Outlook for the Economy in the Coming Year
Prof. Steven Kyle
December 7, 2004
0. On Crystal Balls and Economists’ Projections
As ever, forecasts work well when current trends continue, they work poorly to predict turning pts. (When you most want accuracy)
- longest expansion in 90's - 8 years
- such figures only hold until they don’ t
I. How is My Crystal Ball This Year? At the end of last year I predicted 4% growth this year - That may be a little high but probably isnt seriously off. (Third quarter this year saw 3.7% growth) The year before I was predicting growth of from 1 -2% but it ended up more like around 3%. I was wrong in thinking that consumers would stop accumulating debt - They just kept right on going.
II. The Past Year
A. NBER reported November 2001 start to current expansion. Note that the determination of an end was delayed until July 2003. This was because GDP, personal income and retail sales surpassed previous peaks while unemployment remains stubbornly high and industrial production did not pick up until the third quarter. The mixed nature of the evidence led the NBER to wait before making a decision. Evidence is still mixed though several indicators still point up.
B. Signs of recovery
- Employment - The Unemployment rate peaked at 6.4 but is it stalled? The unemployment rate is down to 5.5% from 6.4, but this leaves out all of the discouraged workers. The absolute number of jobs is still more than a million lower than it was 3 years ago. If we factor in population growth, we are way behind where we would like to be
- Industrial Production - OK so far this year, but Manufacturing orders down in Sept.
- Wholesale/Retail Sales -The Real Question is how much debt those consumers will take on if the overall wage bill stays flat
- Personal Income - Unemployment may have turned around, but average hours worked are still pretty low. The overall wage bill is likewise stagnant, meaning that consumers don’t have a lot more money to spend. Virtually all of the increase in income we have seen in the aggregate statistics has gone to profits and not wages. This dampens the multiplier effects we can hope for. Personal savings are at an all time low of 0.2%. That means if you have takehome pay of $5,000 you are (on average) saving just $10 a month. Consumers are piling on lots of debt. This wont go on forever.
III. Current Policy Stance
A. Alan Greenspan keeps rates low, but they are rising - The quarter percent increases are the least we could have expected given the inflationary signs already evident
- What will his next move be? undoubtedly higher, but the only real question is how fast rates will rise. They should go up to 2-3 percent over the next year, depending how strong the economy looks
- Greenspan worries about deficits In testimony in November he openly worried about federal deficit and current account deficit - something I have been talking about in outlook conferences for quite some time - I am glad he is worried and am willing to forgive his amnesia that he was a major supporter of the tax cuts that got us into this fix if he will do the right thing now. Major fallout of this is that interest rate increases will continue.
B. Fiscal Policy
- Short term outlook
-The biggest stimulus in history
Last fiscal year came in at 413 billion - Discretionary spending has grown at more than 12% - this year even bigger
- Aimed at high income earners, defense and paying the interest on the debt (more to rich than poor)
Note that the lowest 4 quintiles have received most of what they will get already - Lots still to go for the richest 20%. Interest on the debt is now almost a quarter of all spending. Lots of money gone to defense and the war - 79 plus 87 billion so far in supplementals plus more to come
- State and local taxes and fees continue to offset federal cuts for middle and lower brackets
The Feds haven’t helped the states as usually happens in recession. They also have added mandates for states - The result has been steep increases in state and local taxes, in many cases more than offsetting federal cuts. New York has suffered particularly from this.
- Long rates still high
The very low interest rates from the Fed together with the extremely bad long term fiscal outlook twist the yield curve to give low short term rates and high long term ones. Note that even though they look low in nominal terms, with inflation also low real interest rates are at higher than average historical levels..
- Long term outlook
- The chickens are starting to come home to roost on our fiscal train wreck
Bush won the election and immediately issued statements to the effect that he will push for making the tax cuts permanent, along with AMT relief and other promises all of which will contribute to bigger deficits
V. The Republicans won - What does this mean for the economy?
A. Notice that the dollar immediately tanked when it became clear Bush would win (continuation of existing trend)(immediately means at around 2AM on Wed. Nov. 3)
- We need the foreigners to fund our deficits
- In the past year this has come to mean “we need the central banks of China and Japan to keep buying our paper at a rate of $2 billion/day”
- I hope you all took my advice from last year and bought euros those who did got between 20 and 25% return on euro stock funds - now I am personally going for a euro exchange rate play - as close to a no brainer as there ever is. Already 5% in the black since the election. If the federal government continues to heedlessly borrow money, there is a danger that foreigners will tire of lending it to us, provoking an exchange rate crisis, higher interest rates and recession
B. Having won the election, congressional chairmen want their pet legislation approved - That inevitably means more spending
Notice that the first order of business after the election was a $388 billion spending bill that included, among other things, a yacht for the president and Puxsatawny Phil Groundhog Hall of Fame.
C. Social Security reform?
first thing to note is that SS is OK until at least 2040 ( and 2050 according to CBO) - so even if we wait a few years we can still get away with a relatively minor fix - note that the retirement age has stayed the same since the 1930's even while life expectancy has increased by more than 10 years. If we reverted to a pay as you go system after 2040 or 2050 beneficiaries would still get 75-80% of benefits that they were promised. To suggest that the system will collapse is just wrong. Another way to take care of the gap would be to repeal the tax cut on people earning over $500,000 a year.
On privatization, the proposal is to take about one fourth of current payments and divert them to private accounts. This would at first blush imply a cut of one fourth in payments to beneficiaries if there is no other funding source identified. However, at the same time it is promised that there will be no cuts in payments to current retired people. This necessarily implies cuts BIGGER than 25% on those who retire later on. So, those of us who are too young to be protected from the promise not to cut current benefits, but too old to get much accumulation from a private account are truly screwed.
As for the young folks, is this a good idea for them? Well it might be or it might not be. You have to believe that the private accounts will grow fast enough to overcome the high fees that are likely to be charged for managing the accounts. You also have to believe that you wont be retiring in a year that looks like 1929. You also have to believe that people wont be allowed to withdraw their money early or many will and will then be caught short when they retire. You also have to believe that people wont make stupid investment decisions and then be caught short. Bottom line? Under reform like this, the individual bears the risk and not the govt. But wasnt having the govt. bear the risk the whole idea in the first place?
Latest proposal from Washington is to cover the $2 trillion additional (approx) financing gap that would be caused by privatization by borrowing. It is claimed that this wont affect the deficit because it will be kept “off budget”. This reminds me of when my kids were 2 or 3 years old and thought that if they covered their eyes so they couldnt see me, then I couldnt see them either. This kind of nonsense may fool congressmen and maybe even the press, but it wont fool capital markets. Our long term deficit picture will start becoming a short run one, and we will hit the wall that much sooner.
D. Tax reform?
I actually can imagine a tax simplication I would like. The republicans have their own version of a flat tax, but I would do two things:
Flat tax of about 25% for all income over 100k. All deductions eliminated except for home mortgage, state tax deduction and medical expenses. Eliminate the cap on income subject to social security tax while lowering the overall rate to whatever will bring the program into balance
But this is a topic which in my opinion is going nowhere. Not the republicans’ version, not mine, not anyone’s. NOTHING is more guaranteed to piss off every interest group under the sun than taking away their tax break. The Dems after the election said they would be willing to “look at” the presidents suggestions on this topic. I heard that and said to myself “Yeah, look at them and then run away from them while pointing and laughing”
V. Where are We Going Now?
A. The Case for Happiness
- Good GDP figures but slower than the beginning of the year
Third quarter results are OK but not stellar
- Employment picking up (some)
Jobless claims seem to be improving though there is as yet lots of slack in the labor market
B. The Case for Caution
- If Consumers are Going to Spend, Where Will They Get the Money?
- Employment numbers - the pessimistic view
The employment to population ratio is very low - Lots of people are without jobs and the jobs many have arent very high quality. More importantly, most of the increase in income in the past year has gone to profits and not wages, limiting the money people have in their pockets
- Those puzzling productivity numbers
Though output has grown, hiring has stayed flat. This necessarily implies that productivity has gone up. (Note that productivity is never measured directly - it is always inferred from production and employment numbers - hence there is always the possibility that there is a measurement error somewhere). Either employers will have to start hiring soon or consumer spending will cool off - Current trends can’t go on indefinitely. Recent research shows that much of the change in employment in this business cycle has not been cyclical in nature but has been the result of long term restructuring of the economy. That is, many of the jobs lost during the recession aren’t coming back.
- Those troubling consumer debt numbers
They have just kept on going up and up. Lower interest rates mean that monthly payments don’t have to go up even though debt does. But this can turn into an unhealthy backlash when rates eventually do go up. As Herbert Stein said, “Things that can’t go on don’t” (or something to that effect)
- Housing - The Peak is here or just past (sell now)
Housing usually peaks 1 - 3 years after the market - or around the time interest rates start back up again. This is happening now. An added factor here is that housing is more directly connected to consumer spending than it ever was in the past through the home equity loan market.
- P/E numbers look more reasonable than a year ago but still high
They are lower than at the height of the bubble a couple of years ago but with the P/E of the S&P 500 in the low 20's they are predicting higher bond yields and/or somewhat lower?? stock prices. It is also still well above the historical average. But the NASDAQ P/E is still in the neighborhood of 30 even when you exclude all of the negative numbers for those companies not making a penny
- Will Business Investment Drive the Recovery?
- Capacity Utilization - Still in the 70's
- If they were confident they’d be hiring more
- Still, the latest business investment data is good
- Will the Foreigners Help Us Out?
- Oil at around $40 - 50 - No relief in sight
- Foreign Business Cycle News - China puts the brakes on while Europe is mixed - Germany low growth.
- The Exchange Rate - One way bet - With half a trillion new dollars going out into the world every year - about $2 billion every working day, the dollar is likely to fall more since the long term outlook is for a worsening and not an improvement of this situation
V. Opinions from Where I Sit
I expect the rebound to continue but at plodding pace. The fourth quarter figures are likely to come in with growth lower than the first half of the year. Stimulus from the Federal government will continue though more heavily biased toward upper income brackets, thus muting its expenditure effects. The big question is whether interest rates will rebound substantially, creating a sharp retrenchment.
There is some evidence of inflation beginning to be apparent but there is little danger of a major spike in the very near future, especially given the continuing slack in the labor market, and the low levels of capacity utilization. Nevertheless, the continuing very low interest rates (though on the increase) will provide continuing pressure. Another major question mark is the exchange rate. Should the dollar go down sharply, some degree of inflationary pressure will result. Finally, oil prices are a big question mark - they are currently very high but could go even higher - All it takes is one guy with a rocket propelled grenade to cause them to lurch upward.
P/E levels are finally back to something approximating reality. But having said that, they are nevertheless on the high side of what would be considered “normal” in historical terms. If the economy continues to plod, its hard to see a big boom in stocks. It’s particularly hard to see if interest rates are on the way up while oil prices remain high and could go higher.
It is likely that this bubble has reached its peak now that interest rates are starting back up. Given the lack of inflation, we may see an actual decline in house prices. There are already signs of slowdown in the market. Housing starts in April went down and the rise in rates since then coupled with the expectation of more to come should prove a damper as well.
C. Interest Rates
Alan Greenspan wants to raise rates slowly His pattern is to do it a quarter percent at a time. He has said he will continue to raise them steadily as necessary (and he said it WAS necessary). But if there is a spike in inflation or a drastic drop in the dollar he may have to be more aggressive.