“Who is gonna make it?
We’ll find out in the long run
(in the long run)
I know we can take it
If our love is a strong one
(is a strong one)
Well, we’re scared, but we ain’t shakin’
Kinda bent, but we ain’t breakin’
In the long run
Ooh, I want to tell you, it’s a long run
In the long run
In the long run”

From The Eagles song, The Long Run

“In the long run, we are all dead.”

Economist John Maynard Keynes

So how should we view the current state of the economy? Should we be optimistic like the Eagles or join the disciples of Lord Keynes in the pessimists camp? The US economy, despite the improving economic statistics, remains in recession and predicting a robust recovery would seem to be unrealistic in the extreme. And yet the contrarian in me feels uncomfortable adopting the mainstream view that this recovery will be meek and mild like the recovery from the last recession. So is there any reason to believe that a sharp recovery is in our future? The answer is an unequivocal yes….and no. Yes, over the next couple of years we could see a sharp recovery from the credit market, government induced cliff dive of the last 9 months. And no, in the longer term, the US economy is likely to produce growth that is less than the long term average of roughly 4%.

First let’s take a look at the trajectory of the developing recovery. The recovery in economic activity has been steady over the last few months and it seems likely to continue. The housing market that was the proximate cause of the recession is slowly healing and if past is prologue, the recovery may surprise on the upside. Housing starts are very volatile and the current rate of building cannot last for long or we will face a shortage - yes, shortage - of housing sometime in the next few years.

Even in the slow recovery of the early 1990s, housing starts rose 62.5% (800k to 1300k) in the first 15 months after the bottom. The recovery this time has the potential to be even larger because the depth of the falloff has been greater. The key to the rebound is population growth and new household formation. The US population is growing approximately 2.7 million per year:

Based on Census information, new household formation averages roughly 1.4 million per year, but since the economy is in recession it will likely be slower than that. Excess housing inventory (inventory over average levels of the past), by my estimation is somewhere 700,000 units. I base that on the inventory of new single family homes built for sale, inventory of vacant rental units, inventory of vacant existing homes and a fudge factor for second homes that may be put on the market due to the financial circumstances of the owner. (I got all this information from the Census Bureau but it wasn’t easy to find or link it all; feel free to visit the Census website and tease it out for yourself). Even if you cut household formation in half, the excess housing inventory will be absorbed in 1 year or less. 

Remember too that the vast majority of the overbuilding was concentrated in a few states - California, Nevada, Arizona and Florida - so that is where the vast majority of the excess inventory exists. It seems possible that other areas that weren’t as overbuilt may start to see a need for more building sooner rather than later. The most recent report of new home sales showed a divergence in the sales trends. Sales rose 28.6% in the Northeast and 18.6% in the Midwest while sales in the South were down 8.5% and up just 1.3% in the West.

So, it seems likely to me that housing starts will start to pick up soon and should, over the next year get back to a level near the 1,000,000 level. That would be a rise of about 100% from current levels. Since it takes 6-9 months to build a house, starts will have to pick up very soon. Housing should be adding to GDP sometime this year.

Next, let’s look at auto sales, another area of worry. Auto sales have averaged roughly 14 million units over the last 30 years and are now annualizing at about 10 million units.

There are a number of factors which I think could lead to higher sales in the near future. First of all, the average age of cars registered in the US has been rising for quite a while and is now around 9 years. Second, the number of cars scrapped this year will probably exceed the number bought by 4-5 million. Auto industry research firm RL Polk is forecasting a drop in total car registrations this year for the first time since WWII. The number of cars scrapped last year was around 14 million so if sales are only 10 million we’ll see a drop in total registrations. Finally, the recently signed cash for clunkers bill will provide a $3500 or $4500 incentive to trade in a low mileage vehicle for a high mileage one.  

Two factors are required for these sectors to rebound - income and credit. Despite the numerous anecdotal reports of tightening credit, the Fed’s many programs aimed at freeing up credit are having an impact. Fannie Mae, Freddie Mac and the Fed are all buying mortgages and while rates have ticked up recently with the 10 year Treasury note yield, they are still historically low. With the TALF program and the governemnt bailout of GMAC, there is also ample credit available for the auto market. Buyers will have to have better credit and larger downpayments, but credit for the creditworthy is available.

Real Estate Loans

Non revolving Consumer Credit

Despite the rising unemployment rate, real disposable income is still rising as well:

So, with rising disposable income and credit available, it seems there is no reason that home construction and automobile sales cannot rebound to their long term averages. If these two sectors can recover to near their long term averages, the rebound in GDP will be substantial. Housing has been subtracting roughly 1% from GDP for the last two years and declining production of automobiles and parts subtracted at least 1/2 % from GDP since Q4 2007.

Another large contributor to the decline in GDP over the last two quarters has been the drop in inventories. Final domestic sales of goods and services fell 5.4% in the first quarter and businesses responded by liquidating inventory, laying off workers and delaying investments. Based on the preliminary numbers, it looks like final sales will be flat in the second quarter, removing a big drag to GDP. In addition, any uptick in final sales in Q3 and Q4 will likely mean higher production as inventories are lean on an aggregate basis. Business investment also seems to be returning to a more normal pattern. Durable goods orders have risen 3 of the last 4 months and the last report showed a 10% rise in non defense capital goods.

So, in the short term it seems that there are good reasons to believe (hope?) that a rebound could be quicker and more robust than most think. The recent rise in commodity prices would also seem to support that view. What about the longer term though? Is there any reason to believe that when this episode passes that the economy will return to its long term growth pattern? Can the economy grow fast enough to justify the massive government deficit that is being incurred to fight the recession? Unfortunately, I think the answer is no.

The problems with the US economy have built up over many years and are unlikely to be solved in a short period of time. Debt is the root of the problem and while the Fed may be able to engineer a recovery in the short term, long term health will only return when the debt has been reduced to more manageable levels. The global imbalances that caused the problem have not gone away. The basic problems with our economy are: excessive consumption relative to investment, a low savings rate and excessive debt:

 Total Domestic Debt as a % of GDP

Savings Rate

Personal Consumption as a % of GDP

Investment as a % of GDP

If you look at the charts above it seems obvious that our problems didn’t start recently. The savings rate started to decline in the early 80s and never recovered. The other factors are more cyclical and the interaction of the three variables will require more explanation than intended for this economic update. I am working on a longer research project that explains the interactions that I will publish later this year. For now, I want to concentrate on the more recent period.

The rise in consumption that occurred in the late 90s was fueled by the internet bubble which was a product primarily of Federal Reserve policy. When the bust finally arrived in 2000, one would expect, as in the past, that consumption would fall back to pre boom levels, investment would rise and the economy would recover in due course. But that wasn’t allowed to happen. Instead, the Alan Greenspan led Federal Reserve cut interest rates to rock bottom levels and left them there for “an extended period” as they put it in their press releases. This had several effects.

The artificially low interest rates allowed consumption to continue at the previous, unsustainable, rate. Rising home prices and easy lending standards allowed consumers to tap the equity in their homes and continue to spend even though their incomes were not rising. Investment, if you can call it that, was funded by borrowing savings from abroad and diverting it into housing through various intentional government policies (think Fannie Mae, Freddie Mac and CRA). Greenspan in attempting to thwart the natural healing process of the needed recession after the internet bubble, inflated a housing bubble to replace it. The diversion of investment into housing meant that other more productive types of investments were ignored. It is those investments that would be sustaining us now, but they weren’t made. Instead we have too many houses.

Recessions are a needed process of reallocating capital, both human and money, to more productive uses. The internet boom obviously was a massive misallocation of capital to communications and information technology. If the recession had been allowed to run its course, consumption would have fallen, savings would have been built up and while that was going on, entrepeneurs would have had time to make decisions about how to invest in the future. Instead, the savings was discouraged by low interest rates and rising house prices so the necessary investment capital was not accumulated. Entrepeneurs were not given ample time to come up with new ideas in which to invest.

The same process that should have happened after the internet bust, needs to happen now. Unfortunately, this needed reallocation of capital is being thwarted once again. The Fed’s response has been to once again reduce interest rates, this time to basically zero. While savings at the individual level is rising out of necessity, the increase in the government deficit is offsetting the savings of the private sector. It is national savings, including the government, that needs to rise so we can build up the capital needed for the next expansion. While Fed policy is probably appropriate at this time to prevent a destructive deflation, fiscal policy is shaping a recovery that once again will not be sustainable. In the last recession it was mostly the Fed that shaped the recovery; in this one it is fiscal policy.

That’s not to say the Fed hasn’t made mistakes in this recession. Their role in the various bailouts has further misallocated capital and placed them in a position that will make it difficult to unwind their monetary expansion when the time comes. They have expanded their balance sheet (increased the money supply) by buying mortgage securities, Treasuries and Agency securities that will be difficult, if not impossible, to unload when the time comes. If they can’t contract their balance sheet at just the right time, the result will be massive inflation. For now the excess reserves they’ve created in the banking system are not being lent out but rather are residing at the Fed earning interest:

If the banks lend out these excess reserves, it will multiply through the economy and we’ll get another unsustainable boom. The Fed will need to start removing the excess reserves before that happens or the result will be inflation. The way they normally accomplish that is to sell Treasuries that are on their balance sheet, but there aren’t currently enough Treasuries on their balance sheet to offset the accumulated excess reserves. Furthermore, it seems unlikely that they would want to sell Treasuries at the same time the Treasury is selling new bonds to fund the budget deficit. So what will they sell? Mortgage securities? Not likely. That would cause mortgage rates to rise and kill any recovery in housing. Agency securities? Not likely. First of all, there’s not many buyers for Fannie Mae and Freddie Mac paper right now and it would also hurt the mortgage market since Fannie and Freddie are funding the majority of new mortgages right now.

The only alternative will be to raise interest rates and the rate they pay on excess reserves, but this presents other problems. Will it be politically feasible to raise interest rates when the government is running massive deficits? It seems unlikely and it should be remembered that Bernanke’s term is up at the end of this year. Will he get reappointed if he is raising interest rates? I think it more likely that Obama would appoint someone willing to accomodate his spending plans such as Larry Summers. The bottom line is that it will be very difficult for the Fed to contract their balance sheet when the time comes.

How will we know that monetary policy has become inflationary? All we have to do is watch the value of the dollar. The inflation after 9/11 that caused the housing bubble was clearly seen in the value of the dollar:

The dollar has recently started to decline again but as yet is not that worrying. Commodity prices have risen, but at this point that seems to be driven by demand rather than monetary policy. If the dollar starts to fall rapidly, we will know that the Fed has lost control.

Fiscal policy is also playing a major role in this recession. In the last recession fiscal policy also played a role through tax cuts but I see those as less damaging than government spending. The proper response to the last recession (and most recession for that matter) is to reduce taxes, reduce government spending and run a monetary policy that is just loose enough to prevent a large deflation. That would also be appropriate policy right now. Unfortunately, we seem to be going in the wrong direction on fiscal policy. Taxes are set to rise and spending is going through the roof. 

Fiscal policy is also distorting investment through spending and tax policy. Favored projects such as alternative energy get tax credits and direct spending. These investments would not come forth naturally from the private sector because they are econoically infeasible. These types of politically directed investments are notoriously inefficient and in this case will also raise the costs of all other industries. Any jobs created in the “green” economy will come at the expense of jobs in other sectors. If the experience of Spain is indicative, it will actually produce a net job loss.

Much of the rest of the expansionary fiscal policy is spending that will start in earnest after the recovery has already started. Government spending on anything takes time to happen, but infrastructure spending is especially difficult to do quickly. Most of the spending will happen in 2010 and 2011 by which time I expect the housing and auto markets to be in recovery. The government borrowing and spending will be competing for workers and materials at the same time as private activities and will likely just add to inflationary pressures.

The recovery efforts of the government will just reduce the long term growth outlook. The government will consume a much larger portion of GDP than it has in the past and Fed policy seems very likely to cause future inflation. Both policies have been shown through experience to produce lower levels of growth and higher levels of unemployment. The US does not occupy some special economic sphere and if we continue to follow these policies we will likely get similar results. It seems likely that better economic performance and more attractive investment opportunities will be found in countries pursuing more pro growth policies.