“The only function of economic forecasting is to make astrology look respectable”
— John Kenneth Galbraith
The good news is that the economy appears to have hit bottom and is showing signs of recovery. But it will likely be a weak recovery. The primary impetus for the recovery is government spending. A $1.6 trillion deficit (fiscal 2009) with another $1 trillion deficit forecast for fiscal 2010 should keep the economy from sinking into another recession. Government spending has taken the place of household spending. The risk, of course, is that we do not know the outcome of such massive amounts of deficit spending and government borrowing. It could be disastrous for the United States and the world.
Why am I doubtful of a more robust recovery? Our Gross Domestic Product (GDP) consists of four parts: private consumption (spending) by individuals, investment by businesses, government spending, and net exports. In the year ending June 30, 2009, GDP declined by almost 4 percent. And looking ahead, three of the four elements of GDP keep our growth prospects down in the next year.
Personal spending will remain weak for many reasons. Consumers are saving more than they have in the past decade, and I wouldn’t be surprised to see us save even more; our recent savings rate (4.4 percent of disposable income in the first seven months of 2009) is still less than half what it was in the 1970s and early ’80s. The decline in our savings rate between 1985 and 2008 provided considerable stimulus for our economy, but we overspent and undersaved.
Moreover, consumers will be borrowing less in the future. Consumer credit as a percentage of GDP rose from 4.5 percent after World War II to a peak of 18.4 percent in the second quarter of 2003; at its most recent level of 17.7 percent, it is still very high. Our low saving rate and high borrowing rate helped the economy grow the past 20 years. I think we have reached a limit of how much we can borrow, and the deleveraging likely will keep economic growth slow for several years. Fewer Americans have the financial strength to be able to borrow, and banks’ lending standards have become tighter.
Housing won’t help the economy either. Too many Americans are in no financial condition to get a loan to buy a house, and many others won’t be able to continue to own their current homes. In August, there were 14.9 million Americans unemployed, 9.1 million working part time who would prefer to work full time, and 2.3 million others who have just stopped looking for work.
Millions of others were working full time at wages less than they would be making in normal economic times. These sobering employment figures mean a sustained, robust recovery in housing is unlikely anytime soon and will keep spending down.
Other factors will keep housing prices weak. The Sept. 9 New York Times reported there are 2.8 million interest-only home loans worth $908 billion, and the interest-only periods are only now beginning to expire; half the expirations will occur after mid-2011. These 2.8 million homeowners will see their monthly payments rise by 25 percent to 50 percent. Currently, “only” about 18 percent of prime interest-only loans are delinquent. The foreclosures among interest-only loans will lead to losses for mortgage holders (often banks), and another increase in the supply of houses for sale. Estimates of losses that remain to be realized are in the 40 percent range; i.e., another $350 billion.
It is true that home sales rose a robust 7.2 percent in July compared to June, but one-third of those sales were of foreclosure homes. However, 9.2 percent of the country’s mortgage loans were delinquent at the end of the 2nd quarter, and another 4.3 percent of all mortgages were in foreclosure. These are the highest rates since the Mortgage Bankers Association began collecting data in 1972.
The decline in housing prices since mid-2006 wiped out more than $4 trillion in real housing wealth – $50,000 for every homeowner in the country. As of the end of August, the decline in the stock market had wiped out another $4.9 trillion of Americans’ wealth (this is a vast improvement over the $8.4 trillion that had been lost when the stock market was at its March low). According to the Federal Reserve, as of the end of the second quarter of 2009, Americans’ aggregate net worth is down over $10 trillion from its peak.
Besides personal consumption, two other elements of GDP will also remain weak. Net investment by business fell in the second quarter to its lowest percentage of GDP since World War II. Normally, low interest rates would stimulate private investment. However there is so much slack in the economy now (July 2009 industry capacity utilization was only 68.5, its lowest reading since the government began tracking this figure just after World War II), that investment is not likely to pick up anytime soon.
The third weak element of GDP is net exports. Our trade deficit narrowed a great deal in the past year, but only because Americans stopped spending. This trend will likely reverse as we slowly emerge from our recession. Indeed, in the latest month for which data are available, the trade deficit grew at its fastest rate in over a decade. As our economy recovers, our trade deficit will grow in the next few years.
Massive outflow of dollars
Our trade deficit continues to be a problem. As recently as 1997, our trade deficit was “only” about $100 billion per year. In each of the five years between 2004 and 2008, our imports exceeded exports by more than $609 billion in each year. The shrinkage in our trade deficit of the past two years was caused by the 21 percent decline in the value of the dollar during the 30 months ending in the summer of 2008 (making imports more expensive), followed by the deep recession that followed (cutting domestic demand for imports). In 2009, our trade deficit will “only” be around $400 billion, an amount that created great consternation a decade ago, but seems reasonable now. It’s like the price of oil; two years ago, $72 a barrel oil was accompanied by dire warnings of economic collapse. Now we sigh with relief that it is not triple digits.
Cumulatively, we experienced a net outflow of $4 trillion in the past five years – so we can import more stuff from foreign countries to consume than foreigners buy from us. As long as foreigners are willing to keep reinvesting those dollars in the United States – such as buying Treasury bills – the situation is stable. But at some point, foreigners will lose their appetite for dollars, and the result will likely be a decline in the value of the dollar, inflation and higher U.S. interest rates. These outcomes are not good.
Two other areas of our economy will also impede a healthy economic recovery: commercial real estate and state government finances.
Over the next 10 years, about $2 trillion of commercial mortgage debt will come due. Hundreds of billions of dollars of loans and mortgages will have to be refinanced, at sharply reduced values. The IMF believes that about $200 billion in losses will be realized in commercial real estate over the next decade.
All but two states are dealing with fiscal year 2010 budget shortfalls. The total shortfall is $196 billion, which is 28 percent of our total state (including Washington, D.C.) budgets. At least 36 states already anticipate deficits for fiscal year 2011, totaling another $74 billion. Most states are reducing their spending and furloughing and/or firing workers.
The final factor that leads me to believe the country will not have a robust recovery is the price of crude oil. If the economy grows at all, our demand for oil will increase. Add increases in demand for oil from China, India and other developing countries, and I conclude that global demand for oil, and its price, will increase. The faster the world’s economies grow, the greater will be the increase in the price of oil, and this will restrict our economy’s ability to grow in the next several years.
Finally, let me touch on the most ominous, longer term, problem we face: U.S. government finances, including Medicare. The ratio of publicly held U.S. government debt to GDP is just under 70 percent, the highest it has been since 1950 (which was a legacy of World War II). If intra-government accounts are included, then the ratio of U.S. debt to GDP is 98 percent, which is higher than any year in our history, with the exceptions of 1945, 1946 and 1947.
Budget deficit a threat
Even more threatening is our budget deficit outlook. Recently the government forecast an additional $9 trillion in deficits over the next decade. Then beginning in 2020 deficits created by Medicare costs explode. The Congressional Budget Office (CBO) projects that if current laws do not change, federal spending on Medicare and Medicaid combined will grow from roughly 5 percent of GDP today to almost 10 percent by 2035. The present shortfall in Medicare is estimated to be $100 trillion. Recall my statistics concerning the ratio of government debt held by the public relative to GDP (currently 70 percent)? Under one plausible set of CBO assumptions, that ratio will rise to 400 percent by the year 2050! That is higher than any country in the world, even Zimbabwe!
In general, the country has been existing on excess debt. Total debt in the United States to GDP is 370 percent, the highest it has been in history. The buildup in debt since 1980 has been enormous, and it was a major force that stimulated our growth the past 25 years. The deleveraging that is now taking place will have the opposite effect.
Of course, I could be wrong. Regardless of my personal interpretation of all this data, things just might turn out to be better. I never thought the Dow Jones Industrial Average would reach 9,000 so soon, and yet as I write this, we are
nearing a 10,000 Dow. The market seems to believe our economic prospects have improved. Stock prices are also rising because of the decline in risk and the decline in investors’ risk aversion. The world is awash with dollars that have to be invested somewhere. Right now, cash is flowing into many types of risky assets, like equities, and risk premiums are shrinking.
But risk could re-emerge. The two risks that concern me are a state and local
government fiscal crisis (a country-specific risk) and the weakening dollar and the increase in key commodity prices (a globally systemic risk).
What can we do? Thomas Friedman, in his op-ed piece in the June 27, 2009 New York Times, wrote:
“We might be able to stimulate our way back to stability, but we can only invent our way back to prosperity. We need everyone at every level to get smarter.”
When we invent, and implement, the next technology that allows us to grow without putting upward pressure on the cost of energy (crude oil in particular), we’ll return to prosperity, and our growth just may solve all the problems I have
discussed in this article.