Economists Still See Deflation Gloom as Improving Data Doesn't Lift Mood

Thursday, 01 Dec 2011 06:43 AM

 

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After concern last summer of an imminent double-dip recession in the U.S., the data got a bit brighter in the fall. The economy grew faster than expected in the third quarter and has created almost 2.8 million private- sector jobs since the labor market bottomed in early 2010.

“It looks like recovery to me,” says Chris Rupkey, a New York-based economist for Bank of Tokyo-Mitsubishi UFJ Ltd. Even as he’s encouraged by an uptick in consumer spending and slow but steady gains in employment, Rupkey says he knows his optimism is a minority view.

Two and a half years after the official end of the recession, in June 2009, this recovery looks like none before it, Bloomberg Markets magazine reports in its January issue.

Daniel Tarullo, a member of the Federal Reserve Board of Governors, describes the economy as “slogging through the mud.” Arun Raha, chief economist for the state of Washington, chooses a different metaphor. “A return to normalcy seems like a mirage in the desert,” he wrote in a report in October. “The closer we get to it, the further it moves away.”
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The trek through the sand (or mud) may be longer than many had anticipated -- at the Federal Reserve, in the White House or on Wall Street. Growth has picked up several times, only to stall.

In 2009, Federal Reserve Chairman Ben S. Bernanke spotted “green shoots” suggesting a turnaround. He was premature. President Barack Obama in June 2010 started touting a Recovery Summer, only to suffer political embarrassment as stimulus spending failed to cure the jobs crisis. Another false dawn came and went in early 2011, as the labor market added about 200,000 jobs per month before slowing again.

Weakest Recovery

Measured from the December 2007 start of the recession, the rebound in production in the U.S. has been weaker than any recovery since World War II. After previous contractions, the economy has always topped its previous high within two years. This time it took almost four. Annual gross domestic product at the end of the third quarter was less than 0.1 percent higher, after adjusting for inflation, than its pre-crisis peak in 2007.

Job growth too has been more feeble than in past comebacks. Fewer Americans have work today than in April 2000, before the technology stock bubble deflated, even though the population has grown by 31 million. The gains in private-sector employment that reassure Rupkey have been partly offset by lost state and local government jobs, the result of plunging tax revenue and debts coming due.

Joblessness

October’s 9 percent unemployment rate was just 1 percentage point below its 2009 peak -- and more than 4 points higher than it was prior to the recession. The rate likely stayed at 9 percent in November, according to the median forecast of 79 economists surveyed by Bloomberg News ahead of the government’s report tomorrow.

Even with such discouraging news, the U.S. economy today is nowhere near as bad as in the Great Depression, when unemployment topped 20 percent and output shrank for three and a half years -- from 1929 into 1933 -- before recovery even began.

Still, some investors and analysts are batting around terms meant to distinguish today’s economic pain from the less distressing recessions and recoveries of past decades. “It’s the modern equivalent of a depression,” says Lacy Hunt, chief economist at Hoisington Investment Management in Austin, Texas.

Fisher Debt Deflation

What’s holding the economy back? Hunt, who has also worked on the staff of the Federal Reserve Bank of Dallas and as chief economist at HSBC Holdings Plc in New York, says the U.S. is stuck in a debt deflation. The term was coined in 1933 by economist Irving Fisher, a prominent Yale University professor, as he tried to explain the Great Depression. Fisher’s reputation never really recovered from his claim on the eve of the 1929 market crash that stocks had reached a “permanently high plateau.” And yet, his debt-deflation theory has gained currency in the aftermath of the collapse of credit markets in 2008.

Fisher describes a vicious spiral in which liquidation of debt slows the economy, cuts the value of assets, curtails lending, reduces employment and leaves businesses with excess capacity. The subsequent loss of confidence just makes things worse.

Americans are clearly in a sour mood, as Fisher’s theory would predict. Consumers are only slightly less pessimistic than they were at the February 2009 nadir of the financial crisis, according to the University of Michigan Confidence Survey’s expectations index.

Globalization’s Impact

The downward spiral describes well what the economy is going through, says Daniel Alpert, a founder and managing partner of Westwood Capital LLC, the New York investment bank. “It’s a classic Irving Fisher debt deflation.”

The effects of deleveraging are being made worse by excess production capacity due to globalization, according to “The Way Forward,” a report co-authored by Alpert, Cornell University law professor Robert Hockett and economist Nouriel Roubini of New York University. Over the past generation, almost 2 billion new workers from developing Asia and eastern Europe have joined a more integrated global economy, the report explains. That has lifted millions of people out of poverty. It has also disrupted the worldwide balance between supply and demand. Swapping well- paid American workers for lower-paid Chinese or Indians means a loss of demand overall, Alpert says. Workers who are paid less buy less.

While some economists express optimism about a growing consumer class in emerging markets, Alpert and his co-authors emphasize the flip side: the growth in labor supply and productive capacity as developing countries become bigger players in international trade.

Excess Capacity

In the U.S., almost 14 million men and women are unemployed, and factories are operating at 78 percent of capacity, which is below the low point reached in the recession of 1990 to 1991, according to Fed data.

Alpert says unemployment is likely to climb again and may top 10 percent in 2012. He, Hockett and Roubini argue that, to boost demand, the government should oversee the spending of $1.2 trillion on the nation’s crumbling airports, roads, bridges and energy grid, tapping both public and private funds.

That won’t happen, of course. Money from the $787 billion economic stimulus bill that Democrat Obama signed in February 2009 is mostly spent. Republicans won control of the House of Representatives in 2010 with promises to curb spending and tackle the federal debt. They favor fewer government regulations and lower taxes as the recipe to strengthen the economy.

Political Disagreements

Obama’s stimulus package didn’t create the jobs he promised, former Massachusetts Governor Mitt Romney said at an Oct. 11 debate among candidates for the Republican presidential nomination: “The right course for America is not to keep spending money on stimulus bills, but instead to make permanent changes to the tax code.”

Romney has also said Obama’s auto industry rescue was wrong. Yet Michigan has been creating jobs since General Motors Co. and Chrysler Group LLC emerged from bankruptcy with government backing in mid-2009. Bloomberg’s Economic Evaluation of States indexes, which incorporate data on employment, income and tax revenue, show that conditions improved more quickly in Michigan than anywhere else in the country except North Dakota in the two years ended in June 2011.

The struggling economy and the deep political divide in Washington are feeding off each other. Growth might pick up if politicians were working together, and cooperation between the parties might improve if the economy were healing more quickly.

Bernanke Surprised

Closing the government’s $1.2 trillion budget deficit would be easier if economic growth were stronger. If not for the recession, the U.S. likely would be collecting $600 billion more in annual tax revenue. For now, Republicans and Democrats offer mutually exclusive diagnoses of the economy’s ailments and preferred cures, and their squabbles -- such as the brinkmanship over the debt ceiling -- are hurting consumer and business confidence.

The Fed has been surprised that the economy has failed to gain momentum, Bernanke said during a Nov. 2 press conference: “The drags on the recovery were stronger than we thought.” In response, the Fed cut its 2011 and 2012 economic growth forecasts. The central bank sees the economy growing at an annual rate of 1.6 to 1.7 percent in 2011 -- more than a full percentage point below its June prediction -- and 2.5 to 2.9 percent in 2012.

The troubled housing market and consumer deleveraging have contributed to the weakness, Bernanke said, along with Europe’s sovereign debt crisis.

European Hazard

Demand in Europe is eroding as leaders struggle to keep the euro zone intact. Mario Draghi, who took the helm of the European Central Bank at the beginning of November, cut interest rates by a quarter point at his first policy meeting, while warning that Europe is on the verge of a mild recession.

Rupkey at Bank of Tokyo-Mitsubishi is among those who take solace in the positive U.S. economic data in recent months. Americans may be complaining to pollsters, yet they are still shopping, Rupkey says. Consumer spending in October was 2 percent higher than a year earlier, after adjusting for inflation, and shopping over the Thanksgiving weekend gave a preliminary signal that holiday sales will be strong. Rupkey expects pent-up demand for big-ticket items such as homes and cars to begin making itself felt.

Maury Harris, chief economist at UBS Securities LLC, a unit of UBS AG, also says the data show that economic fundamentals are improving in the U.S. His team ranked as the top forecaster of the U.S. economy in the January issue of Bloomberg Markets.

While Bernanke remains concerned about household debts, they have become less burdensome by some measures. Consumers were spending about 11 percent of disposable income on mortgage and credit card payments as of June 2011 compared with nearly 14 percent as the financial crisis gathered force in September 2007.

Debt Burdens

Ethan Harris, co-head of global economic research at Bank of America Corp., doesn’t see that data as grounds for optimism. When the economy returns to normal and the Fed begins raising interest rates, he says, “these debt burdens are going to zoom back up again.” He expects the jobless rate in 2013 to be higher than today.

Household debt peaked at $13.9 trillion in mid-2008. After three years of repayments and write-offs, consumer obligations have been trimmed to $13.3 trillion, down just 4.6 percent from the high, according to the Fed. In the second quarter, the most recent data available, consumers made less progress whittling down their debt than in any quarter since the deleveraging began.

Chronic Ailments

Even if the danger of a new recession has eased, the economy has chronic ailments that defy easy solutions -- and have spawned the Occupy Wall Street protests in New York and elsewhere. The income of the average American household is less than 1 percent greater than it was in 1989.

Measured another way, the current era has been almost 10 times as damaging to household balance sheets as the mid- to late 1970s, generally regarded as a pretty miserable period for the economy. During the past six years, household net worth relative to disposable income has fallen by more than 20 percent, according to Fed data. During a similar span from 1973 to 1979 -- years that encompass both of the Middle East oil shocks, peak inflation above 12 percent and the address by President Jimmy Carter that became known as his “malaise speech” -- the ratio fell just 2.4 percent.

“We’ve had a recovery for 21 months, technically, but the standard of living has continued to decline,” says Hoisington’s Hunt, whose firm oversees $5.7 billion. “So the recovery is very incomplete,” he says.

Wounded Economy

The risk now is that a wounded U.S. economy gets hit with another shock -- this time coming when politicians in Washington can’t agree on a response and central bank officials already have deployed their most-effective tools. (The Fed’s benchmark interest rate has been near zero for three years.) Ripples from Europe’s sovereign debt crisis or some other disruption to the financial system could do the job.

“The worst-case scenario is that we allow the economy to sit in this non-recovery for so long that something comes along and causes that second recession,” says Ethan Harris, a former New York Fed staff economist. “Accidents happen. And if you’re growing at 1 to 2 percent, you’re just waiting for bad luck to hit.”

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