out of work for longer than six months,
by far the highest ratio since World War II.”1
Ben S. Bernanke

Let’s face it, despite a modestly growing GDP,
the labor market remains mired in a long slump. Next
year will mark the fourth year in a row with an unemployment
rate exceeding 9%, the worst performance
of the postwar era. (See Figure 1) Indeed, the broader
U-6 series, which takes into account part-time workers
seeking full time employment and discouraged
workers, has consistently been above 16%. Put simply,
there are currently 25 million Americans looking
for full-time work. Moreover the employmentpopulation
ratio remains below the level reached
at the official bottom of the recession in 2009. (See
Figure 2) Unfortunately, although we are forecasting
modest job growth on the order of 150,000 jobs
a month, total payroll employment will still be about
three million jobs below the late 2007 peak. (See
Figure 3) Given the decidedly weak labor market, it
is not a coincidence that real personal income is still
below the level reached in 2008. (See Figure 4)

Figure 1 Unemployment Rate, 2005Q1-2013Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Although recent data has improved and the notion
of a double-dip recession now appears to be off
the table, we continue to forecast real GDP growth at
a below trend rate over the next five quarters. Specifically
we are forecasting a 2% growth rate for the
current quarter and a sub-2% growth rate for most of
2012. (See Figure 5) However, for 2013 we envision
growth to exceed 3% as several of the contractionary
forces discussed below abate.

Policy in a Trap: The Ghost of David Ricardo

Pimco’s Bill Gross asked the following question
in his latest missive to investors, “Can you solve a
debt crisis with more debt?”2 The answer is usually
you can, except when sovereign debt in excess
of 80-90% of GDP becomes a barrier to growth.3 In
that case, the concept of Ricardian Equivalence may
come into play.4 David Ricardo, the great early 19th

Figure 2 Employment/Population Ratio, 1948 – October 2011, Monthly Data
Source: Federal Reserve Bank of St. Louis

Figure 3 Payroll Employment 2005Q1-2013Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4 Real Personal Income, 2000 – September 2011, In $Billions, Monthly Data
Sources: Federal Reserve Bank of St. Louis

Figure 5 Real GDP Growth, 2005Q1 – 2013Q4
Source: U.S. Department of Commerce and UCLA Anderson Forecast

century English political economist offered up the
theory that the issuance of government debt is essentially
equivalent to a promise to increase taxation in
the future. Realizing that, taxpayers save more today
to meet their projected tax obligations. When debt
is low, taxpayers do not worry about the prospect of
future taxation because they rightly believe that it will
remain outstanding forever and hence never be paid
off. As a historical matter, most folks have not had
kitchen table conversations about how high deficits
will increase their taxes in the future.

However, when debt is high, there is a very
real prospect that it will have to be paid off in the
future and the funds to make the required payments
will come from increased taxation and reduced
government spending. All of a sudden, the
deficit becomes real! (E.g. Greece) A similar process

Figure 7 Federal Funds vs. 10 Year U.S. Treasury
Yields, 2005Q1- 2013Q4F
Sources: Federal Reserve Board and UCLA Anderson Forecast

occurs in corporate finance where a modest increase
in leverage will actually lower the cost of capital.
However, once leverage is deemed to be excessive by
the financial markets, the cost of capital skyrockets.
Closer to home, the Obama Administration’s
proposals to stimulate the economy with social
security tax cuts and infrastructure spending today
to be financed by tax increases in the future is an
example of Ricardian Equivalence. In this case, the
government is explicitly promising taxpayers that
their taxes will go up in the future; no guesswork is
required. For the American consumer already reeling
from home and stock price declines, the prospect of
future tax increases would weigh on current spending.

Similarly, the Ricardian result holds true, to a lesser
extent, with financing the stimulus with future cuts in
long-term reductions in entitlement programs.
Thus, it is unlikely the economy would receive
the stimulative effects of the fiscal policy that normally
would be predicted by the standard econometric
models. In other words, fiscal policy as we have
known has come to a dead end. This eventuality is
a result of the high-deficit fiscal policy of the past
decade and the projection of mega-deficits as far as
the eye can see, Super Committee or not. (See Figure
6) In fact, the high deficits will occur against a backdrop
of declining real federal purchases, but rapidly
increasing transfer (entitlement) payments.

Similarly, the Fed has been following a full
throttle expansionary monetary policy since 2008.
The Federal Funds rate has been set at zero since
early 2009 and will remain there through 2013. (See
Figure 7) With the policy rate set at zero the Fed has
engaged in two massive quantitative easing programs
and recently put in place an “operation twist” to lower
long-term interest rates.

Another quantitative easing program looms on
the horizon. However, it remains to be seen whether
further policy measures will stimulate the economy.
To be sure the earlier policies likely put a floor under
the 2007-09 recession and planted the seeds for
recovery; it is not clear whether or not the policy has
been all that efficacious of late. Remember the implementation
of the second round of quantitative easing

Figure 6 Federal Surplus/Deficit,
FY 2000 – FY 2021F
Sources: Office of Management and Budget and UCLA Anderson Forecas

Figure 8 Global Stock Market Performance,
2011 through Nov. 25

Sources: The Wall Street journal

in September 2010 triggered inflationary fears with
a run-up in commodity prices that worked to depress
consumer spending. It appears that the Fed might be
pushing on a string, the bane of monetary policy.
Another factor inhibiting monetary policy is the
notion that very low interest rates can be contractionary.

I know this goes against the grain of Keynesian
theory, but there may be a new kind of paradox
of thrift at work. A year ago we wrote about the
phenomenon of how low interest rates actually can
encourage savings and reduce consumption.5 How
so? With very low interest rates, pension plans require
increased contributions to meet their actuarial obligations.
The same principle holds true for defined
contribution plans where a target level of savings has
to be reached in order to fund the desired amount of
retirement income.

Because the retirement planning
for most Americans never contemplated a 2% 10-Year
U.S. Treasury bond, the average American facing retirement
over the next 10-15 years is between a rock
and a hard place. Indeed, for those already retired,
low interest rates act as a depressant on consumption.
Thus, while low interest rates work to stimulate
purchases of homes, consumer durables and business
equipment, there is a very real drag coming
from reduced everyday consumption for current and
prospective retirees. Because we are in a whole new
world with respect to interest rates, it is still too early
to tell how powerful in suppressing demand the new
paradox of thrift is.

The Crisis in Europe

The economic situation in Europe continues
to deteriorate with the Eurozone placing its member
countries in straight jacket similar to the gold
standard rules of a century ago. Without the ability
to devalue their respective currencies, the troubled
countries of Portugal, Italy, Ireland, Greece, Spain
and perhaps France are forced to deflate their domestic
economies. Austerity is the rule of the day and it is
likely that the continent will be in recession next year.

With that, U.S exports to the Euro region will
slow and similarly for Asian and Latin American
exports thereby depressing activity world-wide. Thus,
the global economy will grow more slowly in 2012
than 2011. And this assumes that we avoid a full
blown banking crisis in Europe that could bring with
it a world-wide restriction in credit analogous to the
Lehman Brothers collapse of 2008.

Therefore, it is not an accident that most of the
world’s stock markets have suffered declines this
year. In fact, even with the August and November
swoons in U.S. share prices, the U.S. stock market
has held up far better than its counterparts around the
world. For example, as of late-November, the U.S.
market was down 8% year-to-date, while Germany
was down 21%, France down 25%, Japan down 20%,
China down 16%, and Brazil down 21%. (See Figure 8)

Figure 10 Real Consumer Spending,
2005Q1 – 2013Q4F

Sources: U.S. Cepartment of Commerce and UCLA Anderson Forecast

As a result, we forecast that after increasing
11.3% in 2010 and an estimated 6.6% this year, we
forecast that real exports will increase by only 3.4%
in 2012 and rebound to a healthy 7.7% in 2013.(See
Figure 9) The recently announced $40 billion airplane
orders announced by Boeing certainly augers well for
export growth later in the decade.

The Domestic Economy

Despite the scare coming from the recent decline
in stock prices, consumer spending, especially
on automobiles is continuing to grow. (See Figures
10 and 11) To be sure, the recent gains in consumer
spending might not be maintained, but, unlike the
sluggishness earlier in the year, it will remain a
source of modest strength. Moreover, automobile
sales are being buoyed by pure replacement demand
as the fleet is reaching the limits of aging. Furthermore,
housing starts have bottomed and while this
sector won’t be a major source of growth in 2012
we suspect that 2013 will bring with it a rebound in
construction as the backlog of excess supply is eaten
into. (See Figure 12)

Although investment in equipment and software
will continue to grow in 2013, it will come off of its
heady double-digit pace of the past two years. (See
Figure 13) We are forecasting growth of 6.7% and
7.1% in 2012 and 2013, respectively. Nevertheless,
this sector will be growing three times faster than the
overall economy.

Of course as we have noted for many years, the
state and local sector is undergoing a fundamental
restructuring as real spending continues to decline.
(See figure 14) Because of the prevalence of defined
benefit plans, this sector is being especially harmed
by the very low interest rates we are experiencing.
Last month, Rhode Island, under the weight of a huge
unfunded liability, radically reformed its pension
plans that included cuts for existing beneficiaries.
Put bluntly, the laws of arithmetic are overcoming

Figure 9 Real Exports, 2000 – 2013F,
Percent Change
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 11 Automobile Sales, 2005Q1 – 2013Q4
Sources: UCLA Anderson Forecast

Figure 12 Housing Starts, 2005Q1 – 2013Q4F,
in thousands, SAAR
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 13 Real Investment in Equipment and
Software, 2000 -2013F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 14 Real State and Local Government
Spending, 2005 – 2013F, Percent Change
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

the laws of politics, even in the very unionized and
very Democratic state of Rhode Island

The United States is facing an unemployment
crisis in a slow growth economy. A modestly growing
GDP on the order of 2% will not be sufficient
to lower the unemployment rate much below 9%
through 2013. Furthermore, government policy seems
to be incapable of noticeably improving the situation.
Indeed the Federal government will be reducing
purchases during the forecast period. The economy
will be sustained by modest increases in consumption
and business investment along with the beginnings of
a housing recovery in 2013.

1. Bernanke, Ben S., Remarks, At the Town Hall Meeting with Soldiers and Their Families, Fort Bliss, Texas, November 10, 2011, Board of
Governors of the Federal Reserve System.
2. Gross, William H., “Pennies from Heaven,” Pimco Investment Outlook, November 2011.
3. See Reinhart, Carmen M., and Kenneth S. Rogoff, “This Time is Different,” Princeton, Princeton University Press, 2009.
4. See Ricardo, David (1820), “Essay on the Funding System,” in “The Works of David Ricardo on the Life and Writings of the Author, J.R.
McColloch, London, John Murray, 1888. For the modern version of Ricardian Equivalence see, Barro, Robert J., “Are Government
Bonds Net Wealth,” Journal of Political Economy, 82:6, 1095-1117 and “On the Determination of the Public Debt,” Journal of Political
Economy, 87:5, 940-971.
5. See Shulman, David, “Risky Business,” UCLA Anderson Forecast, December 2010.

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